Exotic loan financing terms took over mortgage finance in the Great Housing Bubble. As people using these loan programs began to default in large numbers, exotic loan programs all but disappeared. This left the 30-year, fixed-rate, conventionally amortized loan as the only game in town.
When people decide they want to buy a house, they figure out how much they can afford, then they search for something they want in their price range. For most people, what they can "afford" depends almost entirely upon how much a lender is willing to loan them. Lenders apply debt-to-income ratios and other affordability criteria to determine how much they are willing to loan. Buyers are generally limited in how much they can borrow because lenders are wise enough not to loan borrowers so much that they default. Borrowers behave much like drug addicts, they will borrow all the money a lender will loan them whether it is good for them or not. Most borrowers are not wise to the differences between the various loan types, and they have limited understanding of the risks they are taking on.
The vast majority of residential home sales have lender financing. The interest rates and various loan terms have evolved over time. After World War II a series of government programs to encourage home ownership spawned a surge in construction and the evolution of private lending terms resulting in the 30-year conventionally amortized mortgage. This mortgage generally required a 20% downpayment, and allowed the borrower to consume no more than 28% of their gross income on housing. These conservative terms became the standard for nearly 50 years. Lending under these terms resulted in low default rates and a high degree of market price stability.
There were experiments with various forms of exotic financing during this period, particularly in markets like California where price volatility required special terms to facilitate buying at inflated pricing. The instability of these loan programs was demonstrated painfully during the deep market correction of the early 90s in California characterized by high default rates and lender losses.
Rather than learn a difficult lesson regarding the use of these alternative financing terms from this experience, lenders sought out ways of shifting these risks to others though a complex transaction called a credit default swap. Once lenders and investors in mortgages thought the risk was mitigated, these unstable loan programs were brought back and made widely available to the general public resulting in the Great Housing Bubble.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
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Conservative House Financing Is Making a Comeback!.
