The subprime mortgage collapse for dummies

For all the hoopla about subprime mortgage woes, the media do a fairly bad job of explaining how this problem could even come about in the first place. These are complex phenomena that can be difficult to interpret, because they're so large that it's difficult to see the whole thing. It has taken me until recently to connect the dots and figure out to my satisfaction why it happened.

First, the core problem of the subprime mortgages is that many - many... many - U.S. mortgages were given away to people with incomes too low to repay them in the long run. The loans were made, however, because the people were able to pay them in the short run.

The reason why people were able to pay these loans in the short run were two-fold. First, some loan-givers offered introductory low rates that may have actually been loss-leaders. Second, interest rates throughout the U.S. economy were low.

Interest rates across the economy are determined by the central bank. In the case of the United States, the Federal Reserve was keeping interest rates low to stimulate the economy after the collapse of the Internet bubble, and especially after the September 11 attacks. When interest rates are low, businesses and individuals find it cheap to borrow money, but not very rewarding to save it. Therefore spending on consumption goes up, and spending on investment goes down. The Federal Reserve wanted this effect, because they feared that after September 11, everyone might stop their consumption in anticipation of possible worse attacks to come. If consumption did actually stop, this would produce huge problems in the economy, as all the infrastructure that is currently geared for a certain level of consumption and a certain level of investment would have to be re-geared for a different ratio of consumption vs. investment. If any such re-gearing took place, it would take the form of a severe depression, which the Federal Reserve wanted to avoid. The chances of everyone stopping their consumption out of fear of more terrorist attacks were low; however, there was a chance nevertheless, and the Federal Reserve felt that this was a good enough reason to keep interest rates low.

Now, because interest rates in general were low, interest rates for mortgages were also low. Add to that any loss leader discounts that may have been offered by lenders, and all of a sudden it turns out that people could borrow sums of money that they previously weren't able to afford. Not only that, but most people's willingness to buy a house depends not on the actual price of the house, but on the size of the monthly mortgage payment relative to their income. Since interest rates were exceedingly low, so were the monthly mortgage payments, and lots of people piled in to take advantage - maybe thinking that by the time they pay off their mortgage, real estate is going to appreciate even more, and they are going to be rich!

Now, this state of affairs was bound to change over time. Interest rates were bound to go up much sooner than most people were going to repay their mortgage. First, after an initial few years, any loss-leading interest rates that may have been in place were scheduled to be restored to an economically sensible - that is, higher - level. Second, the Federal Reserve was bound to stop being so concerned about boosting people's consumption, and to raise interest rates in the overall economy. For people who go for an adjustable-rate mortage, their monthly payments are going to vary in size depending on prevailing interest rates in the economy.

So, the interest rates were bound to go up. Meanwhile, lots of these loans were made to financially uneducated people who could never afford the increased payments, but they signed up for the mortgage anyway, because the agent encouraged them that "surely after a few years you will get a raise".

But, what made these agents want so desperately to sell these mortgages to people who could not afford them?

First, the companies who made the loans did not keep them. Instead of being responsible for each mortgage throughout its lifetime, the companies who made these loans instead resold them to other investors - hedge funds, banks - under a recently invented, much championed concept called Collateralized Debt Obligations (CDO). So the people who made the loans were only exposed to risk until they were able to resell the hot potatoes to someone else, and the risk was small in the initial period, because the monthly mortgage payments were still low at that time to begin with.

The second reason why the agents were selling these mortgages is because normally, if a person can't pay their mortgage, this shouldn't be a big problem for the lender. If you miss enough of your payments, the lender comes in, takes the property, and sells it to someone else, recovering their investment. They might take a loss because this process is not usually very efficient, but the whole idea is that the loan is secured against the property, so the lender can give you the loan to begin with, resting securely in the knowledge that they can come in and take the property if you default.

And normally, all of this wouldn't be a problem, if it wasn't for the fact that this lending to people who couldn't really afford it was done not just by one or two lenders, but was instead a widespread fashion that took place over a period of several years. For reasons I'll explain below, investors were actually willing to buy these CDOs, so it made a lot of sense for lenders to make money by relaxing their standards of lending. What else are you going to do, ignore the opportunity while your competitors make a killing? You do that and you're going to be replaced with someone who's going to do the job.

