The Ascent of Money - Part 5
In this episode, titled Safe As Houses, Ferguson explains how the landscape in the housing market went from only the financial elite owning property to home ownership being made affordable for just about everyone.
He explains how this was done by transferring the risk associated with issuing mortgages to uncreditworthy borrowers by selling the mortgages to an investment bank, the investment bank mixing a bunch of bad mortgages with a few good mortgages, and selling the bunch as investments to investors and institutions looking for a higher return on their money.
Ferguson also introduces a relatively new concept in finance called microfinance, which we think will help many developing countries become developed in an accelerated amount of time.
The Ascent of Money (Part 5): Safe As Houses
As in prior posts in this series, we think there are some important issues we should highlight.
The American Dream, The Housing Bubble, and The Credit Crisis
Home ownership has been identified in recent years as being part of the American Dream. This widely held belief was part of the sales pitch that contributed the housing bubble and credit crisis that ensued shortly after. People were sold on the fact that they could own a home of their very own, despite some of them having no income and/or no assets - which are part of the building blocks of a person’s finances. Included in this sales pitch was the faulty assumption that the value of the homes they bought would always increase.
Another major contribution was the historically low interest rates that were present. These low interest rates encouraged banks to borrow money very inexpensively, and since it was so cheap to borrow, many banks borrowed more than they should have.
Now the banks were sitting on all this cheap money they borrowed, and they had to make it work for them. As we mentioned in The Ascent of Money (Part 1): Dreams of Avarice, banks make money by lending money to people.
So many banks had so much cheap money that in order to find borrowers and make their money work for them, they had to relax their criteria for creditworthiness and lend to some people they wouldn’t have normally lent to.
The Downside of Financial Innovation
In The Ascent of Money (Part 4): Risky Business, we wrote about financial risk and how insurance protects us from the financial risks we are afraid of.
The banks that were lending all this money to these sub-prime borrowers, likewise, were afraid of what would happen if these borrowers defaulted on their mortgages. Fortunately for them, investment banks on Wall Street were looking for alternative investments they could sell to investors and institutions.
In order to protect themselves from defaulting borrowers, the banks and mortgage lenders sold their sub-prime mortgages to the investment banks, who pooled them together with other mortgages of different qualities, and sold the pools as investments.
This practice was called securitization, and the idea behind it was that even though some of the mortgages would default, the diversification in these investments would reduce the overall risk of the security.
This securitization of mortgages was quite a clever innovation, as it transferred risk from those who didn’t want it to those who were willing to accept some risk for the possibility of higher returns on their investments.
However, the level of risk associated with these investments could not properly be measured, since there were now several layers between the borrower who actually owed on the mortgage and the investor who bought the security of which that mortgage was a part of.
When interest rates started rising again, the interest rates on adjustable-rate mortgages rose, which meant that the monthly mortgage payments for these borrowers also rose. Borrowers who had gone into a mortgage just barely able to afford the payments now found themselves not able to afford the payments at all, and they began defaulting on their mortgages in significant numbers.
The point we’d like to drive home again here is that financial innovations often are invented with the best of intentions, like transferring risk to someone willing to take it. More and more often, however, they tend to get overly complicated as people try to build more layers into them in order to make increasing amounts of money.
Go to the next post in the series - The Ascent of Money (Part 6) - Chimerica.
Learn more about Niall Ferguson at his website - NiallFerguson.com.
Buy Niall Ferguson’s book - The Ascent of Money: A Financial History of the World.
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