WEBVTT 00:00:00.000 --> 00:00:02.020 Welcome back to the deep dive. We are tackling 00:00:02.020 --> 00:00:04.440 a topic today that sits right at the intersection 00:00:04.440 --> 00:00:09.779 of high finance, personal anxiety, and believe 00:00:09.779 --> 00:00:12.539 it or not, medieval law. It's a strange mix, 00:00:12.619 --> 00:00:14.839 isn't it? It really is. We are looking at the 00:00:14.839 --> 00:00:17.719 single largest financial transaction most people 00:00:17.719 --> 00:00:19.539 will ever make in their entire lives. Without 00:00:19.539 --> 00:00:21.739 a doubt. And yet it's one where the mechanics 00:00:21.739 --> 00:00:24.460 are usually, you know, obscured by this mountain 00:00:24.460 --> 00:00:27.460 of paperwork and jargon that's almost impossible 00:00:27.460 --> 00:00:29.600 to get your head around. It feels intentionally 00:00:29.600 --> 00:00:31.820 dense sometimes. We're unpacking the mortgage. 00:00:32.039 --> 00:00:35.240 But we aren't just doing the mortgages 101 walkthrough 00:00:35.240 --> 00:00:37.299 you might find online. No, we're going a lot 00:00:37.299 --> 00:00:39.920 deeper. We've got a stack of research here, comparative 00:00:39.920 --> 00:00:43.640 studies, legal histories. economic analyses that 00:00:43.640 --> 00:00:46.399 all point to one thing. Which is? That the way 00:00:46.399 --> 00:00:48.399 most of our listeners, especially in the U .S., 00:00:48.399 --> 00:00:51.259 think about this debt is a complete anomaly on 00:00:51.259 --> 00:00:53.420 the global stage. A total outlier. It really 00:00:53.420 --> 00:00:55.280 is. Yeah. When you actually line up the data, 00:00:55.380 --> 00:00:58.299 the American mortgage market is. It's a unicorn. 00:00:58.560 --> 00:01:00.420 Yeah. It operates by a set of rules that just 00:01:00.420 --> 00:01:03.640 don't exist in most other places. Okay. So before 00:01:03.640 --> 00:01:06.180 we get into that global tour and the big macro 00:01:06.180 --> 00:01:08.620 picture, we have to deal with the nature of the 00:01:08.620 --> 00:01:11.879 beast itself. Because, as the sources point out, 00:01:11.920 --> 00:01:14.739 this contract isn't just a loan. Not at all. 00:01:14.780 --> 00:01:18.180 It's a very specific legal bind, an encumbrance 00:01:18.180 --> 00:01:21.200 that has evolved over hundreds of years. And 00:01:21.200 --> 00:01:24.379 that history is hidden in plain sight right there 00:01:24.379 --> 00:01:26.799 in the name. I was digging into the etymology 00:01:26.799 --> 00:01:29.519 provided in the notes and it's surprisingly dark. 00:01:29.659 --> 00:01:31.840 It is, isn't it? It's not just some fancy French 00:01:31.840 --> 00:01:34.640 word for loan. It's law French from the Middle 00:01:34.640 --> 00:01:39.239 Ages. Mort meaning. Yeah. And gauge meaning pledge. 00:01:39.400 --> 00:01:41.480 The death pledge. It sounds like something out 00:01:41.480 --> 00:01:43.280 of a horror movie or, you know, a fantasy novel. 00:01:43.420 --> 00:01:46.299 Exactly. A death pledge. When I first read that, 00:01:46.379 --> 00:01:48.680 my immediate reaction was, well, that feels aggressive. 00:01:48.739 --> 00:01:50.760 It sounds like you're literally signing your 00:01:50.760 --> 00:01:53.540 life away. And in a way, you are signing away 00:01:53.540 --> 00:01:56.780 a huge chunk of your financial life. But the 00:01:56.780 --> 00:01:59.340 sources clarify the death part isn't necessarily 00:01:59.340 --> 00:02:02.200 a threat to the borrower's life. Though the stress 00:02:02.200 --> 00:02:04.859 of a mortgage might feel like it sometimes. I 00:02:04.859 --> 00:02:06.859 think we can all relate to that. But no, the 00:02:06.859 --> 00:02:09.240 death it's referring to is the state of the pledge 00:02:09.240 --> 00:02:13.409 itself. The idea is that the pledge, this security 00:02:13.409 --> 00:02:15.750 interest you've given the bank over your property, 00:02:15.870 --> 00:02:19.150 is dead or static. Meaning it doesn't change. 00:02:19.389 --> 00:02:22.490 Exactly. And it's designed to end. It essentially 00:02:22.490 --> 00:02:25.710 dies in one of two ways. There's the happy death, 00:02:25.870 --> 00:02:27.590 if you want to call it that. I'm guessing that's 00:02:27.590 --> 00:02:30.349 when you pay it off. That's it. The obligation 00:02:30.349 --> 00:02:32.409 is fulfilled. You make that final payment. After 00:02:32.409 --> 00:02:35.189 30 years, the debt dies, the pledge is terminated, 00:02:35.349 --> 00:02:37.689 and the property is finally released to you free 00:02:37.689 --> 00:02:41.629 and clear. And the unhappy death obviously is 00:02:41.629 --> 00:02:44.169 foreclosure. The pledge dies because the lender 00:02:44.169 --> 00:02:46.990 takes the property to satisfy the debt. The deal 00:02:46.990 --> 00:02:49.409 is over. It's concluded. But you've lost the 00:02:49.409 --> 00:02:51.389 asset. So either way, the arrangement is designed 00:02:51.389 --> 00:02:53.990 to be terminal. It's not a revolving door like 00:02:53.990 --> 00:02:57.069 a credit card. It has a definitive end date where 00:02:57.069 --> 00:03:00.449 the gauge, the pledge must die. That framing 00:03:00.449 --> 00:03:02.729 really changes the whole vibe of the closing 00:03:02.729 --> 00:03:05.909 table, doesn't it? It absolutely does. You aren't 00:03:05.909 --> 00:03:09.710 just borrowing money. You are encumbering a piece 00:03:09.710 --> 00:03:13.069 of the earth. And that word encumbrance came 00:03:13.069 --> 00:03:15.129 up over and over again in the legal definitions. 00:03:15.629 --> 00:03:18.870 It's a limitation on your rights. That's a great 00:03:18.870 --> 00:03:20.810 way to put it. You might hold the title, you 00:03:20.810 --> 00:03:23.150 might paint the walls and mow the lawn, but there 00:03:23.150 --> 00:03:26.069 is a heavy, invisible hand resting on that deed 00:03:26.069 --> 00:03:29.009 until the pledge is dead. And that leads to this 00:03:29.009 --> 00:03:31.789 really common point of confusion, which the notes 00:03:31.789 --> 00:03:34.110 highlighted, about the players involved. Ah, 00:03:34.349 --> 00:03:37.169 the morgagor and the mortgagee. Yes. In almost 00:03:37.169 --> 00:03:39.430 every other part of the English language, the 00:03:39.430 --> 00:03:42.669 or suffix implies the giver and the e suffix 00:03:42.669 --> 00:03:45.449 implies the receiver. The employer gives the 00:03:45.449 --> 00:03:48.409 job. The employee receives it. Sure. The actor 00:03:48.409 --> 00:03:50.509 and the one acted upon. But in the mortgage world, 00:03:50.629 --> 00:03:53.719 people consistently get it backward. Intuitively, 00:03:53.780 --> 00:03:56.099 you think, I am the home buyer. I am receiving 00:03:56.099 --> 00:03:58.280 the money, so I must be the mortgagee. And that's 00:03:58.280 --> 00:04:00.759 totally logical, but it's wrong. Yeah. Because 00:04:00.759 --> 00:04:02.939 it ignores the direction of the security of the 00:04:02.939 --> 00:04:05.699 pledge. You have to follow the collateral. Exactly. 00:04:05.919 --> 00:04:09.060 The pledge is coming from you, the homeowner. 00:04:09.379 --> 00:04:11.259 You are giving the security interest in your 00:04:11.259 --> 00:04:14.840 home to the bank. Therefore, you are the mortgagee. 00:04:15.300 --> 00:04:17.660 And the bank is receiving that security pledge, 00:04:17.759 --> 00:04:20.490 so they are the mortgagee. It seems like a small 00:04:20.490 --> 00:04:22.529 pedantic point, but it really matters because 00:04:22.529 --> 00:04:25.750 it defines the entire power dynamic. You are 00:04:25.750 --> 00:04:28.170 the one initiating the encumbrance on your own 00:04:28.170 --> 00:04:31.949 property. Okay, so as the Morgador offering this 00:04:31.949 --> 00:04:35.430 death pledge, the very first hurdle is proving 00:04:35.430 --> 00:04:38.399 you're actually good for it. Right. This brings 00:04:38.399 --> 00:04:40.699 us to the mechanics of the loan itself, specifically 00:04:40.699 --> 00:04:43.560 underwriting. I feel like most people view underwriting 00:04:43.560 --> 00:04:46.120 as just a, you know, a bureaucratic box checking 00:04:46.120 --> 00:04:48.720 exercise. Sending in pay stubs, bank statements. 