On Mortgages

Finance has a long history. Not all of it is good; many scams and genuine risk management mistakes have been made. Sometimes we learn from them. Sometimes we repeat the same mistake over and over.

The mortgage is one such mistake.

Young stock investors generally understand the high risks of leverage. When you borrow $2 to buy something at $3, the lender receives a $1 “safety cushion”. This is the money that you contributed, your downpayment. If the asset halves in value, you are left with a $1.5 asset and a $2 liability. Your equity is gone, and your lender has a problem. You might be tempted to bail, leaving the insufficient collateral and consequences to the lender.

This is well understood in financial markets. Even amateur investors talk of leveraged investing as “degenerate”, “gambling” and so forth.

In the stock market, if the investor’s equity is close to being wiped out, the lender will typically forcibly close the positions. Once the investors’ own capital is wiped out, the lender is no longer making a normal loan: he bears the high risk of equity for the small returns of debt.

A tolerant lender #

In 2022, nickel prices spiked on the London Metals Exchange. A Chinese tycoon was short nickel and was about to be wiped out. Since he was a big customer, LME member brokers decided to wait the nickel spike out - surely it was just a short-lived market frenzy and prices would normalize. This meant that the LME’s members took on equity risk for the tycoon. As nickel prices kept climbing, the LME itself was endangered - the losses were now eating into the loans made to the tycoon, and by not immediately closing or recapitalizing the position, LME members would be forced to buy back the borrowed nickel at ever-rising prices with their own money. This is an example of bad risk management, and the LME was saved only by their ability to tilt the table. They were the exchange, they ran the market, so they just declared the price invalid and undid the day’s trades.

The nickel crisis is a useful illustration of a general principle: a tolerant lender does not eliminate the risk created by leverage. It merely shifts the risk to the lender. The math of leverage does not change.

Leverage in mortgages #

Tell your family that you have borrowed $300k to buy Microsoft shares. See the consternation, the attempts to change your mind. That same reaction should occur if you borrow $300k to buy a house.

If the bank cannot margin call mortgaged homes, the risk does not disappear. It just shifts to the bank, which is financed by grandma’s deposits and the central bank’s ability to create money.

If lenders applied standard risk management practices to housing, they would instantly sell your house as soon as its price goes down a bit. If your down payment is 20%, they might do it when the value drops by 10%. After all, houses take time to sell and have big transaction costs, so the bank would need to get ahead of any crash; it cannot wait until the last moment.

The political economy of leverage #

We live in a society where ordinary people routinely plan their financial future around highly leveraged real estate, while comparing it with the returns of unleveraged investments as though the leverage somehow does not count.

In a society where wide swathes of the population invest with leverage, even a modest drop in real estate prices means that wide swathes of the population will find their life savings wiped out. If the bank takes on the risk instead, well, most of the capital that banks conduct business with is depositors’ savings. In any case, someone is losing their life savings.

Our acceptance of normal people leveraging themselves up to the tits to buy housing creates systemic risk any time house prices drop. In bad times this has obvious consequences, but it also weighs us down in the good times. People understand that their entire net worth is tied up in their house. They may not know what a margin call is, but they know what will happen to their net worth if housing supply is ever allowed to meet demand. The mortgage forces us into a loop of ever-increasing housing prices, which convince onlookers that buying a house with x10 leverage is just a normal and sound financial decision, adding more leverage to more people who are dependent on housing staying scarce so the price can go up.

Housing is a basic necessity, not an investment #

Housing is necessary, but leverage turns it into an investment. If you owe the bank $800k and your biggest asset is a $1MM house, you cannot afford a doubling in housing supply. The fix is to stop putting people in that position.

Housing might be too expensive. But too many people’s financial security depends on it remaining expensive. We can build, but we cannot afford the consequences that an aggressive housing buildout will have on real estate prices.