Last October's meltdown on Wall Street sent a jolt through the world. Some of the blame has rubbed
off on the real estate industry.
Some pundits seem to think strong house prices are a bad thing. They are not. Real property is most
families' biggest asset. We are never in trouble when wealth is widely distributed.
Good intentions, bad results
What got the Americans into mortgage trouble began with their government. Congress passed laws
requiring lenders to open their doors to low-income mortgages. It was not good enough just to offer to
lend. The mortgage companies had to show a result. And so was born the sub-prime mortgage.
Sub-primes typically charge higher fees or interest to compensate for the higher risk. Some of the
costs are back-loaded, so an under-qualified buyer can get started. Later he is hit with balloon
payments, escalated interest rates or fees.
Not that some lenders needed much encouragement. Recognizing an opportunity, they made a virtue
out of the legal necessity with store-front lending and minimal due diligence. Two government sponsored
bodies, Freddie Mac and Fannie Mae (something like CMHC in Canada) bought or endorsed the sub-primes,
which gave people confidence because of the implicit government guarantee.
The resulting loans were parceled up and sold as asset-backed securities (we had some in Canada
too). Financial firms sliced the bundles into tranches and built derivative securities that sold separately
from the underlying mortgages. And thus was born the trade in grot-plus-gold securities.
When the grot in the mix started to smell, the meltdown began. The complexity of the instruments
meant no one could separate good from bad. Everything was tainted and the trade collapsed.
Unintended consequences
When banks have losses, they have to balance them against capital. As capital was eaten up with bad
debts, banks had to restrict loans to good clients, to preserve funds and keep their capital-to-asset
ratio in line. Thus the financial system started to seize up. The shortage of credit spread disease to all
parts of the economy.
A lesson in public policy: good intent isn't good enough. It's a lesson to keep in mind as we embark on
our own "stimulus" program.