A Primer on Easy Credit and the Housing Bubble

Sean sent me this comprehensive and informative (and, thankfully not too long) description of all the easy credit that has been available in the US, how it has affected the housing market, and what will ensue if/when a rash of defaults hits the lenders and the markets: "Could Risky Mortgage Lending Practices Prick the Housing Bubble? "

I had heard of adjustable-rate mortgages (ARMs); I had heard of interest-only mortgages (I-Os). But I had never heard of these:

Finally, there's a minimum-payment option, which doesn't even cover all the interest. The unpaid interest is added to the debt, boosting the interest charge. A borrower who routinely chose this "negative amortization" option would end up owing more than he would have originally borrowed.

People who use these must be expecting large future increases in their wealth. Maybe they are young professionals who expect huge increases in their incomes. Perhaps they expect rich relatives to bestow massive estates on them. Or maybe they expect to win the lottery.

"As interest rates have stayed low, all kinds of lenders and builders are seeking to constantly expand the scope of home ownership," says Wharton real estate professor Lynn B. Sagalyn. Exotic mortgages allow lenders to reach customers "who otherwise might be shut out of the market as home prices soar at record rates."

Lenders scrambling for business are also offering loans to people with poor credit, and borrowers can now make down payments of only 5% or 10% - and sometimes zero percent - while 20% was standard not many years ago. "The deeper we get into the pool of what we call marginally eligible borrowers, the riskier it gets" for borrowers and lenders, Sagalyn notes. "That's something of a time bomb."

No kidding.
The article concludes:

While it's impossible to know which lenders and investors carry the most risk because many loans are bundled into mortgage-backed securities and traded on a world-wide market, mortgage defaults could in fact cause losses in mortgage-backed securities, harming many financial institutions and investors across the globe. "If and when the business cycle turns and we are in a recession, the result of this [heavy use of exotic mortgages] is that the recession could be more severe."