This is the second part of my series trying to answer peoples questions
about how mortgages work, and what went wrong. In the first part, I described
what a mortgage is, and how it works. In this part, I'm going to describe the
mortgage system - that is, the collection of people and organizations involved
in the business of mortgages, how they interact with one another, and how
that system has gotten into trouble. The next and final part will be
from the viewpoint of a homeowner who is taking or has taken out a mortgage to purchase a home, and what can go wrong from their side.
I'll reiterate my usual warning: I don't know much about economics. I come
at these things as a math geek who's spent entirely too much time reading
about the current situation.
One of the big failures in the mortgage system is that the system itself
is broken. Personally, I think it's deliberately broken - not in the sense of
a conspiracy between people to collude on creating a broken system - but by
the fact that each link in the chain is set up by the people in that role
trying to arrange things to maximize their benefit while avoiding
responsibility. When every link in a chain of responsibility sets things up so
that they have no responsibility, you end up with a thoroughly broken
To understand how it's broken, you need to know what the pieces are, and
how they're connected. I've attempted to draw a rough flowchart of the various
people involved, which you can see to the right. In this chart, what basically
happens is that loans flow up the graph, and money flows down the graph. At
each link, there's an exchange of loans for money.
The way that it works is:
- Someone who wants to buy a home goes to a mortgage broker, and fills
out an application.
- The mortgage broker takes the application, and brings it to a lender. The
mortgage broker is generally paid a commission by the lender for bringing them
the potential loan.
- The lender gets applications, and decides whether or not to give the
loan. Once the loan is given, they sell the loans. They make money by
selling the loans.
- Investors don't buy loans directly. So there's another intermediate - an
agent who buys mortgages, bundles them together into groups, and then sells
bonds based slices of collections of mortgages. The mortgage bond agent makes
money by selling mortgage bonds.
- To supposedly manage risk, people like to buy bonds based on the best loans. That leaves a lot of leftover. Investors buy up bonds based on the best parts of the mortgage clumps. The remainder are sold to another kind of agent, who takes the leftover parts of the mortgage clumps, and combines those into a meta-bond, called a collateralized debt obligation. Those CDOs are then sold to investors. There's an elaborate system by which potentially risky
mortgages are repacked into supposedly high-quality investments. I spent
some time describing that system here.
There's a big problem with the structure of this system. Each intermediate
participant in the system makes money by selling the loans to someone else - so they make money not by earning interest on loans as they're repaid, but
by selling the loans before any payments are even received. So none
of them are personally at risk if the underlying loans can't be repaid.
Worse, each intermediate in the system can plausibly claim that they are not responsible for checking the information used to decide whether to approve the loan or not. The mortgage agent just fills out paperwork; he's just a facilitator. He's not really involved in the loan; even if he checked the information on the application, the lender should recheck it anyway, so why should he do it? The lender argues that they don't get to see the borrower, just the information that the mortgage broker gave them; he's their agent, he should have made sure that they got correct information. The investment agent that bundles loans into bonds argues that the lender was responsible for assessing the risk of the loans, and was supposed to give them valid,
checked information. Each participant knows what a farce this is; each one knows that the other parties aren't doing the checking that they should. But each one is making money, hand over fist, by not checking things,
and they've got a plausible excuse for denying their own responsibility.
What could possibly go wrong?
This system works pretty well, provided you assume some basic facts:
- Real estate always increases in value, at a rate higher
than the rate of inflation.
- People tell the truth.
- People will always try to keep their homes - they'll default
on anything else before they let go of their home.
