The Origins of a Lending Meltdown

I was reflecting on current mortgage lending where it’s not unusual for a borrower to have a large loan in first position and a smaller loan or HELOC in second position when arranging for the financing to purchase a home. That led me to think back to the days when second loans weren’t used, but there was a large first loan and Mortgage Insurance to cover lender losses above the 80% LTV point in the event of a default.

Although I did not keep records at the time, I’ll go out on a limb and say that was right around 1994 or 1995 and lending standards started changing shortly after that. Two things happened in the following years, lenders started utilizing the two loan combination eliminating Mortgage Insurance and lenders started making available loans greater than the value of the property.

The switch to two loans makes some sense, it allows the second lender to obtain a higher interest rate to compensate for their higher risk and the borrower has a deductible expense for that interest where Mortgage Insurance is not tax deductible. When lenders started making loans for more than a property is worth is when things started getting a little flaky around the edges, IMHO.

Home loans are based on a borrower’s Credit, Capacity to repay the loan and sufficient Collateral to provide security for the lender making the loan. While at the time it was not outwardly apparent housing prices were, or would be rising, lenders obviously had research in hand which convinced them that the Collateral would be sufficient to cover future losses.

So how did it get so bad, so fast? It didn’t really. Once lenders had a taste of the higher interest rates available when making high LTV loans with fairly low risk due to increasing property values, loan underwriting standards started to ease. From 1996 or so, when underwriting was still mostly based on Credit, Capacity and Collateral each year brought somewhat easier lending standards all the way to 2006 when all that mattered was a Credit score. Ten years of progressively flakier loans along with bankers just getting fatter.

As with most all bubbles, a reasonable indicator of when to get out is when the talking heads proclaim “This time it’s different” , “It’s a new paradigm” or everyone’s favorite “Buy now or be priced out forever”. I believe it’s reasonable to expect this pullback to be a little longer and a little deeper than most due to the longevity and extent of the runup, but it still is part of the real estate cycle which will often run between 10 and 20 years.

I’d like to think we’ve learned something from the extremes of this cycle and it’s accompanying meltdown, but in reality, people seem to have fairly short memories when money can be made.