8-31-07
Risk and Greed
You can’t hardly stick a microphone near a public official, stock market analyst, or economics professor these days without them spewing some elaborate theory about what went wrong in the mortgage, real estate and financial markets. To me, most of them come off like snake oil salesmen, with facts selectively chosen and interpreted to support whatever preconceived notion they’ve been peddling for years.
My theory is simpler. The problem in these markets was plain and simple greed. I know you’re utterly shocked that financial institutions could possibly be greedy, but it is true. (And by the way, there’s no tooth fairy.) Not that lenders and investors were the only offenders: home buyers were often equally greedy.
About Those Financial Institutions
Mortgage lenders’ greed was traditionally balanced by caution. They wanted profits, but they were lending their own money and worried about the risk of loss. The long-accepted criterion was to lend no more than 80 percent of a home’s value. The homeowner’s 20 percent stake meant, first, that the owner had something to protect and would be well motivated to do whatever it took to meet the terms of his mortgage. Second, real estate prices were unlikely to drop by 20 percent, so the collateral was expected to always be worth more than the amount of the mortgage. If the homeowner defaulted, the lender could still foreclose and come out whole.
The loan-to-value ratio was further protected because these were amortizing loans where part of each monthly payment went to interest and part to principal. Each month a little less went to interest due to the prior month’s pay-down of principal; the payment stayed the same, leaving a little more for principal. A loan which began at 80 percent loan-to-value would be 77.1 percent after three years, and 73.7 percent after six, even if the property did not go up in value.
And whoever heard of real estate not going up in value? (More on that later.)
Beginning in the 1980s, though, lenders mostly stopped lending their own money. A bank makes money by borrowing money from its depositors at a low (or zero) interest rate, and lending it to its borrowers at a higher one. This works well when both interest rates are stable. But interest rates soared in the late 1970s and early 1980s. Banks were paying out as much as 18 percent or 22 percent on one-year certificates of deposit, but they had made 30-year mortgage loans that were only bringing in 7 percent or 8 percent. This imbalance of rates and maturities put a lot of savings and loans out of business. The survivors found a safer way to make both mortgages and profits, called securitization. After initiating a loan, they package it with hundreds of other, similar loans and sell that package to investors. The bank makes its profits not from lending, but from fees: the initial fees paid by borrowers and the fees investors paid the bank to service the loans, i.e., collecting the payments, staffing the call centers and so on. It works rather like a casino, where management doesn’t care who wins or loses because the casino makes money whenever anyone wagers.
Ratcheting It Up
The only way fee income could grow was with increased volume. Not everyone could qualify for these conventional mortgage loans, so growth required making riskier loans. And risk tolerance demonstrably increases when it is not your money at stake.
Nobody said they were making high-risk loans. These were “innovative mortgage products” aimed at the “sub-prime” or “A- loan” markets. If you were to call them high-risk, the investors wouldn’t buy them.
Down payments were cut from 20 percent, to 10 percent, then 5 percent, 3 percent, and even nothing. Those buyers had little to lose if they defaulted, but lenders were not worried. After all, real estate prices kept going up and that would create equity for these buyers. Inflation would make sure of that, even if there were no genuine increase in value. Right.
Adjustable interest rate loans also flourished. A reasonable lender can offer a lower initial rate and payment on these loans since he is married to that rate for a shorter period. As the greed spiraled, “teaser” rates became standard. Interest rates were set way low for the first few years, with the potential—now widely realized—for vast increases at the first rate adjustment. Teaser rates just aggravated the risk that rates will go up to the point that the homeowner can no longer afford the payments. This was pooh-poohed: people will be making more money in three years (or whenever), and, of course, the house will be worth so much more by then.
The interest-only mutation of the adjustable rate loan also appeared. The initial monthly payment was even lower with no principal portion, but the proportionate increase after the teaser period is much higher.
You Can’t Cheat an Honest Man
As any con man knows, the victim has to buy into the conspiracy. The investors (or speculators, in some egregious cases) who bought these loan packages closed their eyes. They saw high yields, and “well, with constantly rising real estate prices....” They all had the financial education to know that returns that high must be inherently risky.
Home buyers were just as greedy. In many cases, they understood that there was risk, but did not believe it would apply to them since only a small percentages of loans go bad.
Which is true, but economic risk is a pretty subtle statistical concept. In a portfolio of 100 top quality loans, one or two might be expected to go bad, where in a portfolio of sub-prime loans the figure might be three or four. That’s still a pretty small fraction, but the risk is doubled. Moreover, those expectations have underlying assumptions: that loans will go bad based on the circumstances of particular borrowers, and not of the economy as a whole.
And guess what: Those assumptions were wrong.
A Brief Sermon
For people in the arts, being risk-averse in investing and home buying is particularly important. You have used up all your financial risk tolerance in your career choice. Even rich and famous actors don’t really know what they will earn from one year to the next. Your mail carrier—who will have a job till he retires and a solid pension after that—can take proportionately more risk than you can.
Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.
Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.