Unfortunately, all three of those assumptions have turned out to be completely
Nothing can always increase in value faster than the rate of
inflation. Anyone who expects it to is an idiot. Money is, ultimately, a
finite resource - it's an abstract representation of the stuff we produce. And
we produce a finite amount of stuff. If something is increasing in value
faster than the rate of inflation, that means that a larger portion of the
total value of the stuff we produce is being spent on it. Eventually, it'll
reach a maximum: a point where no more of the total wealth we produce can be
spent on it. It can't go over 100% - because 100% is everything. It can't even
get to 100%, because there's a basic set of stuff that we can't eliminate:
energy, food, clothing. So ultimately, the value of homes has to stop
shooting up so quickly. But so many of the loans that were given could only
every be paid back by selling the property for significantly more than the
Second, the honesty assumption was broken in an incredibly systematic way.
Mortgage brokers routinely advised their clients to lie about their finances;
in some cases, they even altered paperwork to lie about their clients'
finances without the clients knowledge. With the structure of the system set
up so that no one is responsible for verifying that information, brokers
routinely set up applications for people to buy houses that they couldn't
possibly afford. This didn't matter to the broker - they were paid on
commission by the lender, so finding a way to get people to take a bigger
mortgage was very much to their benefit. And numerous buyers were only too
happy to take advantage as well - they believed in the myth of the eternally
rising house price, so they weren't concerned about being left on the hook.
Informed buyers knew what was going on, and went along with it, because they
believed they'd come out ahead. Uninformed buyers got screwed, talked
into fancy mortgage schemes that were foolishly risky. And so it went,
up the chain: at each level, people lied, either through deliberate
deception or foolish ignorance.
Finally, the changing nature of loans changed the underlying facts that
drove people to desperately hang on to their houses. Not all that long ago,
you needed to have a minimum of 20% of the purchase price as a downpayment.
For people other than the very wealthy, 20% of the price of a house was a
huge investment; it was very nearly every penny they had saved in
their adult lives. For most people who owned homes, their home was
their wealth: the equity in their home was the vast majority of everything
they had in the world. In that situation, people would fight, tooth and nail,
to keep their home: if the bank takes it and sells it at foreclosure, they'd
But the modern loan system changed that. Now, you can easily get
a home loan with little or no downpayment. And with HELOCs, it's
very easy for an owner to treat a home as if it's an ATM - to "withdraw" every bit of equity that they've got in it. In fact, the ease of getting HELOCs
has mean that most homeowners in financial trouble have
withdrawn all of their equity already. So when they finally wind up not being able to make the payments, they have nothing to lose by foreclosure. In fact, many places now have a significant problem with people basically taking the keys to their home, putting them in an envelope, and mailing them to the bank - basically saying "Here you go". They've got nothing to lose - so they just move out, and hand the house to the bank.
The short answer to "Who's responsible?" is everyone.
The borrowers are responsible for either lying, or trying to buy
homes that they couldn't afford, or for being ignorant of just what they
were committing themselves to. A lot of people got screwed and lost
their homes, along with everything they put into them, and I do feel
bad for those people. But the fact remains that no one forces
you to take out a loan and buy a house; if you commit yourself to
a financial contract without understanding what it says, and what
obligations it places on you, you're setting yourself up for deep
Mortgage agents are among the worst offenders in this picture. The number
of thoroughly dishonest mortgage brokers is astonishing, and almost every day,
there's new information on the kinds of scams that they participated in.
The lenders were almost as bad as the mortgage brokers - sometimes even worse. They knew that there was a lot of money to be made in re-selling
mortgages, and they were determined to get their share of it, by hook or by
The folks who packaged mortgages into bonds and CDOs set up
structures that took ridiculously risky loans, and by wrapping them
up in enough layers of dishonest paperwork transformed them into
supposedly high-quality investments.
It comes down to a broken structure. The breakage is caused by the fact
that there are so many links; each one has a short-term interest in
seeing loans granted; and each one has a plausible excuse for why
they aren't responsible for any problems. Each one can (dishonestly) argue
that they assumed that someone else had done the checking. Each
level's greatest immediate interest is in selling things to the level above;
if they can make the sale, they're raking in cash, and thus, they're happy.
The structure insulates them: if something goes wrong, they're not left
holding the bag: they've already sold the risk.