Letters to the Editor
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causes of the housing bubble
The reaction of mortgage lenders described by cdunlea is not necessarily rational.
Quality of borrowers had relatively little to do with the housing crash. It was the quality of the collateral.
The main priority of mortgage lenders used to be, logically, not lending over the market value of the house. It's really very simple. If someone owes less in mortgage principle than their house is worth on the market, they can nearly always sell the house and pay off the mortgage (and pocket the equity), rather than foreclose. That's why, traditionally, foreclosed houses have been a risky buy. If they went to foreclosure, it was often (not always but often) because something unexpected happened that reduced the value of the house to below the amount of the original mortgage. Flooding, unexpected zoning changes, something like that.
But if you owe more for the house than you can get for it, you have to either make the payments, sell and take a hit, or foreclose. If you can't make the payments, you're likely to foreclose, unless you can and will pay off a "mortgage balance on nothing".
Why did lenders, after decades of tending to get it about right, suddenly start getting it wrong? Two reasons. The first was, yes, CDO's. Essentially, the original lenders were able to sell the loans more readily than before. That took away the incentive of the original lender to be really sure they were valuing the house correctly, and created an incentive to make as many loans as possible at the highest possible principle. So why did primary lenders get hurt, as well as buyers of CDO's? Because many of them ultimately built up an inventory of inflated mortgages that was more than they could sell.
The other issue was overbuilding. Massive numbers of new units were coming onto markets so fast that the supply increase was higher than what traditional models allowed for. Excess supply depressed prices faster than anyone expected.
The character of the much maligned "subprime borrower" had relatively little to do with it. If the purchase prices had not been inflated, any borrower could have usually avoided foreclosure by selling, even if he or she could no longer make the payments.
It's worth noting that many people did benefit from all this. There was a massive transfer of wealth from buyers and lenders to whoever sold homes in the 2004-5 period.