00:04:49.060 --> 00:04:52.139 Yeah, a formality. But the source material highlights 00:04:52.139 --> 00:04:54.519 that this is actually a massive predictive modeling 00:04:54.519 --> 00:04:57.040 engine. That's exactly what it is. It's the gatekeeping 00:04:57.040 --> 00:04:59.860 function. The underwriter isn't just checking 00:04:59.860 --> 00:05:02.379 if your pay stub is real. They are trying to 00:05:02.379 --> 00:05:04.819 predict the future stability of your life for 00:05:04.819 --> 00:05:07.550 the next three decades. 30 years. It's an incredible 00:05:07.550 --> 00:05:10.649 thing to try and predict. It is. And they do 00:05:10.649 --> 00:05:13.149 it by looking at key ratios. The two big ones 00:05:13.149 --> 00:05:16.769 are payment ratios and debt ratios. And while 00:05:16.769 --> 00:05:19.089 those sound really similar, they measure very 00:05:19.089 --> 00:05:21.810 different kinds of risk. So the payment to income 00:05:21.810 --> 00:05:23.949 ratio, sometimes called the front end ratio, 00:05:24.129 --> 00:05:25.730 that's the simple one. That's just the direct 00:05:25.730 --> 00:05:27.589 burden of the house itself, right? Your proposed 00:05:27.589 --> 00:05:31.029 mortgage payment versus your gross income. Correct. 00:05:31.089 --> 00:05:34.089 It answers the question, can you afford this 00:05:34.089 --> 00:05:37.550 specific house on its own? But the one that really 00:05:37.550 --> 00:05:39.629 trips people up, the one that's the more holistic 00:05:39.629 --> 00:05:43.139 view, is the debt -to -income ratio. The DTI. 00:05:43.379 --> 00:05:46.100 Or the back -end ratio. Right. And the DTI is 00:05:46.100 --> 00:05:48.319 critical because it aggregates everything. It's 00:05:48.319 --> 00:05:50.720 the mortgage payment, PLUS, your student loans, 00:05:50.959 --> 00:05:53.399 your credit card minimums, your car lease, any 00:05:53.399 --> 00:05:55.259 other debt you have. It's the total financial 00:05:55.259 --> 00:05:57.779 pressure you're under. Exactly. And the research 00:05:57.779 --> 00:05:59.699 shows a really strong correlation between high 00:05:59.699 --> 00:06:02.100 DTI and default rates, which isn't surprising. 00:06:02.279 --> 00:06:04.220 But there's a psychological component mentioned 00:06:04.220 --> 00:06:06.240 in the notes that I found fascinating. A high 00:06:06.240 --> 00:06:08.720 DTI isn't just a financial metric. It's a proxy 00:06:08.720 --> 00:06:11.160 for psychological stress. That makes perfect 00:06:11.160 --> 00:06:13.759 sense. I mean, if 45 or 50 percent of your gross 00:06:13.759 --> 00:06:16.079 income is already spoken for before you even 00:06:16.079 --> 00:06:19.220 buy groceries or pay for gas, you're living in 00:06:19.220 --> 00:06:21.899 a state of constant low -grade emergency. There's 00:06:21.899 --> 00:06:24.959 no margin for error. A broken down car isn't 00:06:24.959 --> 00:06:27.740 an inconvenience. It's a catastrophe. And that 00:06:27.740 --> 00:06:30.439 term house poor gets tossed around so lightly, 00:06:30.680 --> 00:06:33.819 but it's a genuinely precarious existence. You 00:06:33.819 --> 00:06:36.019 have the asset, this beautiful house, but you 00:06:36.019 --> 00:06:38.980 have no liquidity to maintain it or, you know, 00:06:38.980 --> 00:06:41.240 to maintain yourself. And lenders know this from 00:06:41.240 --> 00:06:44.379 decades of data. That's why those DTI caps exist. 00:06:44.620 --> 00:06:46.980 They aren't just protecting their capital. They 00:06:46.980 --> 00:06:49.300 are statistically avoiding borrowers who are 00:06:49.300 --> 00:06:51.779 going to burn out under the financial and psychological 00:06:51.779 --> 00:06:54.259 load. OK, so that's the risk of the borrower. 00:06:54.399 --> 00:06:56.439 But there's another ratio that determines the 00:06:56.439 --> 00:06:59.170 safety. of the asset itself and that's the ltv 00:06:59.170 --> 00:07:01.449 loan to value this one seems straightforward 00:07:01.449 --> 00:07:03.810 on the surface it's just the loan amount divided 00:07:03.810 --> 00:07:07.009 by property value so if i buy a 500 000 house 00:07:07.009 --> 00:07:10.509 and i put 100 000 down that's 20 my loan is 400 00:07:10.509 --> 00:07:15.689 000 i have an 80 ltv simple it should be but 00:07:15.689 --> 00:07:17.629 the value variable in that equation is where 00:07:17.629 --> 00:07:20.110 things get really slippery especially in a hot 00:07:20.110 --> 00:07:22.730 competitive market this is the value equation 00:07:22.730 --> 00:07:25.579 problem from the research that's it You have 00:07:25.579 --> 00:07:28.160 multiple conflicting definitions of value. First, 00:07:28.319 --> 00:07:30.199 you have the transaction value, which is simply 00:07:30.199 --> 00:07:32.439 what you agreed to pay the seller. Okay, my $500 00:07:32.439 --> 00:07:35.180 ,000 offer. Then you have the appraised value. 00:07:35.819 --> 00:07:38.839 And this is the crucial one for the bank. In 00:07:38.839 --> 00:07:41.699 a bidding war, the transaction value can completely 00:07:41.699 --> 00:07:44.839 decouple from reality. You mean I might agree 00:07:44.839 --> 00:07:46.920 to pay $500 ,000 because I fell in love with 00:07:46.920 --> 00:07:49.620 the kitchen and I beat out 10 other offers? But 00:07:49.620 --> 00:07:52.379 the appraised value... which is the cold, hard, 00:07:52.500 --> 00:07:55.100 data -driven opinion of a licensed professional 00:07:55.100 --> 00:07:58.019 looking at comparable sales, might come in at 00:07:58.019 --> 00:08:00.899 $450 ,000. And the bank only cares about the 00:08:00.899 --> 00:08:02.959 appraisal. They only care about the appraisal. 00:08:02.959 --> 00:08:05.240 They don't lend on sentiment or bidding wars. 00:08:05.480 --> 00:08:09.220 They lend on collateral. And if the LTV, based 00:08:09.220 --> 00:08:11.639 on that lower appraised value, is suddenly too 00:08:11.639 --> 00:08:14.959 high, say 90 % or more, then the whole deal can 00:08:14.959 --> 00:08:17.279 fall apart. Or I have to come up with an extra 00:08:17.279 --> 00:08:20.300 $50 ,000 in cash to bridge that appraisal gap. 00:08:20.670 --> 00:08:23.350 Exactly. And this is where the down payment or 00:08:23.350 --> 00:08:26.709 deposit, as it's called in UK law, functions 00:08:26.709 --> 00:08:29.930 as the ultimate risk buffer for the lender. It's 00:08:29.930 --> 00:08:31.810 your skin in the game. It's the ultimate skin 00:08:31.810 --> 00:08:34.570 in the game. If you have 20 percent equity from 00:08:34.570 --> 00:08:37.769 day one, you have a huge cushion. If property 00:08:37.769 --> 00:08:40.769 values dip five or 10 percent, you're still not 00:08:40.769 --> 00:08:43.090 underwater. You have a massive incentive to keep 00:08:43.090 --> 00:08:45.679 paying. But if you have zero equity, you have 00:08:45.679 --> 00:08:49.399 absolutely zero barrier to walking away if prices 00:08:49.399 --> 00:08:51.820 dip even 1%. And we'll definitely get to that 00:08:51.820 --> 00:08:53.879 when we talk about the crisis errors. But for 00:08:53.879 --> 00:08:56.500 now, let's assume you pass the underwriting gauntlet. 