Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System

October 2, 2008

Santa Monica


Glenn Yago and James R. Barth



Back in March 2008, Treasury Secretary Henry Paulson told CNN, "I have great, great confidence in our capital markets and our financial institutions."

Just six months later, it was a different story. "The financial security of all Americans . . . depends on our ability to restore our financial institution to a sound footing," the secretary noted in a press release.

How exactly did we get from point A to point B? Milken Institute economists Glenn Yago and James Barth provided a detailed examination of that question in a recent Forum.

Yago began by noting that the word meltdown entered our lexicon after the Three Mile Island nuclear accident in 1979. Since it refers to the core of a plant overheating and setting off uncontrolled chain reactions, it's a particularly apt metaphor for recent events. But he also encouraged the audience to hold on to a hopeful sign: The global economy is posting positive numbers despite the current liquidity problems. "There is extraordinary vibrancy in the real economy," he insisted.

The story of the mortgage meltdown began when the Federal Reserve, in response to the recession of 2001, began slashing interest rates to historically low levels. The result was an era of easy credit that made homeownership more accessible. Soon new mortgage products were introduced, promising instant access to the American Dream.

Many subprime borrowers joined the party via adjustable-rate mortgages (ARMs), enjoying artificially low teaser rates and banking on the hope of refinancing down the road. The market encouraged this kind of wishful thinking: Barth showed multiple charts illustrating the enormous run-up in home prices created by this surge of demand, with prices in California far exceeding the national average.

Viewed in a broad historical context, the rapid growth in home values clearly indicated a bubble. The ratios of home prices and household debt levels to household incomes had reached unsustainable levels by 2006, a year that saw $1.2 trillion worth of subprime mortgages originated. "Those debt levels should have been warning signs to regulators," Barth stated.

Many of these new loans — especially those obtained with no money down — proved untenable when home prices began to sink in 2007. Today some 5 million households are falling behind in payments, with the worst default rates seen in subprime ARMs. "The products themselves are not necessarily bad," observed Barth. "It's how they were used. You can't blame products for being used inappropriately."

Five million mortgage loans in default is no small problem, but even so, how did matters snowball to such a degree that major U.S. financial institutions were toppled? The answer lies in securitization, as lenders moved from an originate-to-hold model to an originate-to-sell model. By 2005—2006, two out of every three mortgages were securitized — and those securities grew increasingly complex. Rating agencies proved to be of little help; 51 percent of all new securities issued in 2007 were rated AAA by S&P, for example. Barth cautioned that people generally tend to think that AAA means no risk, but that's a dangerous assumption, since there's nowhere to go but down.

Many financial institutions became highly leveraged participants in the freewheeling market for credit default swaps (which Barth described as "ticking time bombs"); these derivatives — coverage by the banks of the securities they sold — were essentially enormous wagers on whether the underlying mortgages would default. This market took on a life of its own, with exposures far exceeding the value of the underlying mortgages. "When you're highly leveraged," explained Barth, "even a small decline in asset value can cause huge losses and increase the risk of insolvency."

When those massive, murky bets went sour, the lack of transparency surrounding the original securitizations caused financial institutions to eye each other's balance sheets with suspicion, worsening the sense of fear and uncertainty. Left exposed with high leverage ratios and huge losses, some of the nation's largest banks and financial firms have fallen, sending the stock market into a tailspin. The Federal Reserve's efforts to pump funds into the economy have so far failed to increase liquidity, restore confidence and set the gears of lending back in motion.

Meanwhile, Main Street is also dealing with the ramifications of the credit crunch, as firms, municipalities and individuals are unable to obtain the funding they need to do business. The distressed housing market continues to take a toll on individual homeowners, though Barth noted that much of the real pain is limited to California, Arizona, Nevada and Florida. Foreclosure rates have doubled since 2006, and even those who are in no danger of default have watched their equity vanish. Most economists feel that the housing market has yet to hit bottom, and may not stabilize until home prices fall another 15 percent.

So where do we go from here? As of the Forum, the fate of the rescue plan being debated in Congress remained uncertain. Meantime, the private sector is working to establish a new clearinghouse or exchange structure for derivatives that will provide greater transparency.

Barth pointed out the patchwork web of regulatory agencies overseeing various financial sectors. He underscored the urgent need to modernize and streamline the functions of U.S. regulators, noting that "you would never tell another country to design a regulatory regime this way."

Barth and Yago also discussed the controversy surrounding "mark-to-market" accounting rules, which have made the pricing of mortgage-backed securities even more perilous in this environment.

But their ultimate verdict was that recapitalizing financial institutions is absolutely paramount. An audience member expressed concern about the current wave of consolidation creating even more institutions that are far "too big to fail," but Barth felt that the survivors should be considered not as simply behemoths in the U.S. market but as global players. Modernizing and recapitalizing the U.S. financial system in this complex new era will be the key to ensuring the nation's competitiveness on a global basis.

Barth and Yago will offer detailed and in-depth analysis in a full-length book, The Rise and Fall of U.S. Mortgage and Credit Markets.