Welcome back to the deep dive. We are tackling
a topic today that sits right at the intersection
of high finance, personal anxiety, and believe
it or not, medieval law. It's a strange mix,
isn't it? It really is. We are looking at the
single largest financial transaction most people
will ever make in their entire lives. Without
a doubt. And yet it's one where the mechanics
are usually, you know, obscured by this mountain
of paperwork and jargon that's almost impossible
to get your head around. It feels intentionally
dense sometimes. We're unpacking the mortgage.
But we aren't just doing the mortgages 101 walkthrough
you might find online. No, we're going a lot
deeper. We've got a stack of research here, comparative
studies, legal histories. economic analyses that
all point to one thing. Which is? That the way
most of our listeners, especially in the U .S.,
think about this debt is a complete anomaly on
the global stage. A total outlier. It really
is. Yeah. When you actually line up the data,
the American mortgage market is. It's a unicorn.
Yeah. It operates by a set of rules that just
don't exist in most other places. Okay. So before
we get into that global tour and the big macro
picture, we have to deal with the nature of the
beast itself. Because, as the sources point out,
this contract isn't just a loan. Not at all.
It's a very specific legal bind, an encumbrance
that has evolved over hundreds of years. And
that history is hidden in plain sight right there
in the name. I was digging into the etymology
provided in the notes and it's surprisingly dark.
It is, isn't it? It's not just some fancy French
word for loan. It's law French from the Middle
Ages. Mort meaning. Yeah. And gauge meaning pledge.
The death pledge. It sounds like something out
of a horror movie or, you know, a fantasy novel.
Exactly. A death pledge. When I first read that,
my immediate reaction was, well, that feels aggressive.
It sounds like you're literally signing your
life away. And in a way, you are signing away
a huge chunk of your financial life. But the
sources clarify the death part isn't necessarily
a threat to the borrower's life. Though the stress
of a mortgage might feel like it sometimes. I
think we can all relate to that. But no, the
death it's referring to is the state of the pledge
itself. The idea is that the pledge, this security
interest you've given the bank over your property,
is dead or static. Meaning it doesn't change.
Exactly. And it's designed to end. It essentially
dies in one of two ways. There's the happy death,
if you want to call it that. I'm guessing that's
when you pay it off. That's it. The obligation
is fulfilled. You make that final payment. After
30 years, the debt dies, the pledge is terminated,
and the property is finally released to you free
and clear. And the unhappy death obviously is
foreclosure. The pledge dies because the lender
takes the property to satisfy the debt. The deal
is over. It's concluded. But you've lost the
asset. So either way, the arrangement is designed
to be terminal. It's not a revolving door like
a credit card. It has a definitive end date where
the gauge, the pledge must die. That framing
really changes the whole vibe of the closing
table, doesn't it? It absolutely does. You aren't
just borrowing money. You are encumbering a piece
of the earth. And that word encumbrance came
up over and over again in the legal definitions.
It's a limitation on your rights. That's a great
way to put it. You might hold the title, you
might paint the walls and mow the lawn, but there
is a heavy, invisible hand resting on that deed
until the pledge is dead. And that leads to this
really common point of confusion, which the notes
highlighted, about the players involved. Ah,
the morgagor and the mortgagee. Yes. In almost
every other part of the English language, the
or suffix implies the giver and the e suffix
implies the receiver. The employer gives the
job. The employee receives it. Sure. The actor
and the one acted upon. But in the mortgage world,
people consistently get it backward. Intuitively,
you think, I am the home buyer. I am receiving
the money, so I must be the mortgagee. And that's
totally logical, but it's wrong. Yeah. Because
it ignores the direction of the security of the
pledge. You have to follow the collateral. Exactly.
The pledge is coming from you, the homeowner.
You are giving the security interest in your
home to the bank. Therefore, you are the mortgagee.
And the bank is receiving that security pledge,
so they are the mortgagee. It seems like a small
pedantic point, but it really matters because
it defines the entire power dynamic. You are
the one initiating the encumbrance on your own
property. Okay, so as the Morgador offering this
death pledge, the very first hurdle is proving
you're actually good for it. Right. This brings
us to the mechanics of the loan itself, specifically
underwriting. I feel like most people view underwriting
as just a, you know, a bureaucratic box checking
exercise. Sending in pay stubs, bank statements.