00:08:56.539 --> 00:08:59.679 You have the keys. Now you enter the long 30 00:08:59.679 --> 00:09:01.879 -year phase of repayment. And this is where the 00:09:01.879 --> 00:09:04.639 math, specifically the amortization curve, can 00:09:04.639 --> 00:09:07.460 feel incredibly, incredibly demoralizing for 00:09:07.460 --> 00:09:09.600 a new homeowner. It's a psychological shock for 00:09:09.600 --> 00:09:11.419 a lot of people. It's based on what's called 00:09:11.419 --> 00:09:14.240 the annuity concept. A term from finance. What 00:09:14.240 --> 00:09:16.799 does that mean in plain English? It just means 00:09:16.799 --> 00:09:20.080 the math is designed to produce a flat, predictable 00:09:20.080 --> 00:09:22.820 monthly payment for the entire life of the loan. 00:09:23.080 --> 00:09:26.000 Your principal and interest payment is the same 00:09:26.000 --> 00:09:29.179 in month one as it is in month 360. OK, that 00:09:29.179 --> 00:09:32.539 sounds good. Predictability is nice. It is. But 00:09:32.539 --> 00:09:36.059 to achieve that flat payment, the internal composition 00:09:36.059 --> 00:09:39.100 of that payment has to shift dramatically over 00:09:39.100 --> 00:09:41.860 time. And this is the classic shock of looking 00:09:41.860 --> 00:09:44.820 at your first ever mortgage statement. You write 00:09:44.820 --> 00:09:48.759 a check for, say, $2 ,000. And you look at the 00:09:48.759 --> 00:09:52.600 breakdown and you see that $1 ,850 of it went 00:09:52.600 --> 00:09:55.940 to interest. And $150 went to principal. And 00:09:55.940 --> 00:09:57.659 you feel like you've made no progress. You're 00:09:57.659 --> 00:09:59.580 just running on a financial treadmill, paying 00:09:59.580 --> 00:10:02.460 the bank for the privilege of borrowing. It absolutely 00:10:02.460 --> 00:10:04.759 feels that way. But it's just the reality of 00:10:04.759 --> 00:10:07.879 how interest works on a very large balance. In 00:10:07.879 --> 00:10:10.200 that first month, you owe the maximum amount 00:10:10.200 --> 00:10:13.080 of money you will ever owe. So the interest charge, 00:10:13.179 --> 00:10:15.580 which is a percentage of that huge balance, is 00:10:15.580 --> 00:10:17.840 at its absolute peak. The bank gets paid first. 00:10:18.039 --> 00:10:20.299 They're getting the rent on their money. They 00:10:20.299 --> 00:10:23.539 get their rent first. Whatever tiny sliver is 00:10:23.539 --> 00:10:26.779 left over chips away at the principal balance. 00:10:27.019 --> 00:10:29.320 But the curve does accelerate, right? It's not 00:10:29.320 --> 00:10:33.129 a flat line. Oh, it does, but it's slow. Because 00:10:33.129 --> 00:10:36.950 you paid off that $150, next month the interest 00:10:36.950 --> 00:10:39.730 is calculated on a slightly lower balance. So 00:10:39.730 --> 00:10:43.509 maybe the interest charge is $1 ,849, and your 00:10:43.509 --> 00:10:46.710 principal payment is $151. So it's a flywheel 00:10:46.710 --> 00:10:49.470 that starts off incredibly heavy and hard to 00:10:49.470 --> 00:10:51.950 turn. That's a perfect analogy. Wow. And it takes 00:10:51.950 --> 00:10:55.870 about 15 to 20 years on a 30 -year loan for that 00:10:55.870 --> 00:10:59.080 flywheel to really pick up speed. By the last 00:10:59.080 --> 00:11:01.299 5 to 10 years of the loan, the whole thing is 00:11:01.299 --> 00:11:04.000 flipped. Your payment is almost entirely principal 00:11:04.000 --> 00:11:06.539 with just a few dollars going to interest. The 00:11:06.539 --> 00:11:08.659 math is engineered so the balance hits exactly 00:11:08.659 --> 00:11:11.659 zero on that specified end date. Okay, so that's 00:11:11.659 --> 00:11:13.559 the standard repayment model that most people 00:11:13.559 --> 00:11:15.200 in the U .S. are familiar with. But the outline 00:11:15.200 --> 00:11:17.139 highlights some alternative structures that, 00:11:17.200 --> 00:11:20.399 frankly, sound terrifying. Specifically, the 00:11:20.399 --> 00:11:22.860 interest -only mortgage. This was a huge deal 00:11:22.860 --> 00:11:25.019 in the U .K., right? And in the U .S. leading 00:11:25.019 --> 00:11:28.379 up to 2008. It was massive in the UK, and it 00:11:28.379 --> 00:11:31.379 was the source of a major, major financial scandal. 00:11:31.919 --> 00:11:35.220 In an interest -only mortgage, your monthly payment 00:11:35.220 --> 00:11:37.440 covers only the rent on the money. So the principal 00:11:37.440 --> 00:11:39.840 balance. Stays completely flat. It never decreases. 00:11:40.360 --> 00:11:43.679 If you borrow $300 ,000, you will still owe $300 00:11:43.679 --> 00:11:46.120 ,000 25 years later. So you're just renting your 00:11:46.120 --> 00:11:49.360 own debt indefinitely. Essentially, yes. The 00:11:49.360 --> 00:11:51.600 logic at the time, and this seems crazy now, 00:11:51.820 --> 00:11:54.620 was that you would take the money you saved by 00:11:54.620 --> 00:11:56.879 having a lower monthly payment and you'd put 00:11:56.879 --> 00:11:59.100 it into a separate investment vehicle. Like what? 00:11:59.240 --> 00:12:02.259 In the UK, it was typically an endowment policy 00:12:02.259 --> 00:12:05.899 or later a PP or an ISA, which are just types 00:12:05.899 --> 00:12:08.820 of stock market investment accounts. The theory 00:12:08.820 --> 00:12:11.080 was that the stock market return on that investment 00:12:11.080 --> 00:12:13.480 would easily outpace the mortgage interest rate. 00:12:13.769 --> 00:12:15.570 So you're trying to create an arbitrage. You're 00:12:15.570 --> 00:12:17.570 betting your house that the market beats the 00:12:17.570 --> 00:12:20.330 bank. And you are taking all of the risk. And 00:12:20.330 --> 00:12:23.789 for millions of people, that bet went sour. This 00:12:23.789 --> 00:12:26.289 was the U .K.'s endowment mortgage crisis. The 00:12:26.289 --> 00:12:28.389 investment vehicles dramatically underperformed 00:12:28.389 --> 00:12:30.570 the rosy projections they were sold with. So 00:12:30.570 --> 00:12:33.190 borrowers reached the end of their 25 -year term 00:12:33.190 --> 00:12:35.929 expecting this magic pot of money to be there 00:12:35.929 --> 00:12:38.330 to pay off the house. And instead they found 00:12:38.330 --> 00:12:40.450 there were tens of thousands, sometimes hundreds 00:12:40.450 --> 00:12:42.809 of thousands of pounds short of the principal 00:12:42.809 --> 00:12:45.539 they owed. And the loan is due. The term is up. 00:12:45.679 --> 00:12:48.899 The bank wants their 300 ,000 pounds back. Now. 00:12:49.200 --> 00:12:51.460 Immediately. It was a catastrophe. It forced 00:12:51.460 --> 00:12:54.000 people to sell their homes, take out new expensive 00:12:54.000 --> 00:12:57.360 loans in retirement. It was a mess, and it forced 00:12:57.360 --> 00:12:59.919 a massive regulatory crackdown. As it should 00:12:59.919 --> 00:13:02.000 have. The Financial Services Authority in the 00:13:02.000 --> 00:13:05.379 UK tightened the rules so much that major lenders, 00:13:05.379 --> 00:13:08.139 like the Nationwide Building Society, effectively 00:13:08.139 --> 00:13:10.919 pulled out of the interest -only market for average 00:13:10.919 --> 00:13:14.120 borrowers. To get one today, you need a very 00:13:14.120 --> 00:13:17.220 concrete... verified, and frankly, bulletproof 00:13:17.220 --> 00:13:19.860 repayment vehicle. You can't just say, oh, I'll 00:13:19.860 --> 00:13:21.919 save up. Okay. Then there's the flip side of 00:13:21.919 --> 00:13:23.580 this, which is aimed at the other end of the 00:13:23.580 --> 00:13:26.059 demographic spectrum, the reverse mortgage. In 00:13:26.059 --> 00:13:28.639 the U .S., it's usually the HECM. The home equity 00:13:28.639 --> 00:13:31.379 conversion mortgage. Yes. This turns the entire 00:13:31.379 --> 00:13:34.240 amortization curve completely upside down. Instead 00:13:34.240 --> 00:13:36.679 of you paying down debt to build up your equity, 00:13:36.919 --> 00:13:39.840 you are consuming your equity to generate cash 00:13:39.840 --> 00:13:42.759 flow. The bank pays you. Right. You can get it 00:13:42.759 --> 00:13:45.320 as a lump sum or as monthly tenure payments for 00:13:45.320 --> 00:13:47.279 as long as you live in the home or as a line 00:13:47.279 --> 00:13:50.320 of credit. But here's the key. You don't pay 00:13:50.320 --> 00:13:53.759 any principal or interest monthly. So where does 00:13:53.759 --> 00:13:56.679 the interest go? It rolls up. It gets added to 00:13:56.679 --> 00:13:59.159 the loan balance. So every single month, your 00:13:59.159 --> 00:14:01.480 debt gets larger and your ownership stake in 00:14:01.480 --> 00:14:03.600 your home gets smaller. It's called negative 00:14:03.600 --> 00:14:06.539 amortization. Sounds like a solution for that 00:14:06.539 --> 00:14:09.200 classic problem of being house rich and cash 00:14:09.200 --> 00:14:11.879 poor in retirement. That's exactly who it's for. 00:14:12.159 --> 00:14:14.299 Older borrowers who have a lot of equity but 00:14:14.299 --> 00:14:17.100 need cash to live on. But the compounding effect 00:14:17.100 --> 00:14:19.340 of that rolling up interest can be incredibly 00:14:19.340 --> 00:14:21.779 aggressive. I can imagine. So what's a repayment 00:14:21.779 --> 00:14:24.419 trigger? The loan becomes due and payable when 00:14:24.419 --> 00:14:26.740 the borrower dies or permanently moves out of 00:14:26.740 --> 00:14:28.960 the home. for instance, into a nursing facility. 