How the Housing Crisis Started

 | Feb 14, 2012 | 12:00 PM EST
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The housing and mortgage market bubble and crash were not caused by subprime lenders. They were caused by the prime lenders that violated the rules of risk measurement.

Until we understand what happened and how it happened, it will be impossible for banks and regulators to determine what the real corrective actions should be, and thus it will be very difficult for the housing market and economy to recover.  

A lot has been written about the real estate crisis and about who is to blame -- the "government," "Wall Street," Alan Greenspan, Barney Frank, Franklin Raines, Angelo Mozilo, and the list goes on. Each of these, and many other parties and events, played a role in the housing crisis.

But there were specific events and actions that transformed the productive, virtuous cycle of loan creation and rising home ownership rates into a counterproductive, vicious cycle of defaulting loans and crashing values. Contrary to popular opinion, those specific events are easily identified and could be easily corrected.

What prolongs the crisis facing the housing market today is that the legislature, regulators and bankers are still willfully ignorant about what started it. And because of this, the corrective actions taken, namely though the Dodd-Frank provisions, prevent the housing market from stabilizing.  

All loans are underwritten to the "three C's of credit": character, capacity and collateral. Character is credit responsibility, capacity is income, and collateral is savings and other equity.

Today, all three are verified by a loan underwriter -- character by the credit score on a credit report, capacity by pay stubs and tax returns, and collateral by bank and brokerage account statements and property appraisals.

The erroneous belief by bankers and regulators is that all three must be verified and strong in order for a mortgage loan to be made and be viable. The reality is that as long as any two of the three C's are strong, a viable loan may be made.

A loan that relies on strong credit and collateral but without the verification of capacity, known as a no-income-verification loan, is a viable product. World Savings specialized in making these loans to self-employed borrowers throughout the 1980s, '90s and '00s, and World Savings' default rate was much lower than those of Fannie Mae and Freddie Mac loans that were based on verifying all three C's.

Similarly, a loan can be made on the basis of verified income and assets to borrowers who have poor credit. Banks have offered these mortgage products to medical doctors, who are notorious for having bad credit because they often don't pay their bills in a timely fashion. But they do get paid, and they are a great credit risks for lenders.

Lastly, borrowers with good credit and income but few assets can still be good credit risks. First-time homebuyers, the backbone of the housing market, fall into this category. Many of them access mortgage loans through the Federal Housing Administration and the Department of Veterans Affairs. 

The housing and mortgage crisis began in the U.S. when underwriters began to move away from documenting two of the three C's to relying on either one or none of them.

This is important, because it happened late in the housing boom, and this has not been recognized by the regulators and bankers. There isn't a hard date for when all loan programs tipped into this failure, because it happened gradually as all of the main lending institutions competed for market share in a vicious cycle of underwriting guideline degradations.

However, the critical points where a productive cycle of loan origination became counter-productive are pretty simple to determine. When World Savings, Countrywide and Washington Mutual started offering no-income-verification loans to the employees of companies instead of exclusively to the owners of companies, that was one of those events. Another was when Fannie and Freddie lowered their income and credit requirements simultaneously to levels not supported with actuarial proof.

All of these organizations were part of the prime lending market, not the subprime market. These actions in the early 2000s forced the subprime, non-bank lenders to degrade their underwriting even further in order to compete. The prime lenders failed to abide by the rule of the three C's in order to make a viable loan.

The Dodd-Frank act, however, takes none of this into account, instead mandating underwriting rules for banks that are no more supported by real risk measures or logic than the actions taken by the prime lenders that caused the original problem.

The issues that caused the problem are no longer the problem. The problem today is that the corrective measures are nonsensical. Until that changes, housing won't recover.

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