Vikki Goodwin’s Austin Real Estate Weblog

I recently attended a presentation on the topic of subprime mortgages by a professor at the University of Texas.  He provided a very clear explanation of how subprime loans came about and how they ended up causing so many problems.  In his opinion, one reason for the invention of the subprime loans was not only a demand from people wanting to buy homes, but also a demand for investment securities.  Banks don’t hold onto mortgage loans – they sell them in order to have enough cash to make more loans.  And instead of selling the loans individually, they bundle them and sell them as a package.  Because of the demand, the bundles are then “sliced and diced” creating more securities that can then be sold to more investors.  So, the subprime loans were introduced to feed the demand.  Without going into the details, rating the amount of risk involved in the bundles becomes important, and the rating system could have some flaws.  Because the demand for investments is so great, more slicing and dicing goes on creating “CDO”s or Collateralized Debt Obligations (if I’m recalling correctly).  Basically, the factors involved here are a little bit of greed, a lot of ignoring the risks, and another little bit of desire for home ownership even when it’s not advisable.  (Are you aware of the “Ninja” loans?  These are made to people with “No Income, No Job and No Assets”.  Does that seem advisable?!)

Mixed in with the above is the fact that as home prices increased in some markets, lenders were allowing buyers to use a higher percentage of their income on their mortgage (at least they could qualify for a higher price based on higher ratios).  And at the same time, banks were being allowed to loan out a larger percentage of their funds – overleveraging.  Now that we’ve seen the problems with CDOs and subprime loans, can investors be satisfied with lower returns on safer investments?  Do we need to change the way risk is rated?  Should a lower percentage of the population be homeowners?  And will we run into this problem again?

We may have no choice.  Subprime loans have all but disappeared, so you can’t slice and dice thin air…  Prime loans are safer, so with that being what remains, investors will have to be satisfied with smaller returns, at least for some time.  Yes, I think we need to re-evaluate the rating system.  And yes, history has shown that a good balance equates to 62% of the population owning their homes.  Right now, 68% own their own homes, and many just by a hair.  Finally, I do think we’ll run into this problem or one that is similar.  History just has a way of repeating itself…