00:14:29.679 --> 00:14:32.360 The danger is that if you live a long time or 00:14:32.360 --> 00:14:34.679 if interest rates are high, the rolling interest 00:14:34.679 --> 00:14:37.340 can consume the entire value of the estate. So 00:14:37.340 --> 00:14:39.480 there's nothing left for the heirs. Potentially, 00:14:39.480 --> 00:14:43.080 yes. In the U .S., the HECM is insured by the 00:14:43.080 --> 00:14:46.960 FHA, so the borrower or their estate will never 00:14:46.960 --> 00:14:49.139 owe more than the home is worth at the time of 00:14:49.139 --> 00:14:52.600 sale. but it can certainly wipe out the full 00:14:52.600 --> 00:14:55.519 value. It's a valid tool for some, but you have 00:14:55.519 --> 00:14:57.460 to understand you are essentially spending your 00:14:57.460 --> 00:14:59.799 house. Speaking of interest rates, this brings 00:14:59.799 --> 00:15:03.139 us perfectly to section three, the menu of rates. 00:15:03.690 --> 00:15:06.090 This is where the whole risk transfer game really 00:15:06.090 --> 00:15:08.870 happens. This is the core choice for most borrowers. 00:15:08.970 --> 00:15:11.409 And in the U .S., the 30 -year fixed rate mortgage 00:15:11.409 --> 00:15:14.090 is the absolute gold standard. It's more than 00:15:14.090 --> 00:15:16.190 just a product. It's almost a cultural right. 00:15:16.450 --> 00:15:18.450 It is. And it offers a level of predictability 00:15:18.450 --> 00:15:22.309 that is just. It's supreme. You lock in a cost 00:15:22.309 --> 00:15:24.610 of housing for three decades. Inflation could 00:15:24.610 --> 00:15:26.909 hit 10 percent. Rents in your city could double. 00:15:27.029 --> 00:15:29.090 The economy could go crazy. But your principal 00:15:29.090 --> 00:15:31.769 and interest payment stays frozen in time. That 00:15:31.769 --> 00:15:33.960 is an incredible fact. financial hedge for a 00:15:33.960 --> 00:15:36.820 household. It's a massive form of insurance against 00:15:36.820 --> 00:15:39.139 volatility. Yeah. But that certainty isn't free. 00:15:39.340 --> 00:15:42.039 No, you pay a premium for it, don't you? You 00:15:42.039 --> 00:15:45.019 do. The initial interest rate on a fixed mortgage 00:15:45.019 --> 00:15:48.399 is almost always higher than the starting rate 00:15:48.399 --> 00:15:51.360 on a variable or adjustable rate product. You 00:15:51.360 --> 00:15:53.860 are paying the bank a little extra to take that 00:15:53.860 --> 00:15:56.679 30 -year interest rate risk off your hands. Which 00:15:56.679 --> 00:15:59.460 brings us to the alternative, the adjustable 00:15:59.460 --> 00:16:03.830 rate mortgage or the ARM. Here, you get a discount 00:16:03.830 --> 00:16:06.690 up front. You get a teaser rate or a lower margin 00:16:06.690 --> 00:16:09.830 for the first few years. Because you, the borrower, 00:16:09.970 --> 00:16:12.269 are agreeing to take on the volatility risk. 00:16:12.429 --> 00:16:15.090 You're taking the gamble. You are. If the Federal 00:16:15.090 --> 00:16:16.909 Reserve hikes interest rates to fight inflation, 00:16:17.210 --> 00:16:19.529 your mortgage rate goes up. Your payment goes 00:16:19.529 --> 00:16:21.950 up. You are absorbing the shock so the bank doesn't 00:16:21.950 --> 00:16:24.230 have to. So it's a fundamental tradeoff. Do you 00:16:24.230 --> 00:16:25.970 want to sleep well at night knowing your payment 00:16:25.970 --> 00:16:28.450 will never change? Or do you want a lower bill 00:16:28.450 --> 00:16:30.649 today and are willing to risk it going up tomorrow? 00:16:30.929 --> 00:16:33.309 That's the choice. The lower initial rate can 00:16:33.309 --> 00:16:35.330 be really tempting. It lets you qualify for a 00:16:35.330 --> 00:16:38.269 bigger loan. But as we saw in 2008, when those 00:16:38.269 --> 00:16:41.350 ARMs reset to a much higher rate, it can be devastating. 00:16:41.870 --> 00:16:44.029 It's the ticking time bomb in your finances. 00:16:44.309 --> 00:16:46.070 But then the outline mentions something even 00:16:46.070 --> 00:16:50.490 more exotic. Foreign currency mortgages. This 00:16:50.490 --> 00:16:53.149 sounds like an A .R .M. on steroids. This is 00:16:53.149 --> 00:16:55.169 a phenomenon we rarely ever see in the U .S. 00:16:55.169 --> 00:16:57.250 or the U .K. because our currencies are relatively 00:16:57.250 --> 00:17:00.610 stable. But it's very common in developing economies 00:17:00.610 --> 00:17:03.509 or places with a history of high inflation like 00:17:03.509 --> 00:17:05.710 in Eastern Europe. So what's the concept here? 00:17:05.910 --> 00:17:09.410 The concept is borrowing in a stable low interest 00:17:09.410 --> 00:17:12.240 rate. foreign currency, like the Swiss francs 00:17:12.240 --> 00:17:14.599 or the euro, because the rates are much lower 00:17:14.599 --> 00:17:16.559 than in your home country. Okay, give me an example. 00:17:16.720 --> 00:17:19.319 Let's say I'm in Hungary or Poland, and my local 00:17:19.319 --> 00:17:22.480 mortgage rate in Florence or Zloty is, say, 12%. 00:17:22.480 --> 00:17:24.920 But you look across the border and you see that 00:17:24.920 --> 00:17:27.640 you can borrow in Swiss francs at 3%. I take 00:17:27.640 --> 00:17:29.940 the francs. It seems like a no -brainer. Exactly. 00:17:30.200 --> 00:17:32.140 And for a while, it looks like you're an absolute 00:17:32.140 --> 00:17:35.039 genius. Your monthly payment is tiny compared 00:17:35.039 --> 00:17:38.000 to your neighbors who borrowed locally. But there's 00:17:38.000 --> 00:17:41.099 a huge hidden risk. You are earning your salary 00:17:41.099 --> 00:17:44.400 in Hungarian forints, but your debt is denominated 00:17:44.400 --> 00:17:47.660 in Swiss francs. You have just introduced currency 00:17:47.660 --> 00:17:50.839 risk into your personal housing situation. So 00:17:50.839 --> 00:17:53.079 if the forint crashes against the francs, which 00:17:53.079 --> 00:17:55.920 happens a lot in economic crises. Your debt load 00:17:55.920 --> 00:17:59.319 explodes. Your salary is the same, but you suddenly 00:17:59.319 --> 00:18:01.940 need twice as many forints to make your mortgage 00:18:01.940 --> 00:18:04.799 payment. You could owe double the amount of local 00:18:04.799 --> 00:18:06.779 currency overnight, even if you've been making 00:18:06.779 --> 00:18:09.500 all your payments on time. My God, it could wipe 00:18:09.500 --> 00:18:11.480 you out. And that is exactly what happened across 00:18:11.480 --> 00:18:14.539 Eastern Europe after 2008. It caused systemic 00:18:14.539 --> 00:18:17.700 defaults and a massive political crisis. It's 00:18:17.700 --> 00:18:20.519 the ultimate example of chasing a low rate without 00:18:20.519 --> 00:18:22.779 understanding the underlying structural risk 00:18:22.779 --> 00:18:25.599 you're taking on. This segues perfectly into 00:18:25.599 --> 00:18:28.140 our global tour of mortgage markets. We've touched 00:18:28.140 --> 00:18:30.180 on pieces of it, but I want to really drill down 00:18:30.180 --> 00:18:32.519 into why the US system is considered such an 00:18:32.519 --> 00:18:34.980 outlier. We take the 30 -year fixed rate for 00:18:34.980 --> 00:18:37.480 granted, but the notes say this product basically 00:18:37.480 --> 00:18:40.420 shouldn't exist in a