I’ve got a different theory that involves Bear Stearns creating their own bad luck. I theorize that Bear Stearns adopted the “Credit Card Model” and failed to adjust it for the very real differences in Credit Cards and Mortgages.
When mortgage rates hit 30-year lows after 9/11, lending institutions made money hand-over-fist and rewarded themselves with huge bonuses. When the pool of “qualified buyers” started to dry-up, which would have ended the huge bonuses, lending standards were relaxed to expand the borrowing pool. When that pool started to dry-up, lending standards were again reduced and the process continued until banks were paying residents of skid row to borrow money that they couldn’t repay.
But the folks at Bear Stearns forgot two things:
- The massive increase in borrowing fueled a housing boom that artificially inflated housing prices (in many areas housing prices increased 15-20% per year) so the borrowers late to the party, the “sub-prime of the sub-prime”, had to borrow ever increasing amounts which increased the risk to the lenders drastically.
- The maximum that a Credit Card Company will lose on a borrower is defined by the Credit Limit. Historically about 5% default on mortgages and the banks will sell a foreclosed home at a slight discount (maybe 10%) to limit the losses, so the banks had a historical perspective of how much risk they were taking. But, what happens when the artificial housing bubble bursts and the home that you’ve 100% financed for $250k is now worth $125k? Even the people who can still pay the mortgage are inclined to walk and let you eat the loss because they don’t have anything to gain, why should they pay $250k for a $125k house (plus all of the interest)?. What’s the downside to walking? A bad credit rating? The same bad credit rating they already had because they’d previously walked away from their obligations? Who could have foreseen that bad credit risks were bad credit risks?
The “experts” at Bear Stearns either didn’t understand the risk that they were taking or they figured that somebody else, namely the taxpayer, would get left holding the bag.
As they’ll say in 2021, “A Bear and his Stearns are soon parted”.
