To construct a house, builders need a firm foundation. For a financial empire, Wall Street wizards need only greed, gullibility, and optimism.
The subprime empire began with a tangible structure: a house. For the buyer, that house was a home. It represented upward mobility, a hedge against inflation, a stake in the community. As home prices rose, millions of renters, particularly those with less-than-stellar credit, yearned to seize the American dream. But traditional banks shunned "credit-impaired" borrowers.
These borrowers were ripe for a deal that was too good to be true.
Enter the subprime lenders—willing to take the risk on riskier borrowers, for a price. Thus far the tale testifies to America's entrepreneurial spirit. New mortgage banks specializing in subprime loans sprang up. Their panoply of products (teaser rates, no down payment, variable rate, interest-only, negative amortization) turned millions of renters into homeowners. Subprime lending soared from near 0 in the early 1990s to 20.1 percent of all originations in 2006.
The subprime lenders hawked their mortgages with glitzy ads, Internet quickie deals, and microprint caveats. More crucially, the lenders relied on mortgage brokers to find the loans. The brokers made money when borrowers signed on the bottom line—regardless of the long-term prospects of owners' solvency. If the borrower defaulted, the broker bore no responsibility. The default was somebody else's problem.
In the early days of the subprime market, that "somebody else" was the lender. If a borrower defaulted, the bank recouped its investment by foreclosing on the home. The house represented collateral that, ideally, would reimburse the lender. Thanks to the innovative capital markets, however, the risk of that default shifted. The new "somebody else" was the international cadre of investors, who recognized the possibilities of profit in this market.
The dizzying escalation in home prices masked the shaky underpinnings of this empire.
Investors, frustrated with single-digit returns, looked longingly at a market that seemed to promise endless double-digit returns. Typically, an investor bought a bundle of subprime loans from a mortgage bank. Investment banking houses such as Bear Sterns organized hedge funds. The Industrial and Commercial Bank of China bought $1.23 billion in securities backed by such mortgages.
The chance for profits was huge. But so was the chance for loss.
Cracks In The Foundation
As long as house prices were escalating, all parties thrived: Homeowners got their dream, brokers got their commissions, lenders got their return, investors got rich. If a homeowner could not make the monthly payments, particularly after the grace period of the low opening rate, he could sell the house, maybe make a profit.
The dizzying escalation in home prices, however, masked the shaky underpinnings of this empire. When prices leveled, or even fell in many regions, the empire started to crumble.
The cooling of the hot market was inevitable. Expectations aside, housing prices could not continue to outpace incomes. But builders had overbuilt, creating large inventories of unsold homes. Houses remained on the market for longer and longer. Analysts expected the eventual cooldown.
Recent homebuyers felt the first draft. Those no-down payment "adjustable" mortgages proved toxic. After 2 years (sometimes less), new homeowners faced steep increases in monthly payments. Owners who counted on selling their homes as an exit strategy were trapped with bills they could not pay. Banks were saddled with homes they could not easily sell.
The subprime mortgage company, faced with too many unpaid loans, went under. And the hedge fund—the party holding thousands of these mortgages— suffered the kind of losses that shook the economy.
Throughout the financial markets, all investors grew leery of extending any credit.
Back To Basics
Today, in economists' jargon, we are undergoing a "market correction." Investors who, like the subprime borrowers, thought they had a wondrous deal are once again examining the basics behind the transaction and are no longer relying on the blurred vision of the credit rating agencies. Lenders are requiring better credit and more documentation. Brokers are facing governmental regulations. Borrowers must once again save for a down payment.
This political season, candidates are calling for action, but shying away from a "bailout"—an understandable conundrum, since government is sailing between Scylla and Charybdis as it plots "solutions." Tighter credit will eliminate the shakiest loans, but will shut off many credit-impaired borrowers who truly could make the payments. In fact, today's credit crunch has exacerbated the crisis, by making it hard for the homeowner with a toxic subprime mortgage to refinance to a fixed-rate product or to sell his home. As for bailing out the hedge funds, whose executives earned million-dollar bonuses in the heyday of this bonanza, the government, eager to bolster the economy, must be leery of rescuing Wild West investor/risk-takers.
As this empire crumbles, the people at the base—the waitress in Detroit, the laborer in Sacramento, the daycare worker in Boston—will lose not just the dream and security of a financial asset, but their homes.