normal free market. It really 00:18:40.420 --> 00:18:43.589 shouldn't. And to understand why, you have to 00:18:43.589 --> 00:18:45.589 think about it from a bank's perspective. Why 00:18:45.589 --> 00:18:49.069 on earth would you, as a bank, lend someone money 00:18:49.069 --> 00:18:53.509 for 30 years at a fixed rate of, say, 4 %? Your 00:18:53.509 --> 00:18:56.369 own cost of funds, the interest you have to pay 00:18:56.369 --> 00:18:58.230 to your depositors for their savings accounts, 00:18:58.490 --> 00:19:01.150 that changes every single day. If the central 00:19:01.150 --> 00:19:03.670 bank raises rates and your cost of funds goes 00:19:03.670 --> 00:19:07.710 up to 6%, you are now actively losing 2 % on 00:19:07.710 --> 00:19:10.049 that mortgage loan every single year for the 00:19:10.049 --> 00:19:12.509 next two or three decades. a guaranteed loss. 00:19:12.750 --> 00:19:15.450 No rational bank would hold that risk on their 00:19:15.450 --> 00:19:18.069 balance sheet voluntarily. They wouldn't. It's 00:19:18.069 --> 00:19:20.529 called interest rate risk and it's huge. So how 00:19:20.529 --> 00:19:23.309 does the 30 year fixed exist in the U .S.? Government 00:19:23.309 --> 00:19:25.190 intervention. Massive government intervention. 00:19:25.450 --> 00:19:28.410 Enter the GSEs, the government sponsored entities, 00:19:28.650 --> 00:19:31.190 Fannie Mae and Freddie Mac, and also Ginnie Mae 00:19:31.190 --> 00:19:33.410 for government insured loans. The alphabet soup 00:19:33.410 --> 00:19:35.009 of the American housing market. That's them. 00:19:35.420 --> 00:19:38.740 And these quasi -governmental entities were created 00:19:38.740 --> 00:19:41.180 starting after the Great Depression to do one 00:19:41.180 --> 00:19:44.420 thing, grease the wheels of securitization. Which 00:19:44.420 --> 00:19:46.559 means? They buy the mortgages from the local 00:19:46.559 --> 00:19:49.079 banks that originate them. They bundle thousands 00:19:49.079 --> 00:19:51.759 of these loans together, package them into mortgage 00:19:51.759 --> 00:19:54.579 -backed securities, MBS, and then they sell those 00:19:54.579 --> 00:19:56.980 securities to global investors like pension funds 00:19:56.980 --> 00:19:59.660 and insurance companies. And crucially, they 00:19:59.660 --> 00:20:02.660 guarantee the payments on those securities. That 00:20:02.660 --> 00:20:05.700 is the magic ingredient. They add their government 00:20:05.700 --> 00:20:08.839 -backed guarantee. This takes the long -term 00:20:08.839 --> 00:20:11.619 interest rate risk completely off the local bank's 00:20:11.619 --> 00:20:15.519 books and creates a massive liquid global market 00:20:15.519 --> 00:20:18.759 for this debt. So to put it simply, the reason 00:20:18.759 --> 00:20:21.740 I can get a 30 -year fixed loan in Ohio is because 00:20:21.740 --> 00:20:23.720 the U .S. government has essentially created 00:20:23.720 --> 00:20:26.799 a backstop that makes that piece of paper valuable 00:20:26.799 --> 00:20:30.319 and safe for a pension fund in Tokyo or a sovereign 00:20:30.319 --> 00:20:33.569 wealth fund in Norway. Precisely. Without Fannie 00:20:33.569 --> 00:20:35.930 and Freddie buying up those loans and guaranteeing 00:20:35.930 --> 00:20:38.150 them, the 30 -year fixed mortgage would likely 00:20:38.150 --> 00:20:40.609 disappear almost overnight. Our market would 00:20:40.609 --> 00:20:41.970 start to look a lot more like the rest of the 00:20:41.970 --> 00:20:43.509 world. Okay, so let's look at the rest of the 00:20:43.509 --> 00:20:45.089 world. Let's start with the United Kingdom. They 00:20:45.089 --> 00:20:47.289 don't have this massive securitization machine 00:20:47.289 --> 00:20:50.109 in the same way. No, their system grew out of 00:20:50.109 --> 00:20:53.170 a completely different tradition. The UK mortgage 00:20:53.170 --> 00:20:56.109 market was historically dominated by building 00:20:56.109 --> 00:20:59.210 societies. What are those? They are mutual organizations 00:20:59.210 --> 00:21:01.859 owned by their members. Not by shareholders. 00:21:02.160 --> 00:21:04.859 And they were funded by their members' retail 00:21:04.859 --> 00:21:07.140 savings deposits. So they're taking in short 00:21:07.140 --> 00:21:09.279 -term savings. And because they rely on short 00:21:09.279 --> 00:21:11.640 -term deposits, they can't possibly lend that 00:21:11.640 --> 00:21:14.579 money out for 30 years at a fixed rate. It would 00:21:14.579 --> 00:21:17.880 be financial suicide. So the U .K. market is, 00:21:18.000 --> 00:21:21.240 by necessity, dominated by variable rates, or 00:21:21.240 --> 00:21:23.400 what they call trackers, and short -term fixes. 00:21:23.660 --> 00:21:26.740 Not a 30 -year fix. A two -year fix. A three 00:21:26.740 --> 00:21:29.000 -year fix. Maybe five years if you're lucky. 00:21:29.119 --> 00:21:31.720 Yeah. After that initial period, the rate automatically 00:21:31.720 --> 00:21:34.440 reverts to a higher variable rate and you're 00:21:34.440 --> 00:21:36.660 expected to remortgage. That creates a totally 00:21:36.660 --> 00:21:38.680 different national psychology around housing 00:21:38.680 --> 00:21:41.119 and interest rates. Completely. In the U .S., 00:21:41.119 --> 00:21:43.180 once you lock in your rate, you can basically 00:21:43.180 --> 00:21:45.019 stop caring what the Federal Reserve does for 00:21:45.019 --> 00:21:47.059 the next 30 years. It doesn't affect your biggest 00:21:47.059 --> 00:21:50.329 bill. But in the UK, every time the Bank of England's 00:21:50.329 --> 00:21:53.170 Monetary Policy Committee meets, the whole country 00:21:53.170 --> 00:21:55.509 holds its breath. Because millions of homeowners 00:21:55.509 --> 00:21:58.329 know their short -term fix is expiring in the 00:21:58.329 --> 00:22:01.210 next year or two. It makes the transmission mechanism 00:22:01.210 --> 00:22:03.890 of monetary policy much, much faster and more 00:22:03.890 --> 00:22:06.269 direct. If the Bank of England raises rates, 00:22:06.549 --> 00:22:08.849 millions of people feel it directly in their 00:22:08.849 --> 00:22:12.220 wallet within months. In the U .S., it really 00:22:12.220 --> 00:22:14.859 only affects new buyers or those with home equity 00:22:14.859 --> 00:22:17.539 lines. Okay, now what about our neighbors to 00:22:17.539 --> 00:22:21.000 the north, Canada? I know they have a similar 00:22:21.000 --> 00:22:22.859 structure with these five -year renewals, but 00:22:22.859 --> 00:22:24.759 the notes mention something really unique, the 00:22:24.759 --> 00:22:28.619 stress test. The B -20 guideline. This is a fascinating 00:22:28.619 --> 00:22:32.119 piece of macroprudential policy. It's a form 00:22:32.119 --> 00:22:34.099 of social engineering, really. How does it work? 00:22:34.359 --> 00:22:36.839 In Canada, even if you go to a bank and you negotiate 00:22:36.839 --> 00:22:40.140 a mortgage rate of, say, 4%, the bank is legally 00:22:40.140 --> 00:22:42.599 required to qualify you as if the rate were much 00:22:42.599 --> 00:22:45.059 higher. So they're testing your ability to pay 00:22:45.059 --> 00:22:48.039 a phantom rate. Yes. The rule is you have to 00:22:48.039 --> 00:22:50.819 qualify at the greater of a benchmark rate set 00:22:50.819 --> 00:22:53.500 by the Bank of Canada, or your actual contract 00:22:53.500 --> 00:22:56.359 rate plus 2%. So in my example, I'd have to prove 00:22:56.359 --> 00:22:58.599 I could afford the payment at 6%, even though 00:22:58.599 --> 00:23:01.349 I'm only going to be paying 4%. Exactly. The 00:23:01.349 --> 00:23:04.289 government is asking, on your behalf, if rates 00:23:04.289 --> 00:23:07.470 go up by 2 % when you renew in five years, will 00:23:07.470 --> 00:23:10.529 you go broke? If the answer is yes, you don't 00:23:10.529 --> 00:23:13.069 get the loan. Not even at the 4 % you can afford 00:23:13.069 --> 00:23:17.849 today. Wow. What was the impact of that? It significantly 00:23:17.849 --> 00:23:20.750 reduced the maximum borrowing power for the average 00:23:20.750 --> 00:23:24.549 person. It cooled the housing market. But more 00:23:24.549 --> 00:23:27.309 importantly, it builds a permanent safety margin 00:23:27.309 --> 00:23:30.519 into the entire system. It prevents people from 00:23:30.519 --> 00:23:32.519 stretching to their absolute financial limit 00:23:32.519 --> 00:23:35.359 just to get into the market. It's a paternalistic 00:23:35.359 --> 00:23:37.440 policy, but it seems to have worked in preventing 00:23:37.440 --> 00:23:40.039 a U .S.