Yeah, a formality. But the source material highlights
that this is actually a massive predictive modeling
engine. That's exactly what it is. It's the gatekeeping
function. The underwriter isn't just checking
if your pay stub is real. They are trying to
predict the future stability of your life for
the next three decades. 30 years. It's an incredible
thing to try and predict. It is. And they do
it by looking at key ratios. The two big ones
are payment ratios and debt ratios. And while
those sound really similar, they measure very
different kinds of risk. So the payment to income
ratio, sometimes called the front end ratio,
that's the simple one. That's just the direct
burden of the house itself, right? Your proposed
mortgage payment versus your gross income. Correct.
It answers the question, can you afford this
specific house on its own? But the one that really
trips people up, the one that's the more holistic
view, is the debt -to -income ratio. The DTI.
Or the back -end ratio. Right. And the DTI is
critical because it aggregates everything. It's
the mortgage payment, PLUS, your student loans,
your credit card minimums, your car lease, any
other debt you have. It's the total financial
pressure you're under. Exactly. And the research
shows a really strong correlation between high
DTI and default rates, which isn't surprising.
But there's a psychological component mentioned
in the notes that I found fascinating. A high
DTI isn't just a financial metric. It's a proxy
for psychological stress. That makes perfect
sense. I mean, if 45 or 50 percent of your gross
income is already spoken for before you even
buy groceries or pay for gas, you're living in
a state of constant low -grade emergency. There's
no margin for error. A broken down car isn't
an inconvenience. It's a catastrophe. And that
term house poor gets tossed around so lightly,
but it's a genuinely precarious existence. You
have the asset, this beautiful house, but you
have no liquidity to maintain it or, you know,
to maintain yourself. And lenders know this from
decades of data. That's why those DTI caps exist.
They aren't just protecting their capital. They
are statistically avoiding borrowers who are
going to burn out under the financial and psychological
load. OK, so that's the risk of the borrower.
But there's another ratio that determines the
safety. of the asset itself and that's the ltv
loan to value this one seems straightforward
on the surface it's just the loan amount divided
by property value so if i buy a 500 000 house
and i put 100 000 down that's 20 my loan is 400
000 i have an 80 ltv simple it should be but
the value variable in that equation is where
things get really slippery especially in a hot
competitive market this is the value equation
problem from the research that's it You have
multiple conflicting definitions of value. First,
you have the transaction value, which is simply
what you agreed to pay the seller. Okay, my $500
,000 offer. Then you have the appraised value.
And this is the crucial one for the bank. In
a bidding war, the transaction value can completely
decouple from reality. You mean I might agree
to pay $500 ,000 because I fell in love with
the kitchen and I beat out 10 other offers? But
the appraised value... which is the cold, hard,
data -driven opinion of a licensed professional
looking at comparable sales, might come in at
$450 ,000. And the bank only cares about the
appraisal. They only care about the appraisal.
They don't lend on sentiment or bidding wars.
They lend on collateral. And if the LTV, based
on that lower appraised value, is suddenly too
high, say 90 % or more, then the whole deal can
fall apart. Or I have to come up with an extra
$50 ,000 in cash to bridge that appraisal gap.
Exactly. And this is where the down payment or
deposit, as it's called in UK law, functions
as the ultimate risk buffer for the lender. It's
your skin in the game. It's the ultimate skin
in the game. If you have 20 percent equity from
day one, you have a huge cushion. If property
values dip five or 10 percent, you're still not
underwater. You have a massive incentive to keep
paying. But if you have zero equity, you have
absolutely zero barrier to walking away if prices
dip even 1%. And we'll definitely get to that
when we talk about the crisis errors. But for
now, let's assume you pass the underwriting gauntlet.
You have the keys. Now you enter the long 30
-year phase of repayment. And this is where the
math, specifically the amortization curve, can
feel incredibly, incredibly demoralizing for
a new homeowner. It's a psychological shock for
a lot of people. It's based on what's called
the annuity concept. A term from finance. What
does that mean in plain English? It just means
the math is designed to produce a flat, predictable
monthly payment for the entire life of the loan.
