If only Niall Ferguson had been your mortgage banker (instead of that Mozilo guy)

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Back in July, in Countrywide Financial’s quarterly earnings conference call, CEO Angelo Mozilo uttered these memorable words:

Nobody saw this coming. S&P and Moody’s didn’t see it coming, but they simply just downgrade bonds, they don’t take hits. Bear Stearns certainly didn’t see it coming. Merrill Lynch didn’t see it coming. Nobody saw this coming.

This is of course the rankest nonsense. Lots of people predicted that the mortgage lending boom of 2000-2006 would end badly–even at least one person at Merrill Lynch, chief economist David Rosenberg. They couldn’t predict exactly when it would happen. But they certainly could describe how, and I just reread a 2004 essay that did a particularly nice job of it, so I thought I’d share:

In the U.S. today there are … two kinds of people: those who have hedged against interest-rate rises and those who will soon be digging to meet their monthly payments. The hedgers are mainly corporations, which understand how to use derivative instruments to reduce their exposure to unforeseen rises in the cost of borrowing. The diggers are mainly households, which have grown dangerously fond of variable-rate forms of borrowing, forgetting that what goes down can go up.

That was historian and occasional Time columnist Niall Ferguson, writing in Fortune. He went on:

Over the past ten years millions of ordinary Americans have maximized their consumption by borrowing like mad. According to research by Merrill Lynch, the average ratio of debt to income has risen from around 85% to 118%. Household liabilities have leaped from 16% to 22% of net worth. In particular, through new loans, refinancing, and equity withdrawal, Americans have taken advantage of low rates to crank up their mortgages. The total value of mortgage debt rose from just over $5 trillion at the start of 2000 to nearly $7 trillion in the fourth quarter of 2003.

What is especially remarkable is how many of those new mortgages have been based on adjustable rates rather than on the old fixed-rate system. A year ago little more than 10% of new loans secured on residential real estate were adjustable-rate mortgages (ARMs). The latest figures from the Mortgage Bankers Association put the share above 30%. The “ARMs” race has continued even as rates have gone up.

The implications are disquieting. Suppose ARMs account for 20% of the $2 trillion of new mortgage debt. If rates were to rise … from 5.8% to 8.5%, the cost of servicing those mortgages would jump by more than $10 billion. For many households that would translate into an immediate credit crunch as rising mortgage payments ate into disposable income. A family with a $500,000 ARM would need to find an extra $1,125 a month.