Mortgage Meltdown - what they're not telling us

We got a reminder over the weekend that the credit crisis is far from over.
Everyone has been discussing it today, nonstop.

What's been missing from the discussion is the structural cause of the mess.

Here's why I have been predicting this for the last four years.

Four years ago I started looking to buy a house in Southern California. It was
a hot real estate market. I was aghast when I learned that people were acquiring
mortgages with no down payment, and no paydown of principal.

On the surface, it makes sense. If you're a lender, you care about getting paid
interest. You'd just as soon be paid interest forever. You just care about being
able to extricate yourself if the loan goes bad. You foreclose, and you sell the
house off. The reason you ask for a down payment, and for principal paydown, is
because you need to know that you'll get enough from the foreclosure sale to pay
off the outstanding balance on the loan, plus costs. As long as property values
are rising, your exposure is minimal. In essence, the increase in property value
creates a capital reserve which replaces the down payment.

I'm reminded at this point of the guy who told me he'd bought a house in the
1970's for only $60,000, and today he only owed $250,000 on it.

The problem is the effect that this structure has on property values. It makes
them rise. More precisely, it makes them rise as interest rates fall, and it
makes them fall as interest rates rise.

Here's how it works. When I go to buy a house, I don't ask "how much house can
I afford?", but rather "how much of a monthly payment can I afford?". If I have
to come up with a down payment, the two questions are related. But if there is
no down payment, the questions become decoupled. Suppose I have $1000 I can
afford to pay each month. If I only have to pay the interest, then I can afford
a house whose price is determined by the interest rate. If interest rates are
1%, then I can afford a house that costs $1,200,000. If interest rates fall to
.5%, then I can afford a $2,400,000 house. When they rise to 2%, I can only
afford $600,000.

Four years ago, interest rates were at historic lows. Most people get as much
house as they can afford. There are two kickers here. Many of these mortgages
were variable rate. It was essentially guaranteed that rates would rise, and
that many people would be forced out of their homes when that happened. Of
course these buyers, and lenders, did not understand the effect I'm about to
describe, and assumed that incomes would rise to cover things when interest
rates did rise.

The bigger kicker, though, is the bell curve of income distribution. The number
of people who can pay $1,000 a month is vastly larger than the number of people
who can pay $2,000 a month. That guaranteed that as rates rose, as they did,
the demand for housing had to drop dramatically. If I'm forced out of that
1.2 million home when interest rates double from 1% to 2%, then a buyer for that
home has to be somebody who can come up with $2,000 a month. There aren't enough
of such people - there's no way that all those 1.2M homes can continue to be
worth 1.2M. It's likely to end up much closer to $600,000.

Applying the same argument in reverse as interest rates fell, you can see how
the bubble was built in the first place.

In essence, in an environment where you can obtain interest-only,
no-down-payment loans, the price of homes rises like the inverse of the interest
rate, as interest rates fall, and drops in the exact same way as interest rates
rise. That's a curve that heads off to infinity, when interest rates get near 0.