Your principal and interest payment is the same
in month one as it is in month 360. OK, that
sounds good. Predictability is nice. It is. But
to achieve that flat payment, the internal composition
of that payment has to shift dramatically over
time. And this is the classic shock of looking
at your first ever mortgage statement. You write
a check for, say, $2 ,000. And you look at the
breakdown and you see that $1 ,850 of it went
to interest. And $150 went to principal. And
you feel like you've made no progress. You're
just running on a financial treadmill, paying
the bank for the privilege of borrowing. It absolutely
feels that way. But it's just the reality of
how interest works on a very large balance. In
that first month, you owe the maximum amount
of money you will ever owe. So the interest charge,
which is a percentage of that huge balance, is
at its absolute peak. The bank gets paid first.
They're getting the rent on their money. They
get their rent first. Whatever tiny sliver is
left over chips away at the principal balance.
But the curve does accelerate, right? It's not
a flat line. Oh, it does, but it's slow. Because
you paid off that $150, next month the interest
is calculated on a slightly lower balance. So
maybe the interest charge is $1 ,849, and your
principal payment is $151. So it's a flywheel
that starts off incredibly heavy and hard to
turn. That's a perfect analogy. Wow. And it takes
about 15 to 20 years on a 30 -year loan for that
flywheel to really pick up speed. By the last
5 to 10 years of the loan, the whole thing is
flipped. Your payment is almost entirely principal
with just a few dollars going to interest. The
math is engineered so the balance hits exactly
zero on that specified end date. Okay, so that's
the standard repayment model that most people
in the U .S. are familiar with. But the outline
highlights some alternative structures that,
frankly, sound terrifying. Specifically, the
interest -only mortgage. This was a huge deal
in the U .K., right? And in the U .S. leading
up to 2008. It was massive in the UK, and it
was the source of a major, major financial scandal.
In an interest -only mortgage, your monthly payment
covers only the rent on the money. So the principal
balance. Stays completely flat. It never decreases.
If you borrow $300 ,000, you will still owe $300
,000 25 years later. So you're just renting your
own debt indefinitely. Essentially, yes. The
logic at the time, and this seems crazy now,
was that you would take the money you saved by
having a lower monthly payment and you'd put
it into a separate investment vehicle. Like what?
In the UK, it was typically an endowment policy
or later a PP or an ISA, which are just types
of stock market investment accounts. The theory
was that the stock market return on that investment
would easily outpace the mortgage interest rate.
So you're trying to create an arbitrage. You're
betting your house that the market beats the
bank. And you are taking all of the risk. And
for millions of people, that bet went sour. This
was the U .K.'s endowment mortgage crisis. The
investment vehicles dramatically underperformed
the rosy projections they were sold with. So
borrowers reached the end of their 25 -year term
expecting this magic pot of money to be there
to pay off the house. And instead they found
there were tens of thousands, sometimes hundreds
of thousands of pounds short of the principal
they owed. And the loan is due. The term is up.
The bank wants their 300 ,000 pounds back. Now.
Immediately. It was a catastrophe. It forced
people to sell their homes, take out new expensive
loans in retirement. It was a mess, and it forced
a massive regulatory crackdown. As it should
have. The Financial Services Authority in the
UK tightened the rules so much that major lenders,
like the Nationwide Building Society, effectively
pulled out of the interest -only market for average
borrowers. To get one today, you need a very
concrete... verified, and frankly, bulletproof
repayment vehicle. You can't just say, oh, I'll
save up. Okay. Then there's the flip side of
this, which is aimed at the other end of the
demographic spectrum, the reverse mortgage. In
the U .S., it's usually the HECM. The home equity
conversion mortgage. Yes. This turns the entire
amortization curve completely upside down. Instead
of you paying down debt to build up your equity,
you are consuming your equity to generate cash
flow. The bank pays you. Right. You can get it
as a lump sum or as monthly tenure payments for
as long as you live in the home or as a line
of credit. But here's the key. You don't pay
any principal or interest monthly. So where does
the interest go? It rolls up. It gets added to
the loan balance. So every single month, your
debt gets larger and your ownership stake in
your home gets smaller. It's called negative
amortization. Sounds like a solution for that
classic problem of being house rich and cash
poor in retirement. That's exactly who it's for.
