In Focus

October 29, 2007

What Caused the Housing Bust?

ince the cause of the current housing problem is on nearly everyone's mind, I thought it appropriate to give you our take on the situation at hand.

What caused the housing bubble was taking a good thing to excess, which resulted in leverage in reverse, or what people used to call a "run on the bank." As interest rates fell from 1995 to 2005, more and more capital found its way into housing, and the mortgage and housing business boomed. Lower rates meant more people could afford to buy houses. That was good. Unfortunately, it didn't take long for some people to figure out that with rates so low and lending standards loosening (think 100% financing), they could buy more than one house; some overzealous borrowers bought as many as nine or ten houses. As more money made its way into housing, prices for real estate went up — 20% a year for several years in some places. The higher prices created more equity, which was then used as collateral for still more debt. A housing bubble was under way.

Banks, hedge funds, and insurance companies were all too happy to fund the madness. They believed new "financial engineering" enabled them to transform these risky, lower-quality home loans (like the kind with zero down payment) made at the top of the market into AAA-rated securities. Let me explain how this worked. Wall Street's biggest banks would buy, say, $500 million worth of low-quality mortgages underwritten by a mortgage broker. The individual mortgages, thousands of them at a time, were then organized by type and geographic location into a new security called a residential mortgage-backed security (RMBS). Unlike a regular bond organized by maturity date whose coupon was paid by a single corporation, a RMBS was organized into risk levels, or "tranches." Thousands of homeowners paid the interest and principal for each tranche.

Debt rating agencies and other financial analysts believed these large bundles of mortgages were safe to own; the agencies and analysts theorized that because the financial obligation of a RMBS was spread among thousands of separate borrowers and organized into different risk categories, buyers of these securities would be protected against loss. For example, the mortgage broker that originated the mortgages would be on the hook for any early defaults, which typically only occurred in fraudulently written mortgages. After that risk padding, the next 3% to 5% of defaults would be taken out of the "equity slice" of the RMBS.

The "equity slice" was the riskiest part of the RMBS. They typically sold at a wide discount to the total value of the loans in this category, meaning that if defaults were less than expected, the equity slice buyer could make a capital gain in addition to a very high yield. Even if defaults were average, the buyer would still earn a nice yield. Hedge funds loved this kind of security, because the yield on it covered the interest cost on the money the fund borrowed to buy it. Hedge funds could make double-digit capital gains annually, cost-free and risk-free — or so they thought.

As long as home prices kept rising and interest rates kept falling, almost every RMBS was safe. On the way up there were very few defaults and everyone made money, attracting still more money into the housing market. For a long time, that arrangement worked well for everyone. Buyers of these securities did well and hedge funds made what looked like risk-free profits in the equity tranche for years and years. Financial institutions of all stripes were able to increase the size of their balance sheets by continuing to borrow against their RMBS inventory. That in turn supplied still more money to the mortgage market, which kept the mortgage brokers busy. The problem with all this was that long-dated liabilities (a 30 year mortgage) were matched not by reliable depositors, but by hedge funds that were themselves highly leveraged and subject to redemptions.

The cycle kept going — more mortgage securities, more leverage, more loans, more housing — until one day a marginal borrower blinked. We will never know who blinked or why, but somewhere out there, the "greater fool" failed to close off on that next home or condo. Beginning in about the summer of 2005 the momentum began to lose speed and then, imperceptibly, began to shift. All the things the cycle had going for it from 1995 to 2005 began to turn the other way. The leverage operating in reverse was devastating.

The first sign of trouble was an unexpectedly high default rate in subprime mortgages. The big jump in subprime defaults led to the first hedge fund blow-ups. As the "equity-slice" and mortgage securities collapsed, dozens more funds blew up. With the safety net of the equity tranche removed, the debt rating agencies downgraded these securities. The early downgrades and hedge fund liquidations had important consequences. Why? Because as hedge funds went out of business, they had to sell their RMBS and other collateralized obligations. That selling pushed the prices of those securities down, resulting in margin calls on other hedge funds owning the same troubled investments, which in turn pushed the other hedge funds to sell.

Very quickly the "liquidity" for these types of mortgage backed securities disappeared. There literally were no bids for much of this paper. The subprime mortgage brokers took a huge hit paying off the early defaults on their 2005 and 2006 mortgages. With the loans they held on their books marked down, no available buyers for those loans, no access to additional capital, and creditors demanding greater margin cover on the brokers' lines of credit, subprime mortgage brokers rapidly went out of business.

While under normal conditions the fallout from the failure of the subprime mortgage structure — which led to some hedge fund wipeouts and mortgage broker bankruptcies — might have confined itself to the subprime segment of the market, the new "financial engineering" caused the risk to spread. With Wall Street having wrapped together thousands of these mortgages from different underwriters, it's likely that hundreds of financial institutions around the world had traces of bad subprime and alternate mortgage debt on their books. Hedge fund investors quickly figured that out and asked for their money back. It was a classic "run on the bank," except today the function of the traditional bank has been spread out among several institutions: mortgage brokers, Wall Street securities firms, hedge fund investors, and banks.

Liquidity fears began to creep through the entire mortgage complex, not because the mortgages themselves were all bad, but because all the market players knew a wave of selling, led by hedge funds, was on the way. Nobody wanted to be the first buyer, however, because they knew there would soon be thousands more anxious and eager sellers. As a result, the market "locked up." Nobody would buy mortgage bonds, and everyone owning them needed to sell. Suddenly, huge losses were being suffered; the bonds kept getting marked down as hedge funds and other leverage speculators were forced to sell into a panic market.

Unfortunately for many, the market can be irrational longer than they can remain solvent. The party is over for most mortgage brokers. Something like 80% to 90% of them might be out of business by the end of the year.

— Michael E. Leonetti, CFP®, CFS, AIF®