Wednesday, March 4, 2009

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.


  1. As well a 10% down payment would require saving money, which is the opposite of what the government would like the average person to do. Get the consumer spending again is their answer for getting the economy "back on track".

  2. Sometimes unfair things happen to people.

    I'd prefer to see some people lose the ability to own a home now becaue they can buy one as their financial situation improves.

    I'd hate to see others default on a mortgage they cannot afford. That hurts everyone.

    Agree: criminal penalties for those who push bad loans onto ignorant applicants might be in order. Ditto for those who falsify applications.


  3. Anonymous: Well said. Maybe if our economy produced more goods that interested me I'd spend more. As a small example, I have a leather jacket that never fit me particularly well. I'm only about 10 pounds overweight and the jacket is too big at the waist. When the zipper broke, I wanted to replace the jacket. I tried three stores and all the choices were even fatter than my current jacket. So, I learned enough about zippers to repair my old jacket. I'd still prefer a new one, but I can't find a store that caters to men who aren't obese. I get the feeling that clothing stores cater mainly to shopping addicts rather than people with practical needs. Now that shopping addicts have had their credit lines cut off, maybe things will change.

  4. Mark: I agree with you. Sadly, my guess is that future governments won't.

  5. It seems entirely do-able to me. In Canada, the number of under 10% downpayments is tiny. Anything less than 20% (used to be 25%) requires mortgage insurance payments on top of the mortgage, so many people save until they can at least get that amount down.

    Even if they can't, banks here actually follow through with their fiduciary duties and won't allow anyone to have a mortgage greater than 36% of their income. I've got many friends who continue to rent because the banks won't lend them nearly enough for a home.

    The government has to bite the bullet and force people to take personal responisbility in regards to their purchases. If I'm borrowing hundreds of thousands of dollars, I want to make sure I know every detail of the loan AND that I can pay it off with room to spare. If people bought places they could never afford, I have no sympathy for them now.

  6. Good point Astin.

    I'm proud of the Canadian system and its stricter policies for obtaining a mortgage has pretty much dampened any housing bubbles that we might have.

    What I'm seeing right now as house prices are falling downward is mainly a result of the overall economic conditions and not the bursting of a housing bubble.