Older borrowers who have a lot of equity but
need cash to live on. But the compounding effect
of that rolling up interest can be incredibly
aggressive. I can imagine. So what's a repayment
trigger? The loan becomes due and payable when
the borrower dies or permanently moves out of
the home. for instance, into a nursing facility.
The danger is that if you live a long time or
if interest rates are high, the rolling interest
can consume the entire value of the estate. So
there's nothing left for the heirs. Potentially,
yes. In the U .S., the HECM is insured by the
FHA, so the borrower or their estate will never
owe more than the home is worth at the time of
sale. but it can certainly wipe out the full
value. It's a valid tool for some, but you have
to understand you are essentially spending your
house. Speaking of interest rates, this brings
us perfectly to section three, the menu of rates.
This is where the whole risk transfer game really
happens. This is the core choice for most borrowers.
And in the U .S., the 30 -year fixed rate mortgage
is the absolute gold standard. It's more than
just a product. It's almost a cultural right.
It is. And it offers a level of predictability
that is just. It's supreme. You lock in a cost
of housing for three decades. Inflation could
hit 10 percent. Rents in your city could double.
The economy could go crazy. But your principal
and interest payment stays frozen in time. That
is an incredible fact. financial hedge for a
household. It's a massive form of insurance against
volatility. Yeah. But that certainty isn't free.
No, you pay a premium for it, don't you? You
do. The initial interest rate on a fixed mortgage
is almost always higher than the starting rate
on a variable or adjustable rate product. You
are paying the bank a little extra to take that
30 -year interest rate risk off your hands. Which
brings us to the alternative, the adjustable
rate mortgage or the ARM. Here, you get a discount
up front. You get a teaser rate or a lower margin
for the first few years. Because you, the borrower,
are agreeing to take on the volatility risk.
You're taking the gamble. You are. If the Federal
Reserve hikes interest rates to fight inflation,
your mortgage rate goes up. Your payment goes
up. You are absorbing the shock so the bank doesn't
have to. So it's a fundamental tradeoff. Do you
want to sleep well at night knowing your payment
will never change? Or do you want a lower bill
today and are willing to risk it going up tomorrow?
That's the choice. The lower initial rate can
be really tempting. It lets you qualify for a
bigger loan. But as we saw in 2008, when those
ARMs reset to a much higher rate, it can be devastating.
It's the ticking time bomb in your finances.
But then the outline mentions something even
more exotic. Foreign currency mortgages. This
sounds like an A .R .M. on steroids. This is
a phenomenon we rarely ever see in the U .S.
or the U .K. because our currencies are relatively
stable. But it's very common in developing economies
or places with a history of high inflation like
in Eastern Europe. So what's the concept here?
The concept is borrowing in a stable low interest
rate. foreign currency, like the Swiss francs
or the euro, because the rates are much lower
than in your home country. Okay, give me an example.
Let's say I'm in Hungary or Poland, and my local
mortgage rate in Florence or Zloty is, say, 12%.
But you look across the border and you see that
you can borrow in Swiss francs at 3%. I take
the francs. It seems like a no -brainer. Exactly.
And for a while, it looks like you're an absolute
genius. Your monthly payment is tiny compared
to your neighbors who borrowed locally. But there's
a huge hidden risk. You are earning your salary
in Hungarian forints, but your debt is denominated
in Swiss francs. You have just introduced currency
risk into your personal housing situation. So
if the forint crashes against the francs, which
happens a lot in economic crises. Your debt load
explodes. Your salary is the same, but you suddenly
need twice as many forints to make your mortgage
payment. You could owe double the amount of local
currency overnight, even if you've been making
all your payments on time. My God, it could wipe
you out. And that is exactly what happened across
Eastern Europe after 2008. It caused systemic
defaults and a massive political crisis. It's
the ultimate example of chasing a low rate without
understanding the underlying structural risk
you're taking on. This segues perfectly into
our global tour of mortgage markets. We've touched
on pieces of it, but I want to really drill down
into why the US system is considered such an
outlier. We take the 30 -year fixed rate for
granted, but the notes say this product basically
shouldn't exist in a normal free market. It really
shouldn't. And to understand why, you have to
think about it from a bank's perspective. Why
on earth would you, as a bank, lend someone money
for 30 years at a fixed rate of, say, 4 %? Your
own cost of funds, the interest you have to pay
to your depositors for their savings accounts,
that changes every single day. If the central
bank raises rates and your cost of funds goes
up to 6%, you are now actively losing 2 % on
that mortgage loan every single year for the
next two or three decades. a guaranteed loss.
