I’ll now explain to you why we had very low default rates on mortgages from 2000 to 2005.

Let’s say that I buy a house for a million dollars. The bank gives me a million dollars, and I’m willing to pay a percentage on it.  Then let’s say a year later, I lose my job.  I just can’t pay this mortgage anymore.  I have a couple of options.  I can both sell the house and pay off the debt.  Or I could just tell the bank, I can’t do anything and I’m going to foreclose.  And that would ruin my credit and I would lose all my down payment.

What are the circumstances that I can sell the house? 

If I borrowed a million dollars and I put no money down, just for simplicity.  If I can sell the house for $1.1M, I would do it right?  If I sell for $1.1M, I pay the bank and I net $100K. The bank got their money back, so they didn’t lose any money on the transaction.  I made $100K. 

The whole reason why this worked out, even though I was a credit risk, was that the housing prices went up. When you have rising housing prices the banks will not lose money lending to you. If you can’t pay, you’ll just give back the house.  The bank will sell it, or you won’t even give back the house, you’ll sell the house. You’ll pay it off even though you can’t pay the mortgage anymore.

The only situation where I would foreclose is if the market price of the house goes less than my loan, and that’s actually a situation we’re facing now. Let’s say that I can only sell this house for $900K.  Well, then, I’m just going to give the keys back to the bank. That’s called jingle-mail, because you just mail the keys back.  The bank sells the house for $900K, and then they would take a loss.

When housing prices go down, that’s the only situation where you should have foreclosures.

When housing prices go up, the person who borrowed it is just going to sell the house, pay off the loan, and they’re actually probably going to make some money, so there was every incentive to buy a house.

We said, from 2000 to 2004 housing prices went up.  We could even say from 2000 to 2006. Why did housing prices go up?  Well, we saw the data.  It wasn’t because people were earning more.  It wasn’t because the unemployment rate went down.  It wasn’t because the population increased.  It wasn’t because the supply of houses was limited.  We disproved all of that.

We realized it was because financing got easier 

The standards for getting a loan went lower and lower.  Financing got easier and easier.  And because housing prices went up, what did that cause?  Well, we just said, when housing prices go up, default rates go down.  You could give a loan to someone who’s a complete deadbeat, but as long as housing prices go up, if they lose their job, they can still sell that house and pay you back the loan.  So housing prices going up makes sure there are no foreclosures, so defaults go down.

The perceived risk of lending goes down. That makes more people willing to lend, and corollary of more people willing to lend is that the actual standards go down, and that makes financing easier.  Standards go down.

You had this whole cycle occurring from the late ‘90s, but it really got a lot of momentum around 2001, 2002, and 2003.  Financing got easier despite the fact that people were earning less. The population wasn’t increasing that fast, and there were all of these new houses.

Housing prices went up, and then we had a lot fewer people defaulting on their loans.  No one would default on their loan if they could sell it for more than the loan.  Then a lot more people said, these are safe investments. The ratings agencies, Standard and Poor’s and Moody’s were willing to give triple A ratings to more and more, what I would argue are risky loans, so the perceived lending risk went down.

More and more people liked this asset class

I can get a better return than I can get in a bank or treasuries even though these are very low risk, or perceived low risk, so I want to funnel a lot more money in here.  The mortgage brokers and the investment banks said, “great,” the only way we can get more volume to satisfy all these people who want to lend money is by lowering the standards. This cycle went round and round.

It really started because this whole process of being able to take a bunch of people’s mortgages together, package them up, then turn them into securities, and then sell them to a bunch of investors.  This was an “innovation” in the mid-90s, and it really started to take steam in the early part of this decade.

That’s essentially why housing prices went up, and why all of this silliness happened. In the next video, I’ll talk a little bit more about who some of these investors were, and I’ll tell you about a common hedge fund technique. I think it’s very important not to group all hedge funds together.  There are some good ones.  But what a common hedge fund technique was to take advantage of this virtual cycle to make the hedge fund founders very wealthy.

I’ll see you soon.