5 Red Flags of the Next Mortgage Crisis

mortgage meltdown
mortgage meltdown

By Christopher Maag

What will the next mortgage meltdown look like? For years, some financial analysts have worried that the 2008 financial crisis wasn't unique. Rather, what if the mortgage crash merely exposed a beehive of fundamental problems in our economy that still exist today? Here are some of the competing theories about how these lingering problems might coalesce to form the next big mortgage disaster.

Red Flag 1: Double Dip

The real estate market hasn't exactly rebounded, but at least home sales and prices have stabilized. But what if more problems lie hidden? So asks Dr. Joseph R. Mason, a banking professor at Louisiana State University and a senior fellow at the University of Pennsylvania's Wharton School of business.

Banks wrote lots of bad mortgages during the housing boom, Mason explains. The worst were called "option-ARMs," or adjustable rate mortgages, in which interest rates fluctuate over time. Lenders and loan originators often structured option-ARMs with the low interest rates at the beginning of the loan, sometimes misleading homebuyers into signing bigger loans than they could actually afford, Mason says.

When the interest rate reset, the monthly payment would skyrocket, sometimes by 300 percent. "These loans are the worst of the worst of the worst," Mason told Credit.com last fall.

Most option-ARMs had low-interest "teaser" periods lasting five years. Since the last of these loans were written in 2008, their interest rates are resetting right now. Mason worries that exploding option-ARMs could drive us into a double-dip recession.

Red Flag 2: Gutted Dodd-Frank Means Gutted Future

The financial protections in the Dodd-Frank law were supposed to make another mortgage crisis impossible. But some observers worry that after two years of intense lobbying by investment firms, the Dodd-Frank Wall Street Reform and Consumer Protection Act is not strong enough to do its job.

Mortgage-based credit default swaps and derivatives played a major role in causing the mortgage bubble because big banks made so much money packaging and selling them, says Kathleen Engle, a law professor at Suffolk University and one of the first academics to study the mortgage bubble. The original version of Dodd-Frank clamped down on both practices. But thanks to intense bank lobbying, as Rolling Stone's Matt Taibbi reported, under Dodd-Frank both practices may continue unabated.

Some worry that since many of the practices that caused the first mortgage bust remain legal, there's little to stop the same problems from happening again.

"The fate of Dodd-Frank over the past two years is an object lesson in the government's inability to institute even the simplest and most obvious reforms," Taibbi wrote.

Red Flag 3: People Learned Their Lesson, Too Well

Americans aren't buying many homes, but there's plenty of desire to rent. Only 8.8 percent of apartments are unrented, according to the U.S. Census Bureau, a vacancy rate unseen since 2002.

Is this a cultural shift away from homeownership? If so, it could create an entirely different type of housing-based economic crisis, Liz Davidson, CEO of the financial planning firm Financial Finesse, wrote in Forbes magazine.

"If Americans don't recover soon from their pessimism around homeownership, we predict another fallout from the financial crisis will surface many years from now when a nation of renters tries to retire," she writes. "They won't have equity in their homes. Their paychecks will be stretched to the limit, not leaving room for saving and investing for retirement...."

Red Flag 4: Own a Home? Try Proving It.

Try going to your county courthouse to see who owns your mortgage, and chances are good that the records will say: MERS.

MERS stands for Mortgage Electronic Registration System. Created in 1993 by Fannie Mae, Freddie Mac and the nation's largest banks to speed up securitization, in which mortgages are bundled into trusts and sold as shares to investors, MERS largely supplanted the nation's system of tracking property ownership rights. Now, instead of notifying county governments every time a mortgage changes hands -- and paying a $15 filing fee -- banks register those changes with MERS for free.

Reporting mortgage ownership swaps to MERS is entirely voluntary, and as a result, some observers argue that banks and servicers rarely do. More than 70 percent of the mortgage records in the MERS database are inaccurate, according to a study by Alan M. White, a law professor at the University of Indiana.

"MERS has no information other than hearsay about who the owner and the servicer are," April Charney, an attorney with Jacksonville Area Legal Aid in Florida who has sued MERS, told Credit.com.

"These cases have no merit in our view," says Janis Smith, a MERS spokeswoman. The company has steadfastly maintained that it has not broken any laws (and courts have agreed with them) and in a 2011 email wrote: "With the MERS System, mortgage data is more accurate and title information more reliable."

The problem, Charney argues, is that giant employee retirement plans and 401(k) managers invested trillions of dollars in mortgage-backed securities, and if they lack accurate documents to prove that they own as much as 70 percent of those mortgages, the impact on the real estate market and the entire economy could be far-reaching.

Red Flag 5: Back to the Old Boom and Bust

Many experts blame the last housing crisis partly on Alan Greenspan, the former Federal Reserve chairman, who kept interest rates low and dollar volumes high from 2002 to 2004. This injected cheap money into the economy, which lenders used to fund lots of risky mortgages.

"Money washed through the economy like water rushing through a broken dam," according to the majority report of the Financial Crisis Inquiry Commission.

The Fed has a similar policy now. Ben Bernanke, the current Fed chief, recently told Congress that he will keep the rate at close to zero percent through 2014.

Some worry that such lax monetary policy may already be fueling the beginning of housing's next boom-and-bust. The Fed's policy "is extremely risky," Paul Singer, the investor who became famous for shorting subprime mortgages years before most people saw the danger, told The Wall Street Journal.

Read more on Credit.com:
10 Mistakes New Homebuyers Make
Is One Late Payment Really That Bad?
How to Buy a House Without a Bank

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Home Financing and Down Payments
Home Financing and Down Payments