No rational bank would hold that risk on their
balance sheet voluntarily. They wouldn't. It's
called interest rate risk and it's huge. So how
does the 30 year fixed exist in the U .S.? Government
intervention. Massive government intervention.
Enter the GSEs, the government sponsored entities,
Fannie Mae and Freddie Mac, and also Ginnie Mae
for government insured loans. The alphabet soup
of the American housing market. That's them.
And these quasi -governmental entities were created
starting after the Great Depression to do one
thing, grease the wheels of securitization. Which
means? They buy the mortgages from the local
banks that originate them. They bundle thousands
of these loans together, package them into mortgage
-backed securities, MBS, and then they sell those
securities to global investors like pension funds
and insurance companies. And crucially, they
guarantee the payments on those securities. That
is the magic ingredient. They add their government
-backed guarantee. This takes the long -term
interest rate risk completely off the local bank's
books and creates a massive liquid global market
for this debt. So to put it simply, the reason
I can get a 30 -year fixed loan in Ohio is because
the U .S. government has essentially created
a backstop that makes that piece of paper valuable
and safe for a pension fund in Tokyo or a sovereign
wealth fund in Norway. Precisely. Without Fannie
and Freddie buying up those loans and guaranteeing
them, the 30 -year fixed mortgage would likely
disappear almost overnight. Our market would
start to look a lot more like the rest of the
world. Okay, so let's look at the rest of the
world. Let's start with the United Kingdom. They
don't have this massive securitization machine
in the same way. No, their system grew out of
a completely different tradition. The UK mortgage
market was historically dominated by building
societies. What are those? They are mutual organizations
owned by their members. Not by shareholders.
And they were funded by their members' retail
savings deposits. So they're taking in short
-term savings. And because they rely on short
-term deposits, they can't possibly lend that
money out for 30 years at a fixed rate. It would
be financial suicide. So the U .K. market is,
by necessity, dominated by variable rates, or
what they call trackers, and short -term fixes.
Not a 30 -year fix. A two -year fix. A three
-year fix. Maybe five years if you're lucky.
Yeah. After that initial period, the rate automatically
reverts to a higher variable rate and you're
expected to remortgage. That creates a totally
different national psychology around housing
and interest rates. Completely. In the U .S.,
once you lock in your rate, you can basically
stop caring what the Federal Reserve does for
the next 30 years. It doesn't affect your biggest
bill. But in the UK, every time the Bank of England's
Monetary Policy Committee meets, the whole country
holds its breath. Because millions of homeowners
know their short -term fix is expiring in the
next year or two. It makes the transmission mechanism
of monetary policy much, much faster and more
direct. If the Bank of England raises rates,
millions of people feel it directly in their
wallet within months. In the U .S., it really
only affects new buyers or those with home equity
lines. Okay, now what about our neighbors to
the north, Canada? I know they have a similar
structure with these five -year renewals, but
the notes mention something really unique, the
stress test. The B -20 guideline. This is a fascinating
piece of macroprudential policy. It's a form
of social engineering, really. How does it work?
