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How Did We Get Here

This is part one of a two-part series (Part II) on what has really happened in the mortgage market. Today, I will talk about the events that happened to get us to next week’s topic: where we are today.

To understand where we are today, we must first look at a period of time that starts in 2001 – the beginning of the modern mortgage industry – to 2007 – the peak of the housing bubble. Mortgage lending guidelines were drastically loosened due to a mounting demand for mortgage-based investments. This led to a surge in borrowing power, home prices and mortgage origination.

Investor Demand Skyrockets

Wall Street firms rapidly realize that mortgage products were profitable and, in turn, created a demand for more and more mortgage-based investments. Lenders and their secondary-market investors then relaxed their lending guidelines to generate higher mortgage loan volumes. With more borrowing power, buyers were then enticed by the allure of stretching for larger homes, second homes and investment properties. Homebuilders saw the potential as well and built new homes at a record pace.

Borrowing Power Surges

Prior to 2001, the typical borrower could qualify for a loan amount that was roughly equal to three times their before-tax income.

Beginning in 2001, borrowing power surged based on:

  • Rising income levels
  • Falling interest rates
  • Higher allowable debt-to-income ratios
  • Interest-only mortgages
  • Low- and no-doc mortgage options
  • Low- and no-down payment options
  • Increased credit availability

With these loosening mortgage guidelines, from 2001 to 2007, borrowers could qualify for a loan amount that was roughly equivalent to nine times their before tax income. Wow!

Home Prices Soar

As borrowing power increased exponentially, so did the prices of homes. From 1975 to 2000, the Compound Annual Growth Rate (CAGR) for home prices trended at 1.4 percent. From 2000 to 2007, that rate trended at 7.6 percent. Home prices were driven up by unsustainable increases in borrowing power.

Mortgage Lending Standards Ease

In addition to expanded guidelines, lenders and their secondary-market investors also lowered their credit standards. Subsequently, borrowers were introduced to 100% financing, interest-only loans and limited-to-no documentation loan programs.

Next week, I will talk about the ramifications of the above issues and where we are today after these consequences have been realized.

A special thanks to T2 Partners Management LP (www.valueInvestingCongress.com) and JP Morgan Chase and Company (www.chase.com) for the data that was used for this blog entry.

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