The end of inflated leverage

An extreme relaxation of lending standards inflated the housing bubble.

"Shoddy underwriting on mortgages" is the primary cause of the housing crisis, says York, the Wachovia economist. "People got caught off-guard by how bad it was."

Millions of home buyers — poor, rich and middle class — were approved to buy homes at prices that had been out-of-reach just a few years earlier. Lenders offered low introductory "teaser" rates on adjustable rate mortgages and approved borrowers based on artificially low mortgage payments, not the higher ones that took effect later.

What else changed:

• Optional payments on principal —In 2005, 29% of new mortgages allowed borrowers to pay interest only — not principal — or pay less than the interest due and add the cost to the principal. That was up from 1% in 2001, according to Credit Suisse, an investment bank.

• No verification of income —Half of mortgages generated in 2006 required no or minimal documentation of household income, reports Credit Suisse.

• Tiny down payments —In 1989, the average down payment for first-time home buyers was 10%, reports the National Association of Realtors. In 2007, it was 2%.

Low down payments and ARMs gave homeowners enormous financial leverage to pay high home prices. Leverage boosts buying power through debt, the same way a 100-pound woman uses a lever to jack up a 3,000-pound car.

Consider a couple with $20,000 cash. In 2006, they easily could get a 5% down mortgage to buy a $400,000 house. Today, a 10% down payment would limit the couple to a $200,000 house.
"Leverage matters a lot when you buy a house," says University of Wisconsin economist Morris Davis, an expert on housing prices and rents. "We're not going to go back to the days of only 20% (down payment) mortgages, but the days of putting nothing down are long gone."

Easy access to borrowed money reset all housing prices, even those paid by cautious borrowers. People of all income classes moved up a notch, Census Bureau housing data show.

The sale of new homes costing $750,000 or more quadrupled from 2002 to 2006. The construction of inexpensive homes costing $125,000 or less fell by two-thirds. The biggest boom was in the middle. Homes costing $200,000 to $300,000 became affordable to millions of families.

The failed titans of home lending — Countrywide Financial, IndyMac Bank and Washington Mutual — specialized in high-risk, highly leveraged loans.

"The price correction has been severe, rapid and probably permanent because lending standards have changed," says mortgage credit analyst Suzanne Mistretta, a senior director at Fitch Ratings, a bond rating company. "We are not going to see 2006 peak levels for a very, very long time."