Financial Naivete and Greed Led to Meltdown

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Financial Naivete and Greed Led to Meltdown

Richard Cordray, the Ohio treasurer, spoke recently to the trustees of the University of Cincinnati’s Economics Center for Education & Research about the need for financial education for our citizenry, especially our high school students. He used the region’s problems with mortgage foreclosures and subprime loans as examples of the cost of ignorance about personal finance.

Much of the mortgage problem is caused by new and complex financing techniques that have changed the way in which banks and other financial institutions relate to borrowers. It is not unusual for people to receive mortgages with very low (sometimes zero) down payments at unrealistically low interest rates that jump up to unsustainable rates very quickly.

In the past, financial institutions were hesitant to make these loans; today they often make the lower-quality loans and “bundle” them with higher-quality loans. They are then sold to mortgage brokers and investment companies.

By selling the loans immediately, financial institutions reduce their exposure to bad loans; however, they also may reduce their diligence in determining the borrower’s capability of meeting their obligations.

Cordray believes the use of the secondary market has pushed aside our traditional community-based mortgage lenders. The weaknesses of these loans were covered over when housing prices were rising steadily and rapidly. With increasing prices, the collateral (i.e., the value of the house) of the loan also increased. However, prices are no longer rising, and borrowers are defaulting in droves. The default problem is made worse because of the disconnect between the original borrowers and the thousands of investors who brought the loans on the secondary market. This makes renegotiating these loans difficult.

Another problem is that the investors who purchased the loans don’t know how many subprime loans are in the bundle. This uncertainty has created some skittishness. The market is now increasingly rejecting mortgaged-backed securities, causing money for new mortgage loans (high quality or not) to dry up.

The shrinking pool of funds for mortgages makes home loans harder to come by, reduces the demand for homes and contributes to a shrinking housing market and further declines in housing prices.

This uncertainty has a broader effect. Investors and financiers, including sophisticated financial institutions on Wall Street, are finding that they have underestimated the risk of their investments. This is why we are seeing billion-dollar write-offs. They are finding it difficult to unload these securities, and that is crimping their ability to finance other business deals. Uncertainty in the mortgage markets has increased volatility in financial markets and its consequences are worsening the prospects for the economy.

Here are the lessons:
- Prices (even housing prices) don’t always go up.
- Financial markets can be fragile and volatile
- Ignorance about personal finance is costly to individuals and the public at large.