In its simplest form, there are only three fundamental ways to extract money from the property markets: 1. Sell, 2. Rent, or 3. Borrowing against the Equity. Those fundamentals are largely driven by seven key fundamentals: 1. Demographics, 2. Household Formation Rates, 3. Rising Incomes, 4. Zoning Policies, 5. Immigration, 6. Foreign Capital and 7. Underwriting Standards. Those seven fundamentals largely drive supply and demand for property. But, the 2007-2008 housing crisis led many to believe that financial engineering and securitization obviated those principles, which was untrue. While not the primary cause per se, it was one of the leading factors to the 2007-2008 financial crisis discussed below.
Leading up to the housing crisis of 2007-2008, housing performed relatively well as an investment driven by demographics, rising household formation rates, rising incomes, and, in turn, rising housing prices. As a result of such prosperity, many people were told that housing was one of the best investments that a person could make. Despite such assurances coupled with rising housing prices, the fact still remained that the only way a homeowner could extract that value from their property is either by 1. Selling, 2. Renting, or 3. Borrowing against the Equity.
The securitization of mortgages was supposed to offer an investment opportunity while also diversifying and reducing the risks. Yet, no matter how various tranches were created to reduce risks, a group of investors purchasing securitized mortgages does not reduce risk by any means as the risk still remains in the aggregate commiserate with the underlying which is the homeowners’ ability to pay the mortgage. What securitization did do is no longer hold banks and underwriters accountable for their risks and this is the primary factor that led to the housing crisis of 2007-2008.
If the lendors and underwriters make very poor loans, that will impact their portfolio’s, underwriting standards, solvency ratio’s, loan-to-value ratio’s, etcetera. The securitization process meant lendors and underwriters did not have to hold mortgages on their books as they could simply be reconstituted and sold to investors which opened pandora’s box. As underwriting standards deteriorated, loan origination increased, while more and more people were owning homes who did not have sufficient incomes to pay the mortgages, let alone adjustable rate mortgages. This also led to increased speculation and proliferation of “house flipping” which caused housing prices to become untethered from the fundamentals. Moreover, the increases in housing prices and, in turn, household equity created an illusory cushion that masked the rise in loan delinquencies.
Once the positive reinforcing factors that were created from securitization and lack of accountability dissipated, the process began to reverse itself creating systemic and converging losses impacting both the real and financial economy.