Secret #53 – 1 Secret Reason for the 2000s Real Estate Bubble
Mortgage servicers had a financial incentive to foreclose on home owners as fast as possible.
That wasn’t the case during the earlier Savings & Loan real estate bust.
A lot of early explanations of the 2000s real estate bubble mentioned the principle-agent problem – that mortgage originators weren’t completely honest about the mortgages they sold to Fannie and Freddie and other securitizers. That doesn’t happen when the company that makes the mortgage keeps the mortgage on its own books instead of selling it off to someone else.
A similar problem occurred because the owners of the mortgages often did NOT handle the foreclosures of the mortgages they owned. The owners of mortgages, often Fannie and Freddie, had contracts with mortgage service companies to collect the mortgage payments, and when things went bad, the contracts detailed how the servicers were to foreclose on the house owners.
The way the contracts were written between Fannie and Freddie and the mortgage servicing companies gave the servicers an economic incentive to foreclose as fast as possible which just drove down house prices faster and further, as we saw.
When the servicers, not the owners of the foreclosed houses, determine at what prices to sell the houses, and at the same time, the servicers make more money when they sell faster regardless of the sale price, then the servicers are essentially paid to sell fast, not to sell for the highest price possible. Prices can fall fast.
In earlier times, the S&Ls did all three steps themselves – they originated, held, and serviced their own mortgages. During the S&L bust of the late 1980s and early 1990s, back when S&Ls dominated the market, the S&Ls had an economic incentive to foreclose SLOWLY and to not drive down prices.
S&Ls often worked with distressed home owners, including modifying their mortgages. S&Ls knew foreclosures drove down the value of all the houses they held as collateral so they were slow to foreclosure and sometimes when they did foreclose S&Ls didn’t immediately sell the houses because they didn’t want to drive down prices further.
Instead, S&Ls would sometimes after foreclosing, rent out houses for a year or more and then sell them when the market was stronger and such sales wouldn’t drive down house prices and the value of all their collateral as much, if at all. House prices fell less for everyone simply because of the design of the mortgage system – S&Ls kept the mortgages they made on their own books and serviced their mortgages themselves. The interests of the originator, servicer, and owner of the mortgages were aligned because they were all the same S&L.
Any bad mortgages they made were their own problem since they didn’t usually sell their mortgages. And with foreclosures, their goal was to sell them for the most amount of money possible, unlike the mortgage servicers in the 2000s who made more money by selling as fast as possible at any price.
Yep. Portfolio loans.
While the contractual obligation of mortgage service companies forced properties into an already crowded market, over-supplied with speculative home investments, it was far from the cause of the housing bubble between 2006-2012 and (IMHO) had very little to do with the S&L Crisis. The “06-12 Bubble” was caused by excessive speculation, free money, and an expanding housing affordability index.
The HAI (housing affordability index) is the relationship between the median price of a home and the mortgage interest rate with a normal down payment), where a relationship of 1 to 1 or higher is good, and less than 1 to 1 is bad. Forget the national HAI. You need to look at the local area where you live. For example, many places in California, New York, etc., have been below 1 for a long time, while places in Nevada, Arizona, Florida, and other areas were well above 1, and the reason people moved to those locations during the 80s, 90s, and into the 2000s.
During the S&L Crisis, the housing affordability index was less than 1 to just over 1. The issue wasn’t with S&Ls and single-family loans. The issue was that S&Ls had been deregulated, and they began competing with the banks, investing in highly speculative acquisition and development loans for builders, causing excessive overbuilding in the residential, multi-family, and commercial real estate sectors. Effectively, the S&Ls were overleveraged and under-secured.
In the late 80s and early 90s, S&Ls were phased out and replaced by Federal Savings Banks or absorbed by Commercial Banks. The median home price rose steadily from the 90s through 2006. However, the HAI dropped steadily, dipping well below 1 during the “2006-2012 housing bubble.” Essentially, housing prices were outpacing household income. From 1990 to 2000, the Case Shiller Index (National Home Prices) rose 32% or an average of 3% annually. From 2000 to mid-2006, the CSI rose 84% or an average of 13% annually.
Housing prices declined from mid-2006 through 2012, yet the Feds kept interest rates artificially low, and the economy recovered. Between 2012 and 2020, the CSI rose 60% or 7.5% annually. From 2020 through April of 2024, prices have risen 47% or an average of 12% annually. Annual foreclosures rose during the housing crisis, peaking in 2012 and declining to the lowest level in 2021. In 2022 and 2023, the foreclosure rate has been twice that of 2021.
If you don’t learn from history, you’re destined to repeat it. Are we destined to see a correction? All economic indicators would seem to be pointing towards one. Time will tell.