The Other McCain

"One should either write ruthlessly what one believes to be the truth, or else shut up." — Arthur Koestler

‘We Don’t Have the Mortgage Problem That We Initially Thought’

Posted on | March 1, 2011 | 5 Comments

Liberal wonk Robert Kuttner continues promoting a once-popular idea of how to deal with the mortgage crisis: “Write-downs” on loan principle (i.e., debt forgiveness) as a way to avert escalating foreclosures, bankruptcies and walk-aways. But there are several reasons that won’t work, and among the reasons named by Megan McArdle is this:

We don’t have the mortgage problem that we initially thought. We expected that foreclosures would be driven by resetting adjustable rate mortgages, i.e. higher payments. But with interest rates so low, the problems are on the income side. Either people took on more mortgage than they could afford, or their income has fallen, so they can’t afford the mortgage they have.  This is why most modifications are failing.

What McArdle is saying is that in late 2008-early 2009, when “write-downs” were seen as the solution, most policy wonks misunderstood the nature of the problem. The culprit wasn’t “balloon payments” or “predatory lending” or any of the other trendy explanations for the situation caused by the bursting housing bubble.

No, the problem was actually quite simple: People had borrowed more money than they could afford to pay back.

When the housing bubble was at fever pitch, 2003-06, rapidly rising prices in “hot” markets fostered the dangerous idea that it didn’t matter whether people could make their payments or not.

Normal lending standards were thrown out the window, because if one extrapolated the price-trend, the house that sold at $300,000 today could be resold for $325,000 in a year. So if the buyers couldn’t make their payments either (a) they could re-finance, reaping a windfall from the increase in assessed value that could be used as a temporary patch for the income shortage, (b) they could sell the house and at least break even, or (b) if the lender had to foreclose, there would be numerous potential buyers at a higher price.

“Win-win,” you see. That giddy spirit of generous lending, however, was dependent on prices continuing to spiral upward at the “bubble” rate. The collateral’s estimated future value provided a cushion against any income shortfall on the part of the borrower. Otherwise, the “no-doc” and “low-doc” loans — where there was little or no effort to document the borrowers’ income and other financial data — would not have been made.

People involved in the process — the real-estate agents, the loan originators and the middlemen re-selling these mortgages in derivative deals — were collecting transaction fees on every deal. The more mortgages, the more fees, and so there was a huge incentive to sell, sell, sell and loan, loan, loan. As long as the investment market was hungry for mortgage-backed securities, and so long as housing prices continued to rise, it was possible to overlook such messy little details as whether borrowers could actually afford their loan payments.

After it all finally fell apart in 2008, the problems left behind in the wake of the bubble were seriously misunderstood. A “loan modification” program for a relatively small percentage of  troubled mortgages could not begin to fix the larger problem and, as McArdle said, most of the “modifications” involved borrowers with such serious financial problems that they couldn’t really be helped by the program.

The only “solution” for the housing problem is, alas, the solution that liberals have consistently sought to avoid: Let the market take care of it.


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