-style meltdown. It has been very effective 00:23:40.039 --> 00:23:42.599 at promoting stability. Now, let's cross the 00:23:42.599 --> 00:23:44.460 Atlantic to continental Europe. The outline says 00:23:44.460 --> 00:23:46.819 it's a diverse market, but mentions a common 00:23:46.819 --> 00:23:49.440 funding mechanism called a covered bond. How 00:23:49.440 --> 00:23:51.099 does this differ from the U .S. securitization 00:23:51.099 --> 00:23:54.119 model we talked about? This is a really key structural 00:23:54.119 --> 00:23:56.440 difference. In the U .S., you have what's called 00:23:56.440 --> 00:23:58.799 an originate -to -distribute model. The bank 00:23:58.799 --> 00:24:00.740 makes the loan and immediately sells it, distributing 00:24:00.740 --> 00:24:03.140 to Fannie Mae. They wash their hands of the risk. 00:24:03.279 --> 00:24:05.579 In the European covered bond system, which is 00:24:05.579 --> 00:24:07.579 very popular in places like Germany with their 00:24:07.579 --> 00:24:11.539 fan brief, the bank issues bonds that are backed 00:24:11.539 --> 00:24:15.400 by a pool of mortgages, much like an MBS. But, 00:24:15.400 --> 00:24:17.839 and this is the big difference, the mortgages 00:24:17.839 --> 00:24:20.720 stay on the bank's balance sheet. Ah, so they 00:24:20.720 --> 00:24:23.059 still have skin in the game. 100 % skin in the 00:24:23.059 --> 00:24:26.299 game. If those loans go bad, The bank eats the 00:24:26.299 --> 00:24:29.279 loss, not some distant investor who bought the 00:24:29.279 --> 00:24:33.700 bond. The bondholders have dual recourse to the 00:24:33.700 --> 00:24:35.960 bank itself and to the underlying mortgages. 00:24:36.140 --> 00:24:38.680 That completely changes the incentives, doesn't 00:24:38.680 --> 00:24:41.000 it? It changes everything. It naturally leads 00:24:41.000 --> 00:24:43.779 to much more conservative, careful underwriting 00:24:43.779 --> 00:24:46.140 because the lender has to live with the consequences 00:24:46.140 --> 00:24:49.440 of their lending decisions for years. And it's 00:24:49.440 --> 00:24:51.119 a big reason why default rates in Europe are 00:24:51.119 --> 00:24:53.660 generally much lower than in the U .S. It aligns 00:24:53.660 --> 00:24:55.440 the incentives of the lender with the long term 00:24:55.440 --> 00:24:57.500 performance of the loan. That structural difference 00:24:57.500 --> 00:24:59.779 seems to explain a lot about the relative stability 00:24:59.779 --> 00:25:02.960 of many European housing markets versus the boom 00:25:02.960 --> 00:25:05.460 and bust cycles we seem to specialize in. But 00:25:05.460 --> 00:25:07.220 the most radical difference of all is clearly 00:25:07.220 --> 00:25:10.140 Islamic finance. This is a whole different universe. 00:25:10.440 --> 00:25:12.799 We're talking about a system that prohibits the 00:25:12.799 --> 00:25:15.819 charging or payment of interest entirely. That's 00:25:15.819 --> 00:25:18.640 right. Sharia law prohibits Wiba, which is probably 00:25:18.640 --> 00:25:22.789 translated as usury or interest. The core philosophical 00:25:22.789 --> 00:25:25.849 basis is that money should only be a medium of 00:25:25.849 --> 00:25:28.829 exchange, not a commodity that generates profit 00:25:28.829 --> 00:25:31.470 by itself. You cannot make money from money. 00:25:31.549 --> 00:25:33.670 You can only make money from productive activity 00:25:33.670 --> 00:25:36.390 or trade. So how on earth do you buy a house? 00:25:36.569 --> 00:25:38.950 You can't just pay cash. The whole point of a 00:25:38.950 --> 00:25:41.609 mortgage is to borrow money over time. You do 00:25:41.609 --> 00:25:43.250 it by changing the fundamental relationship. 00:25:43.529 --> 00:25:45.849 The bank and the borrower are not creditor and 00:25:45.849 --> 00:25:48.029 debtor. They become partners or co -owners. Okay. 00:25:48.490 --> 00:25:50.650 There are a few models, but the notes highlight 00:25:50.650 --> 00:25:53.069 two main ones. The first, which is a bit simpler, 00:25:53.109 --> 00:25:55.769 is called by Bithman Agile. It's basically deferred 00:25:55.769 --> 00:25:57.329 payment sale. Walk me through that. How does 00:25:57.329 --> 00:26:00.349 it work? The bank buys the house you want from 00:26:00.349 --> 00:26:02.630 the seller for the current market price, say 00:26:02.630 --> 00:26:06.710 $300 ,000. Then the bank immediately sells that 00:26:06.710 --> 00:26:08.970 same house to you, but for a marked up price, 00:26:09.170 --> 00:26:12.410 say $400 ,000, which you agree to pay in installments 00:26:12.410 --> 00:26:15.539 over 30 years. So the bank's profit, which would 00:26:15.539 --> 00:26:17.579 have been the interest, is just built into the 00:26:17.579 --> 00:26:20.299 price tag of the asset they're selling you. Exactly. 00:26:20.579 --> 00:26:24.279 It's structured as a trade, not a loan. But the 00:26:24.279 --> 00:26:26.599 more elegant model, and the one that's gaining 00:26:26.599 --> 00:26:29.920 popularity, is musharka mutanakisa. That's a 00:26:29.920 --> 00:26:31.980 mouthful. It means a diminishing partnership. 00:26:32.319 --> 00:26:34.859 Okay, break that down for me. You and the bank 00:26:34.859 --> 00:26:37.839 buy the house together as partners. Let's say 00:26:37.839 --> 00:26:40.200 you put in a 10 % down payment. So you own 10 00:26:40.200 --> 00:26:42.720 % of the house. The bank puts in the other 90%. 00:26:42.720 --> 00:26:47.119 So they own 90%. You are co -owners. Right. Now 00:26:47.119 --> 00:26:49.579 you live in the house, so you have to pay rent 00:26:49.579 --> 00:26:52.079 to your co -owner of the bank for the use of 00:26:52.079 --> 00:26:54.359 their 90 % share of the property. Okay. That 00:26:54.359 --> 00:26:56.059 makes sense. It's fair. But here's the clever 00:26:56.059 --> 00:26:59.700 part. Your monthly payment isn't just rent. It's 00:26:59.700 --> 00:27:03.519 structured as rent plus acquisition. A portion 00:27:03.519 --> 00:27:05.960 of your payment is rent. And the other portion 00:27:05.960 --> 00:27:08.640 buys a little more of the bank's equity share. 00:27:08.900 --> 00:27:11.579 So next month, I might own 11 % and the bank 00:27:11.579 --> 00:27:15.220 owns 89%. Exactly. And because you now own more 00:27:15.220 --> 00:27:17.359 of the house, your rent payment for the next 00:27:17.359 --> 00:27:19.599 month goes down slightly because you're renting 00:27:19.599 --> 00:27:22.259 less of their share. So more of your fixed monthly 00:27:22.259 --> 00:27:25.700 payment can go towards acquiring even more equity. 00:27:25.799 --> 00:27:28.980 That is surprisingly logical and elegant. You 00:27:28.980 --> 00:27:32.240 are slowly... systematically buying out your 00:27:32.240 --> 00:27:36.140 partner until you own 100 % of the asset. The 00:27:36.140 --> 00:27:38.279 payments are tied to the use and ownership of 00:27:38.279 --> 00:27:41.279 a real thing, not to the abstract concept of 00:27:41.279 --> 00:27:43.839 interest on money. It creates a direct link between 00:27:43.839 --> 00:27:46.920 the asset and the payment. But it did face significant 00:27:46.920 --> 00:27:49.460 legal hurdles when introduced in Western countries. 