The Finance Professor

Return to Article

Five Lessons From the Mortgage Meltdown

Scott Rothbort

However, academics use terms like dislocation rather than trader talk like "crash," "bubble bursting" or "meltdown." But regardless of how it's labeled, there are a few timeless lessons. However, let's start by doing a brief review of what led up to the recent "debacle."

Late 1990s to Early 2000s

• Thanks to the effects of high interest rates, the failure of the savings and loans industry, and excessive speculation of the late-1980s, the real estate market languished for many years. As an asset class , real estate took a back seat to the global thirst for technology and Internet stocks.
• A collapse of the technology and Internet bubble led the nation into recession , so the Federal Market Open Committee -- FOMC -- lowered interest rates. Then soon after the attacks of Sept. 11, 2001, the FOMC lowered rates even more.
• Demand for home ownership soared as employment rose and interest rates declined.
• New and innovative mortgage products were developed and marketed in parallel with asset-backed securitizations .
• Mortgage originators and REITs stepped into the void left behind by the S&Ls, keeping the S&Ls' trademark poor risk management and outside of the realm of major regulation.

Mid- to Late 2000s

• Excessive speculation and overbuilding took the housing markets to new highs.
• Underwriting standards by mortgage originators were lowered to accommodate more borrowers who fell into the "subprime" category.
• Interest rates rose as the FOMC removed the "policy accommodation," as it began to tighten interest rates by a quarter of a percent on 17 occasions, up to 5.25%.
• Mortgage defaults rose, liquidity for securitization disappeared, mortgage companies failed and home builders were stuck with too much inventory.

So what can investors learn from this history? Here are five key takeaways to benefit investors in the future -- regardless of asset class. 1. Don't Be a 'Marginal Moron'

I have a theory I call The Marginal Moron Rule, meaning: Whenever a market reaches peak levels of speculation, the last entrants into that market lack the necessary knowledge or sophistication to properly navigate their newly chosen field. As my old boss Joe at Merrill Lynch would say, "These are the guys who take the last nickel off the table."

During the height of the technology and Internet boom, there were schoolteachers, doctors, attorneys, housewives and police officers who left their daily roles to take up daytrading . Their fundamental knowledge of investing was practically nil. Some of them took up technical trading by taking courses.

However, ultimately, most of them found out the hard way that they were at the end of a speculative bubble, and their money management days quickly ended. (That is not to say that some of these people did not succeed, because some did, such as RealMoney.com's James "Rev Shark" De Porre.)

After the tech/Net bubble burst, we saw the marginal morons flock to the next investment flavor of the month, real estate -- just when the housing market reached its heights. Again, untrained individuals quit their day jobs and entered a sophisticated market. Many took courses or read books on subjects along the lines of "how to make millions in real estate with no money down."

My wife, a real estate attorney with more than 20 years of experience, would have to face off or work with self-proclaimed real estate attorneys who had little or no real estate law experience or brokers who were clueless as to the ways in which the market operated in the real world. Now they are all out of real estate (and several are unemployed). The lesson: Don't enter a market where the marginal morons are fighting over the "last nickel."

2. If You Can Afford Beer, Then Stick to Beer

My Aunt Bernice has an expression about people who buy things that they cannot afford. She describes them as having "champagne taste with a beer pocketbook."

As a matter of public policy, we should ensure that everyone has affordable housing, but that does not entitle each citizen to own their own home. Yet, throughout the last several years the housing system was bastardized to make home ownership affordable to everyone who could not afford true home ownership.

Besides the complexities of dealing with adjustable rate mortgages (ARMs ), "no doc" and "no money down" loans, home ownership has many more costs and variables, such as insurance, taxes and maintenance.

My wife and I put down 40% on our first house. While I am not saying that everyone should do that, it makes much more sense than putting yourself at risk by buying a house that you simply cannot afford. Buy what you can afford without having to resort to financial gimmickry (see "Understanding Leverage").

3. Cable Programming Is Not the Same as a Proper Education or Apprenticeship

CNBC brought us play-by-play coverage of the tech/Net bubble and daytrading phenomenon. In recent years, courtesy of the ever-expanding cable television landscape, the likes of HGTV and TLC popularized shows such as Designed to Sell, House Hunters and Flip That House, and as a result, a whole new generation of couch potatoes got into real estate (see the Marginal Moron Rule).

With these shows, what starts off as informative or entertaining programming slowly morphs into a collective conscious of speculation. The lesson: Don't mistake or substitute cable programming for a rigorous education or apprenticeship in a particular investment field.

4. If You Build It, They Might Not Come

Real metropolitan centers are built up around centers of industry, government, commerce and finance. Real estate prices always hold up better where there are jobs to be found. Yet, the last 10 years saw a buildup of excess housing inventory in places like Arizona, Michigan, Ohio, Florida and Southern California. Field of Dreams is not a documentary. "They" will not come unless you have jobs for them.

With the exception of Michigan and Ohio, there seemed to be a widespread belief that an endless supply of retirees were seeking to evacuate Northern climates for year-round golf and pay up for the privilege. And the automobile and other heavy-industries are in decline, so could someone tell me why so many houses were built in Michigan and Ohio?

If you plan to get involved in real estate development, please check the local economy and job market.

5. A Fixed-Income Investment Is Not Risk-Free

Maybe it's the legacy of the tech/net bubble or maybe it's investor ignorance or both, but it seems that if something has an interest rate attached to it, investors believe that it has little or no risk, and less risk than stocks . That could not be further from the truth. There were plenty of toxic "pieces of paper " which were packaged and sold to investors and bond mutual funds . Several issuers went into default . Spreads between investment grade corporate paper and government securities widened dramatically. All of those situations caused investors to realize losses or have to mark down fixed-income investments.

The lesson: Fixed-income investments have their own unique risk characteristics, which could cause losses and volatility greater than that of stocks.

To learn more about the recent mortgage meltdown and its repercussions, check out the following stories on TheStreet.com:

• Real Estate Funds Bounce Back
• Mortgage Giants Aim to Reduce 'Jumbo' Rates
• The Fed's Cut Won't Save Struggling Homeowners
• Credit Crises Nothing New -- 1907 Tells Us So
• Why Mortgages Blew Up
• Notes From the Credit Markets Front Lines