The Subpime Mortgage Debacle III: What “Really” Caused It?
"Everything Points Back To The Fed..."
When the Fed, through open market operations, expanded the money supply, commercial lending institutions now had surplus monies to loan out at will. During the height of the bubble, banks—armed with surplus balance sheets—began looking for novel and creative ways to jettison these funds onto the naïve, yet highly motivated borrower. You have to understand how the money creation system works to understand the magnitude of such a decision. The Federal Reserve System regulates the tens of thousand commercial banks in existence today; thus, is responsible for their activities. When the Fed increased the money supply, during the real estate bubble, banks immediately reacted to this decision by selling many different forms of debt instruments: first, second, third mortgages, reverse mortgages, and of course, the ubiquitous lines of credit.
"If It Looks Too Good to be True, Then...."
Potential borrowers of these debt instruments fell for the oldest trick in the books: “if it looks too good to be true, than it ain’t true.” Not only did these bank financial products appeal to potential homeowners, but because interest were so low at the time, existing homeowners, investors, speculators and builders, alike, all jumped on the bandwagon. The golden rule in real estate investing is that, “if utilized correctly, financial instruments can become a means to an extreme financial end.”Further, these financial products were packaged up and sold to the general public as a good bill of health when they clearly weren’t.
This was the makings for what “really” brought about the real estate housing bubble—aka, the real (easy credit) bubble was “really” a bubble of easy money. Under the veil of making every American a homeowner, the Fed expanded the supply of money, which then gave commercial banks a false sense of “banking bravado.” This false sense of “banking bravado” caused commercial lending institutions to abandon conventional lending practices in exchange for its more maniacal version as created by kamikaze economics.
Wall Street Economics: "Conning is Good"
By sweeping normal lending standards under the rug, what commercial banks did was draw the attention of the con artistes on Wall Street. In the backdrop of the entire debacle existed a kind of tacit Wall Street cabal that provided the subprime market with its key ingredient which was the financial flow of funds from hedge funds and CDOs. The financial flow of funds, coming out of Wall Street, now began to augment an already highly expansive credit environment created by the Fed. This combination flow of funds of both the Federal Reserve and Wall Street gave the world the biggest real estate crisis any advanced economy could have ever produced.
Subprime—aka, Sub-par Credit Standards
Subprime lending became a colloquial term for sub-par lending standing. And if under conventional bank lending standards the lending prerequisites required a borrow to have a very high FICO score (with both low debt-to-income and loan-to-value ratios) then the subprime lending prerequisites was set much, much lower. In other words, the higher the FICO score the lower the risk associated with the borrower—i.e., if you had a FICO score (which ranges from 350 to 850) of 720, this score went above the minimum lending standard of a 680; therefore, holding everything else at a constant, you represented a very low default risk on a potential mortgage loan. Nevertheless, during the height of the bubble, we saw the minimum score of 680 drop as low as 100 basis points—these mysteriously deceptive lending standards gave way to the insanity of it all.
Alas, in the case of debt-to-income ratio, this number served as a very critical borrower indicator as well. Namely, when this ratio gets too high, households become increasingly dependent on rising property values to service their debt. But in the subprime market, we saw this ratio slowly started increasing as banks again, slowly started mysteriously loosening its lending standards to cash in on this “real easy credit bonanza.”