Banks and Mortgage Lenders

While there's plenty of blame for Wall Street firms, the rating agencies, and the managers of the $70 trillion, at the end of the day the debacle occurred because banks and mortgage lenders threw their underwriting standards out the window and made millions of bad loans. What could they have been thinking? In part, they were blinded by the money they were making and, in addition, their loss experience was very low, which lulled them into complacency, as Morgan Stanley's Mike Francis explained on This American Life:7

Mike Francis: All the data that we had to review, to look at, on loans in production that were years old was positive. They performed very well. All those factors, when you look at the pieces and parts: A 90 percent NINA loan from three years ago is performing amazingly well. [It] has a little bit of risk. Instead of defaulting 1.5 percent of the time, it defaults

3.5 percent of the time. That's not so bad. If I ' m an investor buying that, if I get a little bit of return, I'm fine____All the data that we had to review, to look at, on loans in production that were years old was positive. Adam Davidson, National Public Radio: As we now know, they were using the wrong data. They looked at the recent history of mortgages and saw that the foreclosure rate was generally below 2 percent. So they figured, absolute worst-case scenario, the foreclosure rate may go to 8 or 10 or 12 percent. But the problem with [that] is there were all these new kinds of mortgages, given out to people who never would have gotten them before. So the historical data was irrelevant. Some mortgage pools, today, are expected to go beyond 50 percent foreclosure rates.

Even if a loan defaulted, the lenders didn 't think they'd suffer any losses, for two reasons: Either they had sold the loan to someone else or they assumed that home price appreciation would bail them out. When home prices are rising rapidly, almost no borrowers default, because anyone in trouble can simply refinance. And, even in the event of a default and foreclosure, the losses are small because the home can be resold for a good price. But when home prices start to decline, watch out below! Figure 2.8 shows that as long as home prices are rising 10 percent or

Home Price Appreciation

Figure 2.8 Cumulative Loss Estimate over Five Years in a Bubble-Era Pool of Subprime Mortgages for Various Home Price Scenarios

Source: T2 Partners estimates.

Home Price Appreciation

Figure 2.8 Cumulative Loss Estimate over Five Years in a Bubble-Era Pool of Subprime Mortgages for Various Home Price Scenarios

Source: T2 Partners estimates.

more annually, losses in pools of even the worst subprime mortgages are minimal, but losses quickly spiral upward as home prices decline."

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