So just a bit of a review. What happened from 2000 to 2006 when the housing bubble happened?
Well, financing got much easier. Essentially, they lowered their standards. And it got progressively easier and easier every year we went, and that allowed more people to bid on homes.
It increased the demand artificially in certain ways. Because we saw from the New York Times article that people’s income weren’t increasing and the population wasn’t increasing anywhere near as fast to soak up the supply. So all it did was allow people who were renting before, who couldn’t save the money for the down payment, to now participate. Now you had more people bidding for the same house.
But that lead to the obvious question. Why did financing get easier and easier?
So let’s go back to the good old days, like the early 90s. What happens to get a housing loan? Well, traditionally, if I want to get a loan, I would go to my bank. And that loan officer at the bank is going to be giving the bank’s money for your house. He gives you money and you’re going to pay him interest.
That loan officer at the bank, he really cares that they’re not going to lose money on the transaction. If he’s going to give you a million dollars, he wants to make sure that no matter what happens, if you lose your job, if you get arrested, if you skip town, that he’s still going to be able to get his million dollars back.
If you go back to our equity and balance sheet presentations, that’s why back in the day, they made sure that you put 20-25% down payment on your house, that you had a good credit rating, and that you had a good steady income. Because that banker, that loan officer was going to be in trouble, and his bonus was based on how good the loans he gave held up. So that was the traditional model.
What started to happen in the mid-90s, especially in California, and then nationwide in about 2001-2002, is you had what we call a securitization of the mortgage market. And in all fairness, this actually happened before with things like Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac essentially had the same standards.
They had the standards of conforming loans. You have to have 20% down. You have to have a certain credit score. Certain steady income. So Fannie Mae and Freddie Mac were these entities that might buy the loan from your local banker, but their standards were just as high as the local bankers.
What you had happen in the late 90s and especially in the early part of this decade is you had a whole industry outside of the government-sponsored entities. The government-sponsored entities are Fannie Mae and Freddie Mac.
And this is essentially, instead of going to your local bank for a loan, going to the local mortgage broker. Countrywide is the most famous of them and essentially I would get a million dollars from them for a home loan. I would agree to pay Countrywide, but then Countrywide would do this a million times.
They’ll give home loans to a million people, put them all together, and then they’ll sell the loans to Bear Sterns as an example. (That’s an investment bank.) They sell to Bear Sterns, and then Bear Sterns will package a bunch of these mortgages together, essentially IOUs from people, and then they would sell those to investors.
They would sell these to investors. So eventually, instead of Countrywide being responsible for my loan, my payments now go to these investors.
Countrywide is just being transactional. They’re just doing the paperwork for my loan, temporarily holding the loan, and doing a little bit of due diligence. In return for that that, the Countrywide mortgage broker will get a fixed fee for doing that transaction. Maybe they’ll get $5,000 for just doing the paperwork for my mortgage.
Bear Sterns will then package a bunch of these mortgages up, re-package them, and sell them to investors. In the process, Bear Sterns gets a cut. Bear Sterns is doing this for millions of mortgages at a time, so it’s in the billions of dollars that Bear Sterns gets a cut of. Bear Sterns just gets a fee, like the mortgage broker. Of course, it’s a huge fee. And then the investors are going to get my interest payments.
And let’s say if the interest rate I’m paying is 7%, and the other million people are paying 7%, the investors are going to get 7% on their money. And that seems like a pretty reasonable proposition. The only reason why the investors would give their money is if they have a lot of confidence that these are really, really good loans.
Well, the investors don’t know who I am. They don’t know what my job is, how likely I am to pay the loan. So the investors have to rely on someone to tell them that these are good loans. And that’s where the ratings agencies come in.
Ratings agencies
These are Standard and Poor’s, and Moody’s, and they rate these assets, these mortgage-backed securities. What they do is look at this big package of mortgages, these millions of mortgages that Bear Sterns has packaged together. They’ll look at the historical default rate, and they’ll say, these mortgages really haven’t been defaulting. And you can think about why they haven’t, because housing prices have been going up.
There’s a very high chance you’re going to be able to get all your money back. So we’re going to give these, what they call, triple A rating. T his investor, who knows, it could be the Central Bank of China. It could be a hedge fund. It could be a whole set of people. It could be the investment banks themselves. They actually bought these just to make some extra money. These investors, they don’t know who actually borrowed the money or what kind of credit rating they had, but they took a leap of faith.
They said, Standard and Poor’s or Moody’s did the work. They’re telling me that this is triple A, which means the highest level of debt. They just took their word for it. And they got their 7% interest on their money, or whatever it was.
That worked out pretty well so these guys liked the fact that they were getting the 7%. They said, this is a good asset class. Then they funneled even more money, so then there were even more investors that wanted to do this. This is with very little risk. I’m getting a very good return on my money. That’s better than putting it in the bank. That’s better than buying Treasury bills. And even more money flowed in.
Well, more money wanted to invest in people’s mortgages, but Countrywide would say, we’re already giving mortgages to all of the people who qualify. So in order to find more people who want mortgages from us, we’ll just have to lower the standards a little bit. And we can lower the standards, because we find that even when we do lower the standards, no one’s defaulting on their mortgages.
Countrywide will issue even more mortgages and give them to these investors with even lower standards. And of course, the mortgage brokers at Countrywide, they love it. Because every time they do a transaction, they just get some money, and then they give the mortgage to the investment banker, which packages them up and sells them to investors. So they get it off of their hands, and they just got the fee. They just collect big cash.
The investment banks love it
They just love doing the transactions. Because they get more and more money every time they do the transactions. And for the moment, the investors seem pretty happy. Because they keep giving money into this system, so to speak, even though they might be reading the newspaper and seeing that the standards are going down. But they’re consistently getting their return.
And because the defaults were very low over this time period, they felt that they were getting a good return. Maybe 6 or 7% on investments that had very, very low risk.
In the next video, I’ll explain why the defaults were very low in that time period. See you soon.
