How Our Financial System Encouraged the Foreclosure Crisis

One of the factors that has had the greatest impact on the subprime mortgage frenzy and the deterioration of lending standards in the mortgage market was the transferring of risk. The securitization process of mortgage loans took responsibility for the performance of mortgages out of the hands of the lenders and put it in the hands of thousands of investors located in areas around the world.

The result of this was that lending standards virtually disappeared during the real estate boom of the early twenty-first century. With the Federal Reserve pushing interest rates to artificially low levels through massive amounts of inflation, all that cheap money had to go somewhere. And it went into the housing market through the mechanisms of subprime loans, inflated property values, and unfair lending practices.

The decade of the 1970s witnessed the beginnings of the push towards mortgage securitization, as lenders moved away from the practice originating and holding loans. Instead, mortgage companies would originate and immediately turn around and sell the loans. In this way, they could quickly generate more money for additional loans, while investors had residential real estate loans to provide monthly income.

However, the main profit source for loan origination companies also shifted with the advent of securitization. Banks had been in the practice of deriving profits through taking in money and lending it out at higher rates of interest than what they paid to get deposits. With mortgages being securitized in higher numbers, though, interest income was replaced with fee income.

Origination companies received their profits from the creation of these loans and the packaging and selling of them to other companies and investors. The investors in the mortgage securities, on the other hand, now received the interest income from the loans. Thus, the banks making the loans had little incentive to ensure the loans were good for the long term once the loans were made and they received their fees.

The practice of securitizing mortgages, though, also created incentives for banks to make loans that could never be paid back. Once the pool of credit-worthy customers had been exhausted, there was left a large number of people without stable income or good credit. But with all of the cheap money flooding into the housing market from the Federal Reserve, the subprime market was vastly expanded.

Homeowners and banks both share part of the blame in fueling the housing market bubble, but all that money came straight from the inflation caused by artificially low interest rates. Securitization allowed banks to hide the risk of the bad loans for a number of years as real estate prices kept rising. For a few years, it worked, but the flood of money began to slow down and property values stopped rising.

Once property values stopped rising and actually began falling, the entire subprime mortgage market collapsed under its own weight. Hundreds of lenders went out of business, Wall Street transformed from predatory investment banks into bankrupt bailed out institutions preying on the economy at large, and the securities created during the boom all began to smell very toxic.

The government, though, quickly stepped in to make the investment banks as whole as possible, by forcing other companies to take them over, providing inflation-created incentives, or simply handing over tens of billions of dollars to banks and financial companies. This was just the latest and largest in a long line of federal bailouts of the financial industry, but all of the investment banks relied on the federal backstop against failure.

Without the transference of risk to the rest of the world and the reliance on the federal government for artificially low interest rates and a guarantee against failure, the subprime market and housing bubble could not have reached the heights they did. But all of these factors created huge non-market incentives for unfair lending and borrowing, with the economy in general now suffering the fallout.