In Canada, even if you go to a bank and you negotiate
a mortgage rate of, say, 4%, the bank is legally
required to qualify you as if the rate were much
higher. So they're testing your ability to pay
a phantom rate. Yes. The rule is you have to
qualify at the greater of a benchmark rate set
by the Bank of Canada, or your actual contract
rate plus 2%. So in my example, I'd have to prove
I could afford the payment at 6%, even though
I'm only going to be paying 4%. Exactly. The
government is asking, on your behalf, if rates
go up by 2 % when you renew in five years, will
you go broke? If the answer is yes, you don't
get the loan. Not even at the 4 % you can afford
today. Wow. What was the impact of that? It significantly
reduced the maximum borrowing power for the average
person. It cooled the housing market. But more
importantly, it builds a permanent safety margin
into the entire system. It prevents people from
stretching to their absolute financial limit
just to get into the market. It's a paternalistic
policy, but it seems to have worked in preventing
a U .S.-style meltdown. It has been very effective
at promoting stability. Now, let's cross the
Atlantic to continental Europe. The outline says
it's a diverse market, but mentions a common
funding mechanism called a covered bond. How
does this differ from the U .S. securitization
model we talked about? This is a really key structural
difference. In the U .S., you have what's called
an originate -to -distribute model. The bank
makes the loan and immediately sells it, distributing
to Fannie Mae. They wash their hands of the risk.
In the European covered bond system, which is
very popular in places like Germany with their
fan brief, the bank issues bonds that are backed
by a pool of mortgages, much like an MBS. But,
and this is the big difference, the mortgages
stay on the bank's balance sheet. Ah, so they
still have skin in the game. 100 % skin in the
game. If those loans go bad, The bank eats the
loss, not some distant investor who bought the
bond. The bondholders have dual recourse to the
bank itself and to the underlying mortgages.
That completely changes the incentives, doesn't
it? It changes everything. It naturally leads
to much more conservative, careful underwriting
because the lender has to live with the consequences
of their lending decisions for years. And it's
a big reason why default rates in Europe are
generally much lower than in the U .S. It aligns
the incentives of the lender with the long term
performance of the loan. That structural difference
seems to explain a lot about the relative stability
of many European housing markets versus the boom
and bust cycles we seem to specialize in. But
the most radical difference of all is clearly
Islamic finance. This is a whole different universe.
We're talking about a system that prohibits the
charging or payment of interest entirely. That's
right. Sharia law prohibits Wiba, which is probably
translated as usury or interest. The core philosophical
basis is that money should only be a medium of
exchange, not a commodity that generates profit
by itself. You cannot make money from money.
You can only make money from productive activity
or trade. So how on earth do you buy a house?
You can't just pay cash. The whole point of a
mortgage is to borrow money over time. You do
it by changing the fundamental relationship.
The bank and the borrower are not creditor and
debtor. They become partners or co -owners. Okay.
There are a few models, but the notes highlight
two main ones. The first, which is a bit simpler,
is called by Bithman Agile. It's basically deferred
payment sale. Walk me through that. How does
it work? The bank buys the house you want from
the seller for the current market price, say
$300 ,000. Then the bank immediately sells that
same house to you, but for a marked up price,
say $400 ,000, which you agree to pay in installments
over 30 years. So the bank's profit, which would
have been the interest, is just built into the
price tag of the asset they're selling you. Exactly.
It's structured as a trade, not a loan. But the
more elegant model, and the one that's gaining
popularity, is musharka mutanakisa. That's a
mouthful. It means a diminishing partnership.
Okay, break that down for me. You and the bank
buy the house together as partners. Let's say
you put in a 10 % down payment. So you own 10
% of the house. The bank puts in the other 90%.
So they own 90%. You are co -owners. Right. Now
you live in the house, so you have to pay rent
to your co -owner of the bank for the use of
their 90 % share of the property. Okay. That
makes sense. It's fair. But here's the clever
part. Your monthly payment isn't just rent. It's
structured as rent plus acquisition. A portion
of your payment is rent. And the other portion
buys a little more of the bank's equity share.
So next month, I might own 11 % and the bank
owns 89%. Exactly. And because you now own more
of the house, your rent payment for the next
month goes down slightly because you're renting
less of their share. So more of your fixed monthly
payment can go towards acquiring even more equity.
That is surprisingly logical and elegant. You
are slowly... systematically buying out your
partner until you own 100 % of the asset. The
payments are tied to the use and ownership of
a real thing, not to the abstract concept of
interest on money. It creates a direct link between
the asset and the payment. But it did face significant
legal hurdles when introduced in Western countries.
