The Future of the US Economy

Like ripples in a pond, the downturn in the US mortgage market will have effects that expand into other areas of the US economy.  This holiday season will likely be especially brutal as the ability to use increasing home values and therefore home equity to fuel consumer spending has all but disappeared.  It seems we should have seen this coming; the reality is many people did.  The issue was not that a slump in housing would occur, but rather the timing.  Most economist using tools developed for the analysis of past housing cycles did not anticipate the impact of the secondary and derivative markets in supporting the continued growth in mortgage lending.  There was no way to predict these impacts, because much of these derivative products never existed until recently.

To understand the impacts these secondary markets had on the mortgage industry is illustrative to follow the path of a typical mortgage: The process typically starts with a mortgage broker.  The broker gathers information from the borrower including personal information, income, and property information.  Since the property is used as collateral, an appraisal is typically ordered and is incorporated into the underwriting process.  Based upon the information gathered, loan terms are generated which include not just income and property information, but also includes an evaluation of the applicants credit bureau.  Many lenders choose not to keep these loans on their books, but instead sell them to Wall Street companies.  The advantage to selling these loans is the ability to generate cash more quickly than gathering payments from customers over time.  The amount received for a loan is based upon many factors such as the type of loan (fixed vs. variable rate), duration of the loan, credit quality, etc.   By selling these loans, the selling company frees up more cash and thereby the ability to go out and generate more loans.  As long as a buyer exists for an originated loan, a selling company has almost unlimited potential to continue to generate loans. 

The process still continues on: Firms buying loans strip them into components for sale to investors.  Some examples are selling principle and interest payments as separate products, selling future originations, etc.  Underlying all of this are rating agencies that were supposed to give some estimate of the probability that the derivative products created might default.  If you have been following this story in the press, you know that the rating agencies have missed the mark. 

To summarize, the secondary markets did what they were supposed to do in one sense; they created liquidity which enabled the housing boom to occur.  However, in another very important sense these same markets created an extreme distortion in the mortgage market.  The underlying principle in any efficient market is having good information.  In the case of the derivative mortgage market information was extremely distorted, kind of like smearing Vaseline over some thick coke bottle eyeglasses. In the ‘old days’, when a bank actually underwrote and managed a mortgage loan the credit quality of an applicant and the asset quality of their home were the primary concern.  Secondary markets refocused this view to originating as many saleable loans as possible.  Over time, underwriting became less of a concern as there were buyers in the secondary markets for almost any type of loan originated.  Again these buyers were less concerned about asset values or credit quality but rather returns and income streams which supposedly were factored into the rating of each derivative product.  In this market cycle products began to be created where an applicant did not even have to provide proof of income and other information.  This type of lending was unheard of in previous mortgage cycles.  In latest cycle there were buyers for these ‘no document’ loans and other types of non-traditional mortgage products.

Irrational exuberance was the term used to define the Internet stock bubble.  The lesson from the fall internet stocks was a loss of sight of investment fundamentals. Investors were not interested in whether a company had any real intrinsic value or even much future potential.  Instead a heard mentality prevailed with everyone scrambling to trade on the latest rumor or a tip from a friend.  The fall of the mortgage market has many parallels to the fall of Internet stocks.  The real question is whether lessons will be learned or will history repeat itself.