Where did High Risk Mortgage Loans Come From?

Can anyone tell me how these high risk loans came into being? Who first created them? Was it legislation? Was it just a choice by one huge lender, which then caught on, or several little lenders, slowly creating a standard? I guess what i'm asking is who's big idea was this? thanks for your time

1 Answer

Ultimately these mortgages where made available due to advances in loan securitization. It is much more complicated than that, and I will do my best to explain over the next few paragraphs, but a growing secondary market for mortgage loans is what started program expansion which led to the offering of these programs.

First I'll give an explanation of what mortgage securitization is and then explain why and how it created an insuppressible appetite for exotic mortgage loans. A securitized mortgage is one that, along with other loans has been placed in a pool and classified as a single asset. Mutual funds, pension funds, and even individuals can invest in this asset just the same as any other stock or bond. When a consumer makes their mortgage payment, a small piece is taken out for servicing (processing the payment and providing customer service) and the rest is passed on, typically to Fannie Mae, Freddie Mac, or Ginnie Mae depending on the type of loan it is. That borrower’s payment is then pooled with other borrowers’ payments, and paid out to people who have invested in these securities. The securities are backed by the mortgage loans in the pool (hence, Mortgage Backed Security, or MBS).

Mortgage Backed Securities originally came to be in 1970, and were created as an alternative investment to bonds, as well as a way to drive additional mortgage lending. Prior to that, when a bank lent money to an individual they had to wait for a monthly payment each month to recoup the money that they lent. With securitization they could write a loan, and lend say $100,000 to a borrower, then turn around and sell that loan to Fannie, Freddie, etc and get their $100,000 back almost immediately to lend to someone else. Fannie and Freddie would pool all of these purchased loans together, and offer small slices as investments. By doing so, in reality the money being lent when you buy a home is being lent by end investors whether they are pension funds, mutual fund managers, etc. This allows for a much larger pool of money than any bank could offer, allowing people to obtain mortgage loans easier.

Now that you understand the basic mechanics, you can learn the 'why'. For a long time securitization was limited to Fannie Mae, Freddie Mac, and Ginnie Mae. These 3 entities created loan guidelines that a bank or lender had to follow to sell their loan. There had to be a certain amount of equity in the property, the borrower must have good credit, etc. As long as the banks followed these guidelines, they could sell the loan to Fannie/Freddie and get their money back to lend to someone else. This was a safe and predictable way to securitize mortgages.

The biggest change, in my opinion came in 1999 with the passage of the Gramm-Leach-Bliley Act. This act essentially repealed a portion of Glass Steagall, which was an act passed in the aftermath of the stock market crash. The original act prohibited any single bank from offering consumer banking, investment banking, and insurance. It was designed to keep consumer banks separated from Wall Street investment banks. Gramm-Leach-Bliley took this protection away, in turn paving the way for some of the financial powerhouses that exist now. What it also did was open up Main Street to Wall Street. All of a sudden, banks who used to only lend to individuals had investment banking arms. This allowed them access to the front side (originating a loan) as well as the back side (securitizing and selling a pool of MBS) of a loan transaction.

As housing started to heat up, someone got the idea that they could offer mortgages that were outside the box of typical lending regulation, and essentially do the same job as Fannie and Freddie. They would offer a loan program for people with damaged credit, or no verifiable income, or no equity, etc and then turn around and package all of these loans to sell as investments taking a piece for themselves along the way. What began with pass-through lenders, which had relationships on Wall Street to sell their loans out the back, became Wall Street firms buying subprime loan origination companies to provide the products directly. As this new availability for credit opened up the housing market further, prices went higher. As prices went higher, the housing market became a speculative market with investors and home flippers and every day consumers all trying to make a buck on the market. As home prices continued to rise, MBS investors clamored for more and more MBS to invest in. Wall Street firms offering higher and higher returns began offering riskier and riskier loans. In the end it became a frenzied circle with one part driving the other, culminating in a market crash when things reached a point where they were no longer sustainable. There are certainly many parts to play in the Real Estate crash, and other reasons that tie into the above, but ultimately an increase in housing parlayed into an increase in MBS interest, which led to looser and looser guidelines, until the market grew past the point of sustainability.