What happened in the mortgage crisis ?
by SevenStrings, Mon Aug 18, 2008 at 03:26:31 PM EDT
This diary is about the housing crisis that we are now facing. A lot of virtual ink has been spilled on the topic by bloggers and economists who understand the problem better than I do. However, I have seen no reporting on an experience that I had, and which is quite relevant to how the crisis unfolded.
My wife and I bought our home well before the current crisis. The housing market was "hot" at the time, and interest rates were headed down. In the years that followed, we refinanced our house several times. In all cases, we scrupulously avoided pulling any money out of the house, and in all cases, we refinanced when we could get a better interest rate.
And what is unusual about this, you may ask ?
Well, it was simply this:
(a) we refinanced whenever we could get an interest rate that was even marginally (i.e., 1/8th of a percent) lower than the rate that we had.
(b) refinancing never cost us a penny. The net out of pocket cost to us was...Zero. Zip. Zilch. Nada. Zed.
(c) refinancing was a relatively painless exercise. The only things I had to do was email my broker with copies of our latest pay-stubs, show an appraiser around, and spend 30 mins with a notary public that would come to our house with a stack of documents.
Our broker took care of it all.
And how is that possible, if you did not pay anything out of pocket, you may ask
Those of you who have refinanced a home will point to several fees, and escrow charges, taxes, and other charges that simply cannot be avoided in any refinancing transaction. These charges are in addition to any "points" that a bank might charge (points are upfront fees that a bank charges in exchange for a lower interest rate). A bank can forego it's points (and charge you a higher interest rate), but an escrow officer cannot afford to not get paid in exchange for the title check he/she must conduct.
So where is all this money coming from ?
Well, it is simple really.
The bank pays a commission to the mortgage broker as a fee for landing that loan. On a loan made to a person with a job, and with good credit, the fee is around $5,000 (for a $500,000 loan). On "sub-prime" and "Alt-A" loans of the same amount, it can be substantially more ~ $ 20,000.
Our mortgage broker figured out how to game this system... honestly and ethically. The transaction fee for each refinancing deal amounts to $2000 (this includes all the fees paid to the escrow officer, the appraisal charges etc.). She paid those fees out of the commission she would have made. Thus, her net commission per transaction was $3000, instead of $5000 (in reality, most of her clients are in the Bay Area, so her commissions were substantially large anyways). She made a smaller commission per transaction.
But she had many more transactions. Since I (her customer) got a reduced interest rate at no cost to myself, I was inclined to refinance with her again.. and again... and again. And she was quite popular... with thousands of happy customers like me.
Now, consider the macroscale impact of all this. Consider the nice family owned bank that makes a loan to me, and writes a $5000 check to my broker. The bank will recoup that $5000 cost if I hold on to my loan for a long enough period of time, and keep making regular interest payments to them every month. But, under the present circumstance, I have no motivation to hang on to my loan ~ oftentimes, I would refinance after making only 1 monthly payment. Thus, the nice family owned bank<sup>TM</sup> effectively loses $5000 every time I refinanced... and I refinanced quite a few times.
And what does all that have to do with the housing crisis ?
Well, the answer to that lies in the manner in which housing transactions are conducted and rewarded.
The bank paid a commission to my broker for originating a loan with me. We (our broker and us) gamed the system such that it was a win-win proposition for us, and a lose-lose proposition for the bank.
Likewise, the banks bundled loans like ours (and others) into various collateralized debt obligations (CDOs), and resold it to other entities... for a bonus. They, too, gamed the system such that it was a win-win proposition for them, and a lose-lose proposition to those that bought the CDOs.
At every step of the way, we generously reward work that does not increase our quality of life ~ at least not beyond a certain point. For instance, the same house can be bought and sold 17 times in a year. The first time, it increases our quality of life ~ perhaps a family is downsizing, and wants to move to a smaller place. They move out, and a family with children moves in... and everyone benefits. But if it happens 17 times in a year, it does not benefit anyone.
And the way we have set up our system of rewards in the housing and capital markets, we encourage people (such as myself) to game the system in a way that serves no useful purpose... and that leaves us at the mercy of the giant pool of money that now resides overseas.