I can imagine how so. Specifically, things like
stamp duty or property transfer taxes. In the
UK, for example, every time a property changes
hands, you have to pay a tax. In this Islamic
model, the property technically transfers from
the original seller to the bank and then from
the bank over time to the borrower. That's two
transactions, so double taxation. Precisely.
It made Islamic mortgages prohibitively expensive
and uncompetitive at first. But in a really interesting
move, the UK government actually amended the
Finance Act back in 2003 to recognize these alternative
structures and waive the double stamp duty. That's
a huge deal. It was a major move to adapt a Western
legal framework to accommodate Islamic finance,
and it opened the market up significantly. That's
a great example of legal systems adapting to
reality. But what happens when the legal system
has to deal with failure? We have to move on
to Section 5, foreclosure, recourse, and insurance.
This is where the rubber really meets the road.
This is the unhappy death of a pledge. Foreclosure,
or repossession in the UK, is the legal mechanism
for the lender to seize the collateral when you
default. But the process can vary wildly. You
mean judicial versus non -judicial foreclosure?
Exactly. In some jurisdictions, the lender has
to go through the court system to prove the default
and get permission to sell the property. That's
a judicial foreclosure. It can take months, even
years, and gives the borrower many opportunities
to fight it. And non -judicial. In other places,
the mortgage documents contain what's called
a power of sale clause. If you default, the lender
can move to sell the property much more rapidly
without a lengthy court process. It's much faster
and cheater for the lender. But the big question,
the one that really fundamentally separates CUS
from almost the entire rest of the world, is
the question of recourse. This is maybe the most
important concept in this whole deep dive. It
defines what happens after the foreclosure sale
if the house isn't enough to cover the debt.
Okay, so let's use an example. I owe $400 ,000
on my mortgage. The market crashes. I lose my
job. I default. The bank forecloses and sells
my house, but they only get $300 ,000 for it.
There's a $100 ,000 shortfall. That's called
a deficiency. Now, what happens? In a recourse
jurisdiction... which is most of the world, Europe,
Canada, the UK, and many U .S. states, you, the
borrower, are still personally liable for that
$100 ,000 deficiency. The debt follows you even
after you lose the house. It follows you. The
bank can get a deficiency judgment against you
and then garnish your future wages, seize your
other assets, freeze your bank accounts, and
pursue you into bankruptcy. The debt is attached
to you personally. Okay, but then there are the
non -recourse states in the U .S. This is the
big anomaly. This is the huge anomaly. In about
12 states, including big ones like California
and Arizona, depending on the specific loan type,
the loan is secured only by the property, period.
So in my example, if I'm in a non -recourse state,
the bank gets the house. And that's it. The debt
is extinguished, they get the keys, and the story
is over. They cannot sue you for that $100 ,000
deficiency. They have no recourse to your other
assets or future income. That completely changes
the borrower's calculation, doesn't it? It creates
what economists call a put option. If the value
of my house drops below the amount I owe, I can
just walk away. And people did, in massive numbers.
During the 2008 crisis, this led to the phenomenon
of jingle mail. People literally mailing their
house keys to the bank and just leaving. It turns
the whole moral hazard equation on its head.
In Europe. Walking away isn't a rational option
because the debt will haunt you forever. In the
U .S. non -recourse system, the borrower's risk
is capped. Your maximum loss is the house itself
and a bad credit score. It absolutely encourages
speculation and risk -taking. If I can bet on
house prices with the bank's money and my personal
downside is strictly limited... I'm going to
be much more willing to take that bet. OK, so
to protect themselves against all these risk
default, foreclosure, non -recourse laws, lenders
use mortgage insurance. They do. But we need
to be crystal clear on this because it is. probably
the most misunderstood product in the entire
industry. Right. People hear the word insurance
and they think it protects them. They think if
I lose my job, the insurance will pay my mortgage
for me. It is absolutely not what it is. That
product exists. But it's a separate thing called
mortgage protection insurance. The insurance
we're talking about, often called PMI or private
mortgage insurance in the U .S., it protects
the lender. Let me repeat that. It protects the
bank. The bank is the beneficiary. You, the borrower.
