The Fallacy of Financial Innovation

stiflePerhaps the hardest part of the housing bubble was not taking part in the rally. There was pressure from everyone and the lenders were giving away money. It was very difficult to make a conscious choice not to participate, particularly when people want to own. I felt these desires; I wanted to own again. My intellect and my emotions were in conflict. Now that the bubble is bursting and prices are coming down, I see the light at the end of the tunnel, but it is still difficult to wait. Like Archie Bunker said, “Patience is a virgin.” I will only buy once at the bottom, and I want the time to be right.

For those who participated in the bubble, the hardest part (beyond the financial problems) is yet to come. It will be accepting that everything they thought they knew was wrong. As I described in What is a Bubble? a financial mania is supported by a whole series of erroneous and fervently held beliefs. It will take time for the participants to come to the realization that they were wrong, very wrong. Accepting this truth will be even harder. Unfortunately, financial markets have a way of forcing a painful awareness on its participants. Whether they like it or not, each participant in the market will come to realize it was a colossal mistake.

The cutting edge is sharp. Innovators often pay a heavy price for advancement. Sometimes these advances lead to quantum leaps in human knowledge and understanding. Sometimes the time, effort, and money is merely thrown into the abyss. The innovations of the Great Housing Bubble were of the latter category.

The lending industry touted its “innovation” with exotic loan products. They sold these toxins far and wide. Now that these loans are achieving the highest default rates ever recorded, it is safe to say the “innovations” over the last 5 years were not entirely successful. It is amazing that a group of intelligent bankers came up with this loan and expected a positive outcome. When you really look at the whole “innovation” meme, you see that it is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.

Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing. The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common.) This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans. A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.king_conforming

Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include, interest-only loans, adjustable rate loans, and negative amortization loans among others. It is this group of loans that has consistently failed in the past for one simple reason: if payments can adjust higher, people will default. It is really that simple. The Option ARM is certainly the most sophisticated loan on the market today. It is a dismal failure, not because it isn’t sophisticated, but because it has embedded within it the possibility (probability, no — near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment.

Here is where the lenders lie to themselves and to the general public after a financial debacle like the Savings and Loan problems of the 1980s or our current housing bubble: they blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all by themselves. There are still many out there who believe the high default rates and problems in the housing market in the 90s were caused by a weak economy. This is rubbish. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans. Whenever lenders start loaning people money with total debt-to-income ratios over 36% people start to default. Whenever lenders start loaning more than 80% of the purchase price, people get underwater and start to default. These phenomenons, which we document daily on this blog, are not new. It happened in the early 90s; it is happening again, and it is happening for the same reasons: lax lending standards.

Someday the lending community may actually innovate and come up with some financial product that has low default rates which most people can qualify to obtain — Not. Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments. This is the key to any loan program. Either people do or do not make their payments. You can reinvent new terms and schedules as often as you like, and it will always boil down to people making payments. When these fancy loan programs contain provisions that make it difficult for people to make payments — like increasing payment amounts — they will default, and the loan program will fail. This is certain.loan_we_cant_repay

When lenders create new, “sophisticated” loan programs that require advanced financial management on the part of the borrower, both the lenders and the borrowers fall victim to the Lake Wobegon effect. Everyone thinks they have above average abilities when it comes to managing their finances. In reality, perhaps 2% of borrowers have the financial discipline to handle an Option ARM loan. Unfortunately, 80% of borrowers think they are in this 2%. The reason for this comes from the inherent conflict between emotions and intellect. 80% of borrowers may understand the Option ARM loan, but when the pressures of daily life create emotional demands for spending money on one’s lifestyle, the intellectual knowledge that this money should go toward a housing payment is conveniently set aside. It is this 2% of the most disciplined borrowers who will cut back on discretionary spending to make their full housing payment. Everyone else will make the minimum payment, fall behind on their mortgage, and end up in foreclosure.

It seems lenders forget basic facts about lending every so often and create a new financial bubble. Perhaps they succumb to the pressure of the investment community or their own shareholders, or perhaps they just start believing their own “innovation” bullshit and forget the basics of sound lending practices. This is why we need the upcoming recession. These pathologic lending practices must be purged from the system or else they will survive to build an even bigger and costlier bubble — although it is difficult to imagine a bubble bigger than this one, it is still possible.

In the aftermath of a financial fiasco, lenders return to the practices that did not fail them in the past. Some will consider this taking lending standards back 50 years. They would be right. The only program lenders know is stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrowers gross income (36% maximum total debt.) This is what is coming. The last vestige of kool-aid denial I see in the comments is the insistence that equity requirements will not get that high. They will, and it will be a catastrophe for sales volumes and home prices. This is why I always post the downpayment and income requirements on my posts. People need to think about Your Buyer’s Loan Terms.

misfortune_tellerWhy would banks continue to loan 90% of value when there is a likelihood of a greater than 10% decline and banks know high loan-to-value ratios result in high default rates? They are doing it now because they have to to make any loans at all, but they are limiting these loans to those with very high FICO scores, and they are betting these people will not default do to moral reasons or the desire to keep that high FICO score. If they try to extend these loans to lower FICO score individuals or subprime borrowers, they won’t stay in business long. Think about the losses we have documented here on this blog. Banks can’t sustain those losses indefinitely. Large downpayments are coming back, and government assisted financing will become widely used by first-time homebuyers to overcome the high equity requirements. There really is no other way forward. The credit crunch we have all been hearing about was not caused by some unexpected or unknown factor, it was caused by the failure of lenders. Credit will continue to tighten until lenders stop making bad loans. The bad loans will not disappear until lenders return to the stable loan programs with a proven track record. That is how the credit cycle works.

Note to Lenders:

I plan to purchase in the aftermath of your most recent failure. Please wait until about 5 years before I am ready to retire before you innovate again so I can sell my house near the top of the next bubble you facilitate.

Thank you,