Thus, people were able to buy houses who otherwise could not have, entering the real estate market. Additionally, those who already could buy property, could now buy bigger and more expensive property. Demand grew larger for the same amount of real estate, which means that prices grew fast.

The problem is that this growth turned out to be temporary. The reason it was temporary is that there were so many people in the real estate market who couldn't really afford to be there when the actual interest rates kicked in, and indeed, as soon as that happened, lots of these people found themselves in default - unable to pay their mortgages, losing their properties, and not returning to the market as buyers. The number of buyers in the market was thus reduced, while the foreclosed properties began to be put on sale, and prices started to go down. As prices started to go down, investors who had purchased the CDOs, and thus the mortgages, and who were thus entitled to the proceeds from foreclosures, lost money. The more people defaulted, the more foreclosures there were, the more the prices went down, and the more investors lost money.

The reason this was a problem for the financial system is that some important and large financial institutions were heavily invested in these CDOs, which means that even supposedly rock solid institutions could fall. However, it was difficult - and it still is difficult - to tell which institutions were actually so exposed. Because there was so much uncertainty about who might be holding the hot potatoes, and how much they might be exposed to them, the credit markets dried up; money that was previously readily available to borrowers, now stopped being available.

But as a normal course of business, large financial institutions had been heavily dependent on liquidity in the credit markets - being able to borrow money as they needed it. Now, institutions who earlier never had any trouble borrowing money whenever they needed it, simply couldn't get it - even if they were not exposed to CDOs. Northern Rock relied on this business model, which is why it failed.

Bear Sterns apparently failed because they actually were exposed to quantities of bad debt from subprime mortgages. It needed to be "rescued" because the financial system is technologically so unprepared for losing a member like Bear Sterns that, if it failed, all finance would grind to a halt until the muddied waters cleared, potentially bringing down the U.S. economy in the process.

But there is one more crucial thing. How come people were buying the CDOs to begin with? How come investors buying the lender's side of packaged mortgages didn't realize that the housing market was in a bubble; that lots of subprime borrowers were being set up to default; that the housing prices were going to come down as a result; and that anyone who purchases the lender's side of those mortgages is going to get hurt? Why did they buy the CDOs packaging those mortgages anyway? Did they not know?

One answer may be that everyone genuinely expected subprime borrowers to make good on their loans. After all, what reasonable person would take out a mortgage that they will be uncapable of repaying? If the subprime borrowers didn't start to massively default, then the real estate prices would stay up.

A plausible answer, however, may be that the people who decided to buy CDOs may have known about the risks - but didn't care. You see, the way all this investment is actually structured is that, very often, the person who owns the money - such as a company, a rich individual, or a pension fund - doesn't actually make the decision of where to invest it. Instead, the investment decisions are made by people who are paid to do so. But the way these investment managers are usually paid is, if the funds they're managing are losing money, they merely earn a big salary; however, if the funds are making money, the managers get a percentage of the profits. So you have an agency problem: the person who calls the shots has different incentives than the person on behalf of whom decisions are being made. The investment managers may have known, or may have suspected, that buying CDOs just helped inflate the housing balloon, and that the prices were going to drop in the long run. But if you are an investment manager whose bonuses are paid on an annual basis; and you invest other people's money into CDOs; and the funds under your management grow by 40% a year - even though you're setting things up for a long-term fall; then you're going to get a big cut of that 40%, which means that your share might be tens or hundreds of millions. Having earned that kind of money, your financial needs are taken care of - and if the market later falls, you can always pretend that you were making an honest mistake. Like everyone else who participated. Everyone lost. It was no one's fault. Right?


In order for this to happen in the first place, the environment had to be right - low interest rates were crucial. But also importantly, a certain proportion of people had to be stupid enough to take on debt that they could not realistically repay.

However, in order for this to become a debacle, enough investors had to be stupid enough to put their money in what essentially turned out to be a Ponzi scheme for investment managers.

In the end, it is the responsibility of investors how they make their investments - wisely or foolishly. It seems to have turned out that giving someone billions of dollars, letting them make decisions for you, and paying them based on annual gains, does not sufficiently align their incentives with yours as the investor. Your horizon is long-term, to build (and keep!) your wealth over the course of decades; their horizon is short-term, until the next year's bonus.

