Housing Conundrum (part 4) The virtuous circle of housing price appreciation making defaults go down making lending lax making housing appreciate even more
Housing Conundrum (part 4)
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- I'll now explain to you why, from 2000 to 2005, we had very
- low defaults on mortgages.
- Let's say that I buy a house for $1 million.
- I buy a $1 million house.
- So let's say the bank gives me $1 million.
- And then I'm willing to pay a percentage on it.
- So this is from the bank.
- This is me.
- And I use that to buy a house.
- I don't know if these diagrams help you.
- But you get the general idea.
- And the bank does that.
- And let's say, I don't know, a year later I lose my job.
- I just can't pay this mortgage anymore.
- So I have a couple of options.
- I can either sell the house and pay off the debt, or I
- guess I could just tell the bank, well I can't do
- anything, and I'm going to foreclose.
- And that would ruin my credit.
- It would hurt my credit.
- And I would lose all my down payment.
- So what are the circumstances that I can sell the house?
- Well, if I borrowed $1 million, as long as-- and
- let's say I didn't put any money down, just for
- If I can sell the house for $1.1 million, well I
- would do it, right?
- Let me sell for $1.1 million.
- If I sell for $1.1 million, I pay the bank--
- let me switch colors.
- I pay the bank $1 million, and I net $100,000.
- And everyone's happy.
- The bank got their money back, so they didn't lose any money
- on the transaction.
- I made $100,000.
- And so the whole reason why this worked out, even though
- maybe I was a credit risk, is because the
- housing prices went up.
- So when you have rising housing prices, the banks will
- not lose money lending you.
- Because if you can't pay, you just give back the house, the
- bank can sell it.
- Or, you won't even give back the house.
- You'll sell the house and you'll pay it off, even though
- you can't pay the mortgage anymore.
- The only situation where I would foreclose is if the
- market price of the house goes less than my loan.
- And that's actually the situation that
- we're facing now.
- So if, let's say that I can only sell
- this house for $900,000.
- Well, then I'm just going to give the
- keys back to the bank.
- That's actually called jingle mail, because you just mail
- the keys back.
- And then the bank sells the house for $900,000.
- And then they would take a loss.
- So when housing prices go down, that's the only
- situation where really you should have foreclosure.
- When housing prices soon. go up, the person who borrowed it
- is just going to sell the house and pay off the loan.
- And they are actually probably going to make some money.
- So there was every incentive to buy a house.
- So let's think about this whole dynamic over the last
- several videos that we've been building.
- So we said, from 2000 to 2004 housing prices went up.
- Let me do it like this.
- Let me change it a little bit.
- We can even say, from 2000 to 2006.
- So we know that housing prices went up.
- And why did why did housing prices go up?
- Well, we saw the data.
- It wasn't because people were earning more.
- It wasn't because the unemployment rate went down.
- It wasn't because the population increased.
- It wasn't because the supply of houses were limited.
- We disproved all that.
- We realize it was just because financing got easier.
- The standards for getting a loan went lower and lower.
- Financing got easier and easier.
- And because housing prices went up, what did that cause?
- We just said when housing prices go up,
- default rates go down.
- You could give a loan to someone
- who's a complete deadbeat.
- But as long as housing prices go up, if they lose their job,
- they can still sell that house and pay you back the loan.
- So housing prices going up makes sure there's no
- foreclosure, so defaults go down.
- So then the perceived risk goes down, of lending.
- Perceived lending risk goes down.
- So that makes more people willing to lend.
- And the corollary of more people willing to lend, is you
- that the actual standards go down.
- That's financing easier.
- We could actually write that.
- Standards go down.
- So you had this whole-- I guess you could argue whether
- this is a negative or a positive cycle.
- But you had this whole cycle occurring from the late '90s,
- but especially, it really got a lot of momentum at around
- 2001, 2002, 2003.
- That financing got easier, despite the fact that people
- were earning less, population wasn't increasing that fast,
- that there were all of these new houses.
- And that caused housing prices to go up.
- Housing prices went up, then we had a lot fewer people
- defaulting on their loans.
- No one would default on their loans if they could sell it
- for more than the loan.
- Then a lot more people said, well these are super safe.
- And so the ratings agencies, Standard and Poor's and
- Moody's, were willing to give AAA ratings to more and more,
- what I would argue, are risky loans.
- So the perceived lending risk went down.
- Then more and more people liked this asset class.
- They said, wow, this is great.
- I can get a better return than I can get in a bank, or in
- Treasuries, or in a whole set of securities, even though
- these are very low-risk or perceived low-risk.
- So I want to funnel more and more money in here.
- And so the mortgage brokers and the investment banks said
- great, the only way we can get more volume to satisfy all
- these people who want to lend money-- the only way we can
- find more people to lend money to, is by
- lowering the standards.
- And this cycle went round and round and round.
- And it really started because this whole process of being
- able to take a bunch of people's mortgages together,
- package them up, and then turn them into securities and then
- sell them to a bunch of investors-- this was a
- quote-unquote innovation in the mid-'90s, or early '90s.
- I forgot exactly when.
- And it really started to take steam in the early part of
- this decade.
- So that's essentially why housing prices went up.
- And why kind of all of this silliness happened.
- And in the next video, I'll talk a little bit more about
- maybe who some of these investors were.
- And I'll tell you what a common hedge fund technique.
- And I think it's very important not to group all
- hedge funds together.
- There are some good ones.
- But what a common hedge fund technique was, to take
- advantage of this virtual cycle, to make the hedge fund
- founders very wealthy.
- I'll see
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