Saturday, October 20, 2007

Subprime Mortgage Mess

The Fed very likely ignited the housing bubble by keeping interest rates abnormally low from about the middle of 2002 through 2005. In general terms the interest rate should only be very low when output of the economy is too low. From 2002, in part due to the dot com bust and in part due to 9/11 the Fed kept rates unusually low, around 1%.

Twenty percent of mortgages are now from the bottom of the credit barrel, which allows lower income folks get homes. The problem is most of those loans went out at 95% of the value in the property. If property values always go up that's fine, but property values don't do that. About half the loans were made by companies that are almost completely unregulated. Half the loans required no documentation on income.

Usually the bank takes a keen interest in a borrowers ability to pay, but now they sell off these loans, often to off balance sheet entities of banks in Europe. The risk of mortgage default was sold off to these investors bundled with good loans based on ratings by firms paid for by the very companies selling the securities. Very often the mortgage initiator would call up the ratings firms asking how many more low quality loans they could squeeze into a bundle.

Some would have you believe that greedy people on both sides deserve what they got, but if you can't see opportunities to prevent these issues in the future and that this represents an efficient market at work, you have some very clouded glasses. For an amazing in depth loook check out The Economist.