Buffett’s Solution for Mortgage Abuses

In his 2008 letter to shareholders of Berkshire Hathaway, Warren Buffet offers his solution for preventing a repeat of the mortgage crisis. His ideas are quite reasonable, but governments may not like them much.

It’s hard to improve on Buffett’s explanations. So, I’ve reproduced his summary of the crisis, real reason why foreclosures happen, and his proposed solution. As sensible as his solution is, political interference very likely would undermine it.

Summary of the mortgage crisis:

“The need for meaningful down payments was frequently ignored. Sometimes fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did.”

The real reason for foreclosures:

“Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.”

The solution:

“Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.”

Of course, if such rules are adopted there would have to be meaningful penalties for borrowers or lenders who break the rules.

Buffett’s proposed rules (or something similar) might seem uncontroversial, but let’s look at it from the government’s point of view. Every government wants to be seen as being on the side of the people which includes helping them fulfill the dream of owning a home. Politicians often publicly admonish banks for not lending enough money to people.

Requiring a 10% down payment on a home is a major barrier to home ownership. In my opinion, it is a reasonable barrier, but it would prevent many people from buying homes, particularly if loopholes that allow people to borrow this 10% some other way are closed.

A 10% down payment would prevent many foreclosures. But, it would also deny home ownership to many people who would go on to comfortably make all their mortgage payments. The pressure for governments to seek votes by relaxing mortgage rules would eventually lead to smaller down payments.

So, we may see more stringent mortgage rules put in place in the aftermath of the credit crisis, but don’t expect these rules to stay in place indefinitely no matter how sensible they are.