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Explaining the Mortgage Meltdown

Explaining the Mortgage Meltdown

There will likely be more than 1 million foreclosures this year. In many places, home prices have dropped significantly. Speculation fever has been replaced with talk of a crisis. Even President Bush has stepped in with a plan to help some troubled homeowners.
In a way, though, this is a much-needed correction.
We learn to swim by paddling around the wading pool -- not by diving into the deep end. Today's situation isn't much different: People caught in the "deep end" -- with loans they can't afford and homes in peril of foreclosure -- are often those who jumped into homeownership before learning how to stay afloat financially.
Here's how it happened. In the mid-1990s, the housing market grew dramatically. The creation of a secondary market for sub-prime loans made credit available to those who were historically underserved. At the same time, a roaring stock market gave people the assets to purchase more expensive homes.
When the dot-com bubble burst, investors sought refuge from volatile stocks by pumping money into real estate. In short, the booming stock market that launched the housing bubble inflated it even more when stocks plummeted. Also during that time, to stem a crisis of consumer confidence, the Federal Reserve began a series of interest rate cuts that cheapened credit.
Within a few years, the homeownership rate hit an all-time high. Constant for more than 20 years around 64 percent, homeownership soared from 1995 to 2006 -- hitting nearly 70 percent.
This rise was mostly due to people who dove into the deep end. Before the mass-merchandizing of sub-prime lending, and seemingly cheap credit, many of these buyers would never have qualified for a conventional mortgage.
Some took out oversized loans without understanding how much debt they were assuming and how much their interest rates and payments could change. Others dove in with full knowledge -- gambling on a superheated market to boost their home's value, so that they'd be able to handle high-priced loans by refinancing later at lower rates. Others hoped to make money by "flipping" their properties.
For a few years, it seemed to work. In much of the country, prices steadily increased. Homes -- traditionally viewed as places to live and long-term financial commitments -- became short-term investments.
Buyers who were already deep in mortgage debt got in even deeper by using their homes as ATMs, cashing out the equity created by the real-estate appreciation.
But many of these borrowers weren't in a position to keep up with their loans if the housing market cooled. When it did, they faced the prospect of owing more than their homes' retail value, or of coping with a mortgage that would soon reset to a much higher monthly payment.
Many people who got in over their heads are hurting. So are the companies holding the securities backed by these loans -- for the same reasons.
To prevent a similar crisis from happening again, some common sense is needed. To begin, we must accept that not everyone is ready for homeownership.
In the past, young people entering the work force typically rented for a while to establish good credit and save for a down payment. Mortgages were harder to get, but they were solid.
Lenders who offered zero-down home loans and low-cost, introductory rates to "cram" buyers into homes that they couldn't otherwise afford were irresponsible. But so were the borrowers who cast caution to the wind and either overpaid for a house, or bought into a house or locale beyond their means.
Further, lenders should hold and manage the loans they create. When lenders sell off the loans they write to investors, they have every incentive to "move as much paper" as possible -- as long as they're not the ones holding worthless paper at the end of the day.
Put another way, the "mortgage meltdown" should teach both borrowers and lenders to behave more rationally.

Bill Higgins is the head of lending services for ING DIRECT.

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