Pay the premiums every month. But if you default,
the insurance company writes a check to the bank,
not to you. That feels structurally unfair. I
am being forced to pay for an insurance policy
that pays out to my bank if I fail. It is the
price of high leverage borrowing. The bank typically
requires it if you have less than 20 percent
equity, so an LTV over 80 percent. They are essentially
saying. You are a high -risk borrower to us because
you have so little skin in the game. We are only
willing to make this loan if you pay for an insurance
policy that indemnifies us against your potential
default. So it's a risk premium disguised as
a separate product line. That's a perfect way
to describe it. If your house is foreclosed on
and sold at a loss, Creating that deficiency
we talked about, the PMI company passed the bank
the difference. The borrower, meanwhile, still
loses the house, still has their credit ruined
and gets absolutely nothing from the policy they
paid for. All right. Let's zoom out to the macro
trends to start tying this all together. We've
talked about how these different mechanisms work,
but how do they impact overall economic stability?
The outline mentions a U .N. study comparing
the U .S. and German systems. It's a really striking
comparison of two philosophies. Germany has a
system built on stability. It's funded by those
covered bonds we discussed, which keep risk on
the bank's balance sheet. They have a culture
that values saving. And their nominal mortgage
interest rates have historically hovered around
a very stable 6%, with very low volatility. And
what's the effect on their housing market? Historically,
a very stable housing market. Until some recent
global pressures, prices in Germany didn't double
every five years, but they also didn't crash
by 30%. It was a slow, steady and frankly boring
market. Contrast that with the United States.
The U .S. is a roller coaster. In the early 1980s,
under Paul Volcker, mortgage rates hit 18 percent.
18. By the early 2000s, they had fallen to 3
or 4 percent. This incredible volatility combined
with the originate to distribute model where
banks don't hold the risk. It's a recipe for
crisis. It has made the U .S. mortgage market
the epicenter of multiple major global financial
crises. The savings and loan crisis in the 1980s,
and of course the subprime crisis in 2007 and
2008. both of which were, at their core, mortgage
crises. Absolutely. The subprime crisis was specifically
driven by those toxic products we discussed earlier,
the interest -only adjustable rate mortgages,
given to borrowers with poor credit who couldn't
possibly afford the payment when the rate reset
higher. It was a catastrophic failure of the
gatekeepers in underwriting. And it was driven
by the insatiable appetite of the securitization
machine for more and more mortgages to package
and sell, regardless of the quality. Exactly.
The incentives were all wrong. So synthesizing
all of this, the death pledge is so much more
than just a monthly bill. It is this incredibly
complex web of law, math, cultural norms, and
government policy. It really is. It's the bedrock
of private property ownership for the middle
class in the modern world. It's the mechanism
that allows us to buy assets that vastly exceed
our annual income. But the mechanics, as we've
seen, matter enormously. They really do. Whether
you are entering a diminishing partnership with
your bank in Kuala Lumpur, facing a government
mandated stress test in Toronto, or securing
a 30 year fixed rate bond in Chicago, the rules
of that specific game will dictate a huge part
of your financial destiny. And I think realizing
that you are the morgagor, the one giving the
pledge, is really empowering. It puts the agency
back in your hands. You are the one initiating
this. You are entering a serious long -term contract
where the collateral is your family's home. Understanding
these rules isn't just academic. It's essential.
And I'll leave you with this one final provocative
thought to chew on. We talked about the non -recourse
system in some U .S. states. The ability to just
walk away from the debt. And we talked about
the Islamic partnership model. Two completely
different ends of the spectrum. A deep philosophical
divide. In one system, you are a partner with
your financier, sharing in the risk and the asset.
In the U .S. non -recourse model, you are a debtor
who is actually incentivized to gamble on appreciation
because the system allows you to bail on the
crash while socializing the losses. Which makes
you wonder, does the specific legal structure
of the American mortgage, this non -recourse
anomaly, actually cause the very bubbles we're
all so afraid of? If you knew you couldn't just
mail the keys back, if you knew that debt would
follow you for the rest of your life, would you
have been so willing to bid $50 ,000 over the
asking price back in 2006? It's a question worth
asking. Next time you sign a legal document,
maybe check the etymology. You never know what
kind of pledge you're really making. Thanks for
listening to the deep dive. See you next time.