00:27:49.640 --> 00:27:52.380 I can imagine how so. Specifically, things like 00:27:52.380 --> 00:27:55.460 stamp duty or property transfer taxes. In the 00:27:55.460 --> 00:27:57.519 UK, for example, every time a property changes 00:27:57.519 --> 00:28:00.539 hands, you have to pay a tax. In this Islamic 00:28:00.539 --> 00:28:02.599 model, the property technically transfers from 00:28:02.599 --> 00:28:04.799 the original seller to the bank and then from 00:28:04.799 --> 00:28:07.140 the bank over time to the borrower. That's two 00:28:07.140 --> 00:28:10.039 transactions, so double taxation. Precisely. 00:28:10.140 --> 00:28:12.960 It made Islamic mortgages prohibitively expensive 00:28:12.960 --> 00:28:16.579 and uncompetitive at first. But in a really interesting 00:28:16.579 --> 00:28:19.380 move, the UK government actually amended the 00:28:19.380 --> 00:28:23.059 Finance Act back in 2003 to recognize these alternative 00:28:23.059 --> 00:28:26.119 structures and waive the double stamp duty. That's 00:28:26.119 --> 00:28:29.140 a huge deal. It was a major move to adapt a Western 00:28:29.140 --> 00:28:31.440 legal framework to accommodate Islamic finance, 00:28:31.640 --> 00:28:34.119 and it opened the market up significantly. That's 00:28:34.119 --> 00:28:36.359 a great example of legal systems adapting to 00:28:36.359 --> 00:28:38.680 reality. But what happens when the legal system 00:28:38.680 --> 00:28:41.059 has to deal with failure? We have to move on 00:28:41.059 --> 00:28:44.240 to Section 5, foreclosure, recourse, and insurance. 00:28:44.759 --> 00:28:46.980 This is where the rubber really meets the road. 00:28:47.359 --> 00:28:50.240 This is the unhappy death of a pledge. Foreclosure, 00:28:50.259 --> 00:28:53.220 or repossession in the UK, is the legal mechanism 00:28:53.220 --> 00:28:55.400 for the lender to seize the collateral when you 00:28:55.400 --> 00:28:58.700 default. But the process can vary wildly. You 00:28:58.700 --> 00:29:01.279 mean judicial versus non -judicial foreclosure? 00:29:01.460 --> 00:29:03.680 Exactly. In some jurisdictions, the lender has 00:29:03.680 --> 00:29:05.680 to go through the court system to prove the default 00:29:05.680 --> 00:29:08.150 and get permission to sell the property. That's 00:29:08.150 --> 00:29:10.650 a judicial foreclosure. It can take months, even 00:29:10.650 --> 00:29:13.170 years, and gives the borrower many opportunities 00:29:13.170 --> 00:29:15.349 to fight it. And non -judicial. In other places, 00:29:15.490 --> 00:29:17.609 the mortgage documents contain what's called 00:29:17.609 --> 00:29:21.430 a power of sale clause. If you default, the lender 00:29:21.430 --> 00:29:24.130 can move to sell the property much more rapidly 00:29:24.130 --> 00:29:27.950 without a lengthy court process. It's much faster 00:29:27.950 --> 00:29:30.450 and cheater for the lender. But the big question, 00:29:30.569 --> 00:29:33.309 the one that really fundamentally separates CUS 00:29:33.309 --> 00:29:35.450 from almost the entire rest of the world, is 00:29:35.450 --> 00:29:38.180 the question of recourse. This is maybe the most 00:29:38.180 --> 00:29:40.819 important concept in this whole deep dive. It 00:29:40.819 --> 00:29:43.359 defines what happens after the foreclosure sale 00:29:43.359 --> 00:29:45.740 if the house isn't enough to cover the debt. 00:29:45.920 --> 00:29:48.480 Okay, so let's use an example. I owe $400 ,000 00:29:48.480 --> 00:29:51.200 on my mortgage. The market crashes. I lose my 00:29:51.200 --> 00:29:54.319 job. I default. The bank forecloses and sells 00:29:54.319 --> 00:29:56.779 my house, but they only get $300 ,000 for it. 00:29:56.880 --> 00:30:00.099 There's a $100 ,000 shortfall. That's called 00:30:00.099 --> 00:30:03.000 a deficiency. Now, what happens? In a recourse 00:30:03.000 --> 00:30:05.490 jurisdiction... which is most of the world, Europe, 00:30:05.670 --> 00:30:09.069 Canada, the UK, and many U .S. states, you, the 00:30:09.069 --> 00:30:11.829 borrower, are still personally liable for that 00:30:11.829 --> 00:30:15.130 $100 ,000 deficiency. The debt follows you even 00:30:15.130 --> 00:30:18.490 after you lose the house. It follows you. The 00:30:18.490 --> 00:30:20.869 bank can get a deficiency judgment against you 00:30:20.869 --> 00:30:23.849 and then garnish your future wages, seize your 00:30:23.849 --> 00:30:26.569 other assets, freeze your bank accounts, and 00:30:26.569 --> 00:30:29.240 pursue you into bankruptcy. The debt is attached 00:30:29.240 --> 00:30:31.839 to you personally. Okay, but then there are the 00:30:31.839 --> 00:30:34.200 non -recourse states in the U .S. This is the 00:30:34.200 --> 00:30:36.700 big anomaly. This is the huge anomaly. In about 00:30:36.700 --> 00:30:39.380 12 states, including big ones like California 00:30:39.380 --> 00:30:41.720 and Arizona, depending on the specific loan type, 00:30:41.940 --> 00:30:44.700 the loan is secured only by the property, period. 00:30:45.000 --> 00:30:47.200 So in my example, if I'm in a non -recourse state, 00:30:47.339 --> 00:30:49.819 the bank gets the house. And that's it. The debt 00:30:49.819 --> 00:30:52.200 is extinguished, they get the keys, and the story 00:30:52.200 --> 00:30:55.029 is over. They cannot sue you for that $100 ,000 00:30:55.029 --> 00:30:57.549 deficiency. They have no recourse to your other 00:30:57.549 --> 00:31:00.349 assets or future income. That completely changes 00:31:00.349 --> 00:31:02.349 the borrower's calculation, doesn't it? It creates 00:31:02.349 --> 00:31:04.589 what economists call a put option. If the value 00:31:04.589 --> 00:31:07.309 of my house drops below the amount I owe, I can 00:31:07.309 --> 00:31:11.049 just walk away. And people did, in massive numbers. 00:31:11.269 --> 00:31:13.769 During the 2008 crisis, this led to the phenomenon 00:31:13.769 --> 00:31:16.809 of jingle mail. People literally mailing their 00:31:16.809 --> 00:31:19.269 house keys to the bank and just leaving. It turns 00:31:19.269 --> 00:31:21.009 the whole moral hazard equation on its head. 00:31:21.190 --> 00:31:24.539 In Europe. Walking away isn't a rational option 00:31:24.539 --> 00:31:27.400 because the debt will haunt you forever. In the 00:31:27.400 --> 00:31:29.839 U .S. non -recourse system, the borrower's risk 00:31:29.839 --> 00:31:33.079 is capped. Your maximum loss is the house itself 00:31:33.079 --> 00:31:36.380 and a bad credit score. It absolutely encourages 00:31:36.380 --> 00:31:39.240 speculation and risk -taking. If I can bet on 00:31:39.240 --> 00:31:42.500 house prices with the bank's money and my personal 00:31:42.500 --> 00:31:45.019 downside is strictly limited... I'm going to 00:31:45.019 --> 00:31:47.000 be much more willing to take that bet. OK, so 00:31:47.000 --> 00:31:49.940 to protect themselves against all these risk 00:31:49.940 --> 00:31:53.160 default, foreclosure, non -recourse laws, lenders 00:31:53.160 --> 00:31:55.559 use mortgage insurance. They do. But we need 00:31:55.559 --> 00:31:58.769 to be crystal clear on this because it is. probably 00:31:58.769 --> 00:32:00.910 the most misunderstood product in the entire 00:32:00.910 --> 00:32:03.089 industry. Right. People hear the word insurance 00:32:03.089 --> 00:32:05.049 and they think it protects them. They think if 00:32:05.049 --> 00:32:07.410 I lose my job, the insurance will pay my mortgage 00:32:07.410 --> 00:32:09.490 for me. It is absolutely not what it is. That 00:32:09.490 --> 00:32:11.809 product exists. But it's a separate thing called 00:32:11.809 --> 00:32:14.069 mortgage protection insurance. The insurance 00:32:14.069 --> 00:32:16.730 we're talking about, often called PMI or private 00:32:16.730 --> 00:32:19.690 mortgage insurance in the U .S., it protects 00:32:19.690 --> 00:32:21.849 the lender. Let me repeat that. It protects the 00:32:21.849 --> 00:32:25.549 bank. The bank is the beneficiary. You, the borrower. 