I guess that people would be well advised, in future, to put their money away from hedge-fund-like setups, which are ridden with agency problems, but rather more of their money into setups like Berkeley Hathaway - the investment company controlled by Warren Buffett. Not only does he manage other people's money, but a big chunk of the money is his own. As a result, he has had strong long-term incentives to invest in businesses that are going to grow over the long run, which resulted in Berkshire's persistent and steady growth over the course of many decades.

Let the investment manager put his money where his mouth is, and let his fortune rise and fall in lockstep with yours.


Anonymous said…
I am an Economics major in college and this was the best and easiest way for me to understand this whole situation... thanks.
Anonymous said…
That's a brilliant article! Plus I learned a new way to use to the word "default". I always knew it only in a computer-sense and never in its original one. ;)
daniel said…
Kudos Denis!

Only one thing I am wondering about is the form prizes from profits take, as they are rewarded to managers? As far as I know money is rarely the case at such amounts, usually it materializes in the form of share of stocks(here particulary stocks of real-estate firms they- the managaers- invested in). Presuming latter being the case, managers would have atmost interesting job explaining the investors why are they reallocating the rewarded assets-which they surely at some point would if they knew about the long term decline of mortgage market.
denis bider said…
Anonymous, Sunshine - thanks, much appreciated. :-)

Daniel: good point. Unfortunately I'm not an insider, and I have only tenuous connections to people who are.

But here's my speculation. There's probably a way investment managers can, at least to some extent, "diversify" their holdings.

But even to the extent that they can't, they would still be motivated to make risky decisions, such as investing in bubbles, because they benefit handsomely if the bet pays off; but if it fails, the money they spent is dispropotionately not their own.

The odds that an investment will pay off are the same for the investor and the investment fund manager. But whereas the investor's gain in case of success is X%, and their loss in case of failure is -Y%, the fund manager's gain in case of success is magnitudes larger, and their loss in case of failure is magnitudes smaller.

So even if there is no apparent fraud, the structure of the setup pays investment fund managers to make much riskier decisions than it would pay for the investors to make themselves. For example, decisions such as investing in a bubble.
denis bider said…
Here's a rather more "nuanced" explanation that has been circling the internet. :-)
Anonymous said…
Good gather of information regarding mortgages and it provided a clear view of understanding the present scenario. basically what ever may be the investment long or short term take certain tips.
Anonymous said…
Hi Mr. Bider,

I dont know if you are still tracking this blog, but it's been about 10 months since you first wrote the article and the US economy seems to be worsening; with house prices decreaseing and the financial institutions are still shaken up, I was wonder if you could answer some questions for me:

1) You mentioned that, Bears Sterns, I believe it was, was bailed out by the US government, well my question is aside from bailing out these financial pillars, what else has or is the US government doing to subdue the subprime crises and why?

2) This leads me to my second question; I was wondering if you had an update of the subprime mortgage crises and I am looking forward to your predictions on the future possibilities of the crises.

Thank you, Mr. Bider, after hours spent scanning through articles and reports, yours, was the only one that clearly outlined the subprime mortgage crises. Thank you.
denis bider said…
Thank you for your comment!

First and foremost, please be aware that I am not an expert on the macroeconomy, merely someone trying to understand the issue, and writing these blog articles to consolidate my thoughts and, more importantly, hoping to get insightful feedback from others.

That said, this crisis does appear to have shown that there are, in fact, no experts who fully understand this. People with degrees in economy, even professors who teach macroeconomy, confess ignorance and lack of insight. Others, who proclaim to have solutions and insight, tend to be in conflict with each other.

I have just written another blog post reflecting my current assessment:
It all starts with the mortgage. About six million people in the United States who have no money have borrowed about 100% of the value of a house, right at the top of a housing market which has since fallen sharply. These are the Mortgage subprime borrowers.
victoria.marie said…
Wow. I saw The Inside Job last night (narrated by Matt Damon) and I was having a very hard time understanding everything that happened. Thank you SO much Denis for making it much simpler.
Merily said…
Hello, thanks so much. I know nothing about economics but last night was watching "the big short" and couldn't understand a thing until now. What a simple explanation!

Now I'm going to research the "short".

thanks again, Merily

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