Sub Prime Mortgage Crisis Caused By Unexpected Success

by Brian Brady

Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL

Author website

Sub prime mortgage are defaulting at record proportions.  Lenders are closing their doors and confidence is waning on Wall Street. Greed, corruption, and irresponsibility have all been cited as the reasons for this contraction and collapse. While these factors might be contributing reasons, they are all byproducts from the underlying reason:

The real estate markets behaved better than were expected.

Understanding this concept will require a mastery of Dan Green’s presentation proving that real estate data is granular and not mosaic. Dan said:

But real estate is not a national story, folks. It’s highly, highly local.

To beat the point home, when you buy your next home, it won’t be a home that exists in all 50 states. It will be a home that exists in one state, in one town, in one neighborhood, on one street and that has its own character and economics. Much like the small pictures above.

And that’s what real estate is — it’s a series of very, very small pictures.

Lending developed into a national, or to use Dan’s analogy, mosaic, business. Local factors weren’t considered in the modeling when Wall Street developed the guidelines for Alt-A and sub prime loans. The Wall Street forecasters were correct in their assumptions that real estate was undervalued… nationally. The aging baby boomers and short supply would apply steady pressure on prices in the first decade of this millennium. Nationally, they expected properties to appreciate faster than the prior appreciation rate; they just didn’t anticipate that local markets would behave outside of their model.

Let’s set “ground zero” to Y2K. Wall Street forecasters expected real estate to appreciate at a rate exceeding 6% per annum. It did. They loosened loan guidelines, in a quest for yield, protected by rapidly appreciating collateral. Desirable areas, like Southern California Vegas, South Florida, and Phoenix, led the appreciation wave at rates that were double the expected appreciation rate. Other parts of the country, Idaho, Utah, and Texas, didn’t follow the boom until 3-5 years later. Nationally, the numbers made sense to Wall Street.

The problem? Lenders made loans to San Diegans, in 2005, based on guidelines that were meant for Houstonians. San Diego appreciated some 100% or more in the period of 2000-2005; far above the expected appreciation rate. Reversion to the mean theory dictates that underperformance was in the cards for San Diego for 2006-2010 while out performance is expected for Houston. The national data hid the fact that the riskier loan product was made, an a very risky asset in San Diego, in 2005.

Money is ammoral and naturally flows to higher returns. Residents of industrial cities, like Philadelphia, took advantage of the easy credit revolution and migrated to Cape Coral, FL. It was rational, in the Philadelphian’s mind, to bid up the price of Southwestern Florida real estate because the borrowing terms were so inexpensive. The Philadelphian’s perspective of value was 175% higher than a Floridian’s. The problem is that the underlying economic base didn’t support the appreciated price in the boom town; this removed the ability to service the new debt. That combined with the now risky collateral, made for the lending disaster we face today.

The real reason for the sub prime mortgage market collapse?

Unexpected success. In three years, real estate will have appreciated to prices that are over 60% higher than they were in 2000. If the graph looked like an escalator, instead of a roller coaster, there would be no mortgage crisis today.