00:32:25.930 --> 00:32:28.450 Pay the premiums every month. But if you default, 00:32:28.710 --> 00:32:30.930 the insurance company writes a check to the bank, 00:32:31.029 --> 00:32:34.529 not to you. That feels structurally unfair. I 00:32:34.529 --> 00:32:36.569 am being forced to pay for an insurance policy 00:32:36.569 --> 00:32:39.430 that pays out to my bank if I fail. It is the 00:32:39.430 --> 00:32:42.490 price of high leverage borrowing. The bank typically 00:32:42.490 --> 00:32:44.569 requires it if you have less than 20 percent 00:32:44.569 --> 00:32:48.049 equity, so an LTV over 80 percent. They are essentially 00:32:48.049 --> 00:32:51.720 saying. You are a high -risk borrower to us because 00:32:51.720 --> 00:32:54.359 you have so little skin in the game. We are only 00:32:54.359 --> 00:32:57.039 willing to make this loan if you pay for an insurance 00:32:57.039 --> 00:32:59.319 policy that indemnifies us against your potential 00:32:59.319 --> 00:33:02.180 default. So it's a risk premium disguised as 00:33:02.180 --> 00:33:04.079 a separate product line. That's a perfect way 00:33:04.079 --> 00:33:06.440 to describe it. If your house is foreclosed on 00:33:06.440 --> 00:33:08.779 and sold at a loss, Creating that deficiency 00:33:08.779 --> 00:33:11.359 we talked about, the PMI company passed the bank 00:33:11.359 --> 00:33:13.799 the difference. The borrower, meanwhile, still 00:33:13.799 --> 00:33:16.059 loses the house, still has their credit ruined 00:33:16.059 --> 00:33:18.539 and gets absolutely nothing from the policy they 00:33:18.539 --> 00:33:20.720 paid for. All right. Let's zoom out to the macro 00:33:20.720 --> 00:33:23.759 trends to start tying this all together. We've 00:33:23.759 --> 00:33:25.839 talked about how these different mechanisms work, 00:33:25.960 --> 00:33:28.500 but how do they impact overall economic stability? 00:33:29.200 --> 00:33:31.619 The outline mentions a U .N. study comparing 00:33:31.619 --> 00:33:34.680 the U .S. and German systems. It's a really striking 00:33:34.680 --> 00:33:38.170 comparison of two philosophies. Germany has a 00:33:38.170 --> 00:33:40.789 system built on stability. It's funded by those 00:33:40.789 --> 00:33:43.430 covered bonds we discussed, which keep risk on 00:33:43.430 --> 00:33:45.569 the bank's balance sheet. They have a culture 00:33:45.569 --> 00:33:48.509 that values saving. And their nominal mortgage 00:33:48.509 --> 00:33:50.410 interest rates have historically hovered around 00:33:50.410 --> 00:33:53.890 a very stable 6%, with very low volatility. And 00:33:53.890 --> 00:33:56.130 what's the effect on their housing market? Historically, 00:33:56.130 --> 00:33:58.789 a very stable housing market. Until some recent 00:33:58.789 --> 00:34:01.130 global pressures, prices in Germany didn't double 00:34:01.130 --> 00:34:03.430 every five years, but they also didn't crash 00:34:03.430 --> 00:34:07.160 by 30%. It was a slow, steady and frankly boring 00:34:07.160 --> 00:34:09.619 market. Contrast that with the United States. 00:34:09.739 --> 00:34:12.800 The U .S. is a roller coaster. In the early 1980s, 00:34:12.800 --> 00:34:15.760 under Paul Volcker, mortgage rates hit 18 percent. 00:34:15.980 --> 00:34:18.679 18. By the early 2000s, they had fallen to 3 00:34:18.679 --> 00:34:22.000 or 4 percent. This incredible volatility combined 00:34:22.000 --> 00:34:24.820 with the originate to distribute model where 00:34:24.820 --> 00:34:27.099 banks don't hold the risk. It's a recipe for 00:34:27.099 --> 00:34:29.769 crisis. It has made the U .S. mortgage market 00:34:29.769 --> 00:34:33.269 the epicenter of multiple major global financial 00:34:33.269 --> 00:34:36.829 crises. The savings and loan crisis in the 1980s, 00:34:36.829 --> 00:34:39.349 and of course the subprime crisis in 2007 and 00:34:39.349 --> 00:34:42.329 2008. both of which were, at their core, mortgage 00:34:42.329 --> 00:34:45.670 crises. Absolutely. The subprime crisis was specifically 00:34:45.670 --> 00:34:48.730 driven by those toxic products we discussed earlier, 00:34:49.050 --> 00:34:51.170 the interest -only adjustable rate mortgages, 00:34:51.250 --> 00:34:54.010 given to borrowers with poor credit who couldn't 00:34:54.010 --> 00:34:56.309 possibly afford the payment when the rate reset 00:34:56.309 --> 00:34:58.630 higher. It was a catastrophic failure of the 00:34:58.630 --> 00:35:01.010 gatekeepers in underwriting. And it was driven 00:35:01.010 --> 00:35:03.489 by the insatiable appetite of the securitization 00:35:03.489 --> 00:35:06.349 machine for more and more mortgages to package 00:35:06.349 --> 00:35:08.550 and sell, regardless of the quality. Exactly. 00:35:08.730 --> 00:35:11.150 The incentives were all wrong. So synthesizing 00:35:11.150 --> 00:35:13.889 all of this, the death pledge is so much more 00:35:13.889 --> 00:35:16.309 than just a monthly bill. It is this incredibly 00:35:16.309 --> 00:35:20.889 complex web of law, math, cultural norms, and 00:35:20.889 --> 00:35:23.030 government policy. It really is. It's the bedrock 00:35:23.030 --> 00:35:24.670 of private property ownership for the middle 00:35:24.670 --> 00:35:26.650 class in the modern world. It's the mechanism 00:35:26.650 --> 00:35:29.070 that allows us to buy assets that vastly exceed 00:35:29.070 --> 00:35:31.809 our annual income. But the mechanics, as we've 00:35:31.809 --> 00:35:35.380 seen, matter enormously. They really do. Whether 00:35:35.380 --> 00:35:38.019 you are entering a diminishing partnership with 00:35:38.019 --> 00:35:41.039 your bank in Kuala Lumpur, facing a government 00:35:41.039 --> 00:35:44.280 mandated stress test in Toronto, or securing 00:35:44.280 --> 00:35:47.699 a 30 year fixed rate bond in Chicago, the rules 00:35:47.699 --> 00:35:50.780 of that specific game will dictate a huge part 00:35:50.780 --> 00:35:53.090 of your financial destiny. And I think realizing 00:35:53.090 --> 00:35:55.349 that you are the morgagor, the one giving the 00:35:55.349 --> 00:35:58.510 pledge, is really empowering. It puts the agency 00:35:58.510 --> 00:36:00.989 back in your hands. You are the one initiating 00:36:00.989 --> 00:36:03.909 this. You are entering a serious long -term contract 00:36:03.909 --> 00:36:06.769 where the collateral is your family's home. Understanding 00:36:06.769 --> 00:36:08.769 these rules isn't just academic. It's essential. 00:36:09.090 --> 00:36:11.269 And I'll leave you with this one final provocative 00:36:11.269 --> 00:36:14.030 thought to chew on. We talked about the non -recourse 00:36:14.030 --> 00:36:16.840 system in some U .S. states. The ability to just 00:36:16.840 --> 00:36:18.820 walk away from the debt. And we talked about 00:36:18.820 --> 00:36:20.880 the Islamic partnership model. Two completely 00:36:20.880 --> 00:36:23.099 different ends of the spectrum. A deep philosophical 00:36:23.099 --> 00:36:26.000 divide. In one system, you are a partner with 00:36:26.000 --> 00:36:28.519 your financier, sharing in the risk and the asset. 00:36:28.880 --> 00:36:32.000 In the U .S. non -recourse model, you are a debtor 00:36:32.000 --> 00:36:34.300 who is actually incentivized to gamble on appreciation 00:36:34.300 --> 00:36:36.980 because the system allows you to bail on the 00:36:36.980 --> 00:36:39.750 crash while socializing the losses. Which makes 00:36:39.750 --> 00:36:42.690 you wonder, does the specific legal structure 00:36:42.690 --> 00:36:45.590 of the American mortgage, this non -recourse 00:36:45.590 --> 00:36:48.829 anomaly, actually cause the very bubbles we're 00:36:48.829 --> 00:36:51.869 all so afraid of? If you knew you couldn't just 00:36:51.869 --> 00:36:54.769 mail the keys back, if you knew that debt would 00:36:54.769 --> 00:36:57.670 follow you for the rest of your life, would you 00:36:57.670 --> 00:37:00.449 have been so willing to bid $50 ,000 over the 00:37:00.449 --> 00:37:03.849 asking price back in 2006? It's a question worth 00:37:03.849 --> 00:37:05.530 asking. Next time you sign a legal document, 00:37:05.769 --> 00:37:08.130 maybe check the etymology. You never know what 00:37:08.130 --> 00:37:10.150 kind of pledge you're really making. Thanks for 00:37:10.150 --> 00:37:11.869 listening to the deep dive. See you next time.