Robert Shiller talked with the McKinsey Quarterly about the housing market recently and covered some wide ranging topics on the United States financial and mortgage markets.

One of the key points that Shiller made was that our criteria for writing mortgages was a mess. I agree with him.

When the mortgage instrument gained popularity, the contract was that a homeowner had a significant investment in the home so that they would feel compelled to fight through bad times.

Then came the time of 80–20 loans and 97 percent loans and even the 125 percent loans. Where the homeowner did not take any of the initial risk of the investment but faces huge problems in a down market. It led to them overextending the risk they took in buying a new home that would not have occurred previously.

For example, if home buyer Jim had $20,000 for a down payment, back in the day he could afford a $100,000 home (20% down). Logical, gave the bank some wiggle room for market fluctuations, and allowed the homeowner to buy at a reasonable level.

The came the early part of this century. That down payment got Jim into a $500,000 home with an Adjustable Rate Mortgage to keep the payments reasonable. The ARM loan made sense as prices were sure to go up and he would refinance.

However, when housing prices dropped, hypothetical Jim was left holding the bag on a home with higher maintenance costs, higher utility costs, and being down 20 percent, and was now was worth $400,000, a loss of $100,000. His loss was as much as the house he should have qualified for originally!

So back to Robert Shiller, the risk that was built into the market became unsustainable for both the homeowners and the banks. It allowed valuation to increase rapidly as too much easy money entered the equation while taking homeowners out of a safe situation where they built equity slowly and created a huge risk.

Another thing is risk management with regard to housing, for example. We have a huge mess-up here, because people have been urged by experts and by national leaders to invest all of their life savings in a single risky investment, a home in a city, in a leveraged way. They would borrow 80 percent, 90 percent, or even more of the money to buy the home. And so they’re putting their life savings on the line in a crazy way. So this shouldn’t be the new normal; but we have to then redesign our mortgage institutions.

We have over 12 million people who are underwater—that is, they have negative net worth in their homes. And, typically, these people have nothing else, so they’re wiped out. How can it be that we were anywhere close to the right system? There are some people who doubted it would ever happen. I’ve talked to these people, and it seems to be often based on the assumption, one way or the other, that home prices would only go up. Well, we’ve just learned that they don’t just only go up. via The McKinsey Quarterly

Related posts:

1. Robert Shiller Says BUY BUY BUY!!!
2. Case Shiller Report For September 2009
3. Case Shiller January 200 Report Shows Declines in Housing Speeding Up
4. Case Shiller December 2008 Report Shows Consistent Declines
5. Case Shiller Report For May 2009 – Real Estate Looking Better