A Brief Anatomy of the Housing, Mortgage and Credit Crises

The Fed established historically low interest rates in the wake of the 9-11 tragedy, a policy that unquestionably bolstered the American economy. During these benign credit conditions, the national homeownership rate approached 70 percent--an admirable achievement, considering this statistic had hovered around 65 percent for over a decade. Some ambitious Americans even achieved the dream of homeownership several times over. This flurry of activity in the nation's housing markets also fueled an unprecedented growth in house prices, and consumers feverishly tapped into this newfound wealth to finance, well, more consumption. Things were going well. We were winning a different war on terror: widespread fears of a serious economic downturn had been averted.

But enough about the miracle that is the American consumer, let's shift our focus to the mortgage finance industry. As demand for mortgage products soared to record levels, lenders increased their reliance on third-party originators--a move that, coupled with technological innovations, enabled mortgage companies and financial institutions to streamline the lending process and expand into new markets. Unfortunately, this growing emphasis on wholesale and correspondent production also shifted critical functions to outside parties, heightening exposure to potential risks. Not only did these intermediaries usually lack the internal control structures of a larger institution, but these parties also had little accountability for the subsequent performance of their originations: Brokers and conduit lenders are compensated according to volume and do not actually bear the credit risk of their lending decisions. Needless to say, down the line, these risk factors would have serious implications for credit quality.

The mortgage finance industry sewed the seeds of its most recent implosion in 2005-2006, when affordability issues in the nation's overheated housing markets threatened loan production volumes. As house prices began to outstrip incomes in many areas, demand for mortgage products showed signs of foundering. Did lenders and financial institutions scale back operations in anticipation of the seemingly inevitable contraction? With liquidity flowing in through securitization, short-term profits proved far too enticing, especially for an industry with a longstanding history of financial "innovation." Affordability issues were solved with (what else) "affordability products." In addition to lowering requirements for minimum credit scores, originators maintained loan production volumes by offering payment-option loans and adjustable rate mortgages with low, initial teaser rates-products that artificially reduced (at least for a time) the costs of homeownership. When these risky policies were combined with stated income/stated asset loans, credit quality suffered extraordinarily at the expense of volume.

Inevitably, the delinquencies and foreclosures rolled in, especially as ARMs reset from their initial teaser rates. Distressed borrowers flocked to put their homes on the market, resulting in soaring housing inventories, particularly in states rampant with overbuilding and areas afflicted by depressed economies and population drain. On the demand side, the credit crunch has made it difficult for even qualified homebuyers to obtain financing. With the decline in house prices expected to continue, especially in former bubble markets such as Florida and California, banks will likely contend with a second wave of foreclosures as some borrowers find themselves owing more than their home is actually worth.

These disturbing trends have serious implications for both domestic and global markets. Job losses in the mortgage and housing sectors along with erosions to home equity are expected to reign in consumer spending, while financials both at home and abroad likely face additional write-offs as the surge in defaults and foreclosures continue. Questions about the value of mortgage-backed securities and the collateralized debt obligations containing these mortgages have likewise effected a virtual freeze in the credit markets. Meanwhile, banks are tightening lending in other areas to maintain sufficient capital for the deleveraging process.

When confronted with such a complex and multilevel conflagration, where does one apply the water to put out the fire? In many ways, this is the unenviable problem facing the nation's banking regulators, which are finally emerging from duck and cover mode. At the Independent Community Bankers of America's recent annual convention, Federal Reserve Chairman Ben Bernanke outlined the intricacies of the interrelated housing, mortgage and credit crises and urged servicers to reduce the principal on some loans to avert further foreclosures. This recommendation echoed the previous advice of fellow policymakers at the FDIC and the Office of Thrift Supervision. Whether investors will allow servicers to write-down borrowers' mortgage liabilities remains to be seen, but given the recent foreclosure data from the Mortgage Bankers Association, such a concession might not be a bad idea.