Subprime Time

We are no longer shocked when the Dow Jones industrial average plunges 10 percent — as it did this summer — or when a single hedge fund, this one run by Goldman Sachs, drops 30 percent in a week. But real estate, we thought, was different. Hedge funds execute hundreds of trades a day, often according to the whims of a computer; people buy their homes one at a time and usually retain them for years. But last month's market turmoil revealed a doleful transition for real estate. Formerly the most prosaic and dependable of investments, homes over the last 30 years had been turned into trading chips for Wall Street. And now, even at a time when the economy is still growing apace, two million Americans are suddenly said to be at risk of losing their homes to foreclosure. How did real estate become an industry with the vulnerabilities of esoteric financial instruments?

In the golden age of American home buying — the years after World War II — savings-and-loan institutions or government agencies supplied returning G.I.'s with fixed 30-year mortgages. Home prices appreciated, steadily but at modest rates, and lending fiascoes were rare. And homeownership rates climbed. The buyers of that era were not necessarily more cautious than today's; they simply spent what their bankers lent them. The bankers, persnickety folks that they were, required that buyers demonstrate sufficient income to qualify for a mortgage. They did this because a) they would get stuck with the property if the buyer defaulted and b) regulators insisted on prudence.

The world began to change in the late 1970s, when Salomon Brothers, in the person of a banker named Lewis Ranieri, pioneered the mortgage security. This showed a flash of genius. Even though each unit of real estate continued to be a slow-moving, illiquid asset, Ranieri perceived that the underlying mortgages could be traded as rapidly as stocks and bonds. Instead of keeping his mortgages in a drawer, the banker on Main Street could unload his risk by selling them to Salomon. The banker was thus converted from a long-term lender to a mere originator of loans.

Salomon and other institutions would take the mortgages sold by banks and stitch together bonds backed by the payments of many mortgagees, which they sold to investors. Voilà! Ranieri had knitted a group of inert mortgages into a tradable security. The mortgage market thus obtained liquidity, which, according to Wall Street, made mortgages cheaper and benefited us all. Once the mortgage originator became, in effect, a supplier to Wall Street, new, often unregulated nonbanking companies jumped into the game of brokering and also issuing mortgages. Over time, this weakened lending standards.

As Robert Rodriguez, a mutual fund manager for First Pacific Advisors (where I own shares), declared in a speech in June, "The distancing of the borrower from the lender has contributed to the development of lax underwriting standards." Rodriguez's point was that investors in the securities, being remote from the actual real estate, could hardly be expected to scrutinize the underlying mortgages loan by loan. Most delegated the task to ratings agencies, and in time the agencies, intoxicated by the booming market, also grew lax. Meanwhile, Wall Street, sensing the appetite of investors, devised exotic ways of repackaging mortgages. Investors bought these securities in bulk, just as Goldman bought stocks.

The absence of scrutiny on Wall Street had a profound effect on mortgage origination. As mortgage bankers discovered that investors would buy virtually any loan whatsoever, they naturally lowered their standards. What difference whether a loan was sound if you could flip it in 48 hours? The market thus corrupted, it only wanted for the right circumstances to implode. And over the last few years, as Robert Barbera, the chief economist at the investment advisory firm ITG, observed, the Federal Reserve took short-term interest rates from 1 percent to 5 1/4 percent. This raised mortgage rates and put home buyers at risk of being priced out of the market. But bankers lent to them anyway, offering, in effect, "junk mortgages" — risky loans with low teaser rates (and much higher rates later), as well as other deviations from sound finance. Lenders and borrowers alike knew that such loans were dicey; they were counting on the borrowers to refinance — which, as long as home prices kept rising, was a cinch. Naturally, when prices stopped rising, the music stopped.

What happened over the last generation is that housing was turned from a market that responded to consumers to one largely driven by investors. Liberal mortgage financing pushed home prices higher — and younger, first-time buyers were effectively priced out of the market. Rates of homeownership are scarcely any higher than in the mid-1960s.

There is no going back to the 3 percent fixed mortgages, single-earner households and tract housing of that era, but housing — like any investment market — could surely use a dose of (re-)regulation. At the very least, there should be a clear line between a mortgage company and a casino. Homeowners should not be induced to gamble on mortgages that will leave them insolvent should prices fall. Fewer mortgages might be written, but more mortgagees would stay solvent. And if the mortgage market surrendered a smidgen of its vaunted liquidity, it would be no great loss.

It was John Maynard Keynes who observed the paradox of securities markets: their very liquidity, which investors perceive as a safeguard, creates the conditions for disaster. "Each individual investor flatters himself that his commitment is 'liquid,'" Keynes wrote, and the belief that he can exit the market at will "calms his nerves and makes him much more willing to run a risk." The catch is that investors, collectively, can never exit in unison. Whenever they try, panic and losses are the sure result. Once, you had to be a hedge-fund player to experience such a trauma. Now, thanks to the dubious wonders of financial engineering, home buyers are exposed to the very same risks.

The New York Times Magazine, September 2, 2007, pp. 11-12.