Transcription:

Home mortgages as know them have been around since the 1930s. They’ve helped millions of families become home owners while earning profits for lenders. But now the financial system is failing, and bad mortgages are to blame. Why now? How has mortgage banking changed over the years?

Let’s look at a traditional example. Say you took out a home mortgage of $100K, payable over 30 years at an interest rate of 6.5%. Beyond the principal $100K, you would pay around $130K in interest and $2K in fees for a total of $232K. Except for the one time fee, this sum is paid off in regular monthly payments.

Banks lent to the most credit worthy clients. After all, these clients were their source of regular income. If they couldn’t make payments, the bank suffered. But in the last few decades, a new model increasingly took hold. In this model, mortgage brokers acted as middle men between home buyers and lenders. Brokers profited exclusively from one time fees, not from interest payments. For brokers, it made sense to originate as many mortgages as possible to earn as many fees as possible. They tried to sell mortgages to everyone, their brother, and their dog Fluffy.

Lenders typically required brokers to refund fees if buyers defaulted within a few years of signing. But in the early 2000s, this refund window was cut to as little as 3 months. Brokers seized this opportunity, offering mortgages with attractive terms reflecting the low interest rates of the time. These teaser rates were promised only for the first two years of the mortgage. Most people could afford the initial payments.

After the default window closed, brokers could keep the fees. The ongoing risk of default became someone else’s problem. Whose problem was it? It should have been the original lender’s problem. But they passed the buck by repackaging mortgages and selling them to investors. This process is called securitization.

Investors then sold these fancy packages to one another without ever examining the mortgage terms in detail. Meanwhile, those two year teaser rates expired, and borrowers could no longer afford the ballooning payments. Investors expecting 30 years of payments were suddenly left with no revenue, and no way to pay their own debts.

The bad loans afflicted the whole financial system. That’s how the financial crisis started. Bad incentives, the short-term push for fees at the expense of the long-term economic stability led to bad lending practices. In the coming months, expect heated debates about how these dangerous incentive structures can be revised.