: what was the subprime mortgage crisis ?
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This crisis happened because banks and regulators all bought into the incorrect notion that “real estate always goes up in value.”
Imagine you go for a home loan, and the bank tells you that you need to put 20% down. This means if you’re buying a $100K home, you need to pay $20K now and take out a mortgage for $80K, which you then pay off over the next 30 years. If you take out a loan you can’t pay, even in the early part of the loan, the bank can foreclose and take your house, sell it, and get their money back.
The reason you have to put 20% down is that it can take several months—even more than a year— for this process to play out, and the bank has to spend a lot of money to get you out of there. They want to make sure that after all those costs are totaled up, they’ve made money, or at least not lost any money. IOW, that whole time they’re spending your $20K to kick you out of the house you’re no longer paying for.
There’s also the value of the house to consider. If the value of the house goes down, the bank wants to make sure that the $20K you put down will not only cover their expenses to get you out and resell it, but also cover any drop in value.
Example: You take the loan for $80K on a $100K house and never pay, after a year the bank has spent $10K in legal fees to kick you out, $2K to fix up wear and tear on the home, and the house dropped $4K in value, so they can only sell it for $96K. So the bank has spent $16K on this situation, but in the end they still made $4K on the time you were in the house.
In the early part of the first decade of the 2000s, there were many parts of the country where real estate value was climbing 5–10% per year. This changes the math considerably. In this scenario, the banks realized that they could write a lot more mortgages if they relax the 20% down requirement, because a lot of people couldn’t come up with that downpayment. But if the house is appreciating anyway, then the bank is still covered. In this scenario, if you buy a $100K house that goes up 10% per year, and you put down only 5% instead of 20%, that means the bank’s downside on the worst case scenario is they spend $16K and can get $15K out of your downpayment + appreciation … but if they just hang on to the house another 6 months in an appreciating market, they’ll get another $6K out of it. So there’s really no risk to the bank to make loans with a lower downpayment. In fact, so many real estate markets were so hot that banks didn’t even care if you could pay or not, so they started giving “no doc” loans, meaning you didn’t have to provide documentation that prove how much money you’re making. They actually didn’t mind if borrowers defaulted on loans because that just means they get to come into possession of a quickly appreciating asset.
Now if you’re talking about one particular house, there’s still a lot of risk because weird market conditions can create a situation where there are no buyers for that particular house and it doesn’t go up in value like “the market” says it should. However, if you are a bank, you have a lot of these loans across a diverse range of properties, and all you care about is the average case, not any one in particular. So this creates the rationale for bundling all these loans together. They’re called “subprime” mortgages because the loans are risky; a lot of the borrowers can’t afford to pay them. However, that doesn’t matter if the house is going to keep climbing in value. (Never mind how unethical it is to make a loan to someone who can’t afford it…after all, that person’s life and credit will be wrecked in the aftermath, even if the bank can make money.)
The assumption that this is all based on is that demand is going to keep housing prices going up. This would have been a good assumption if all the demand was organic; that is, if everyone buying these houses was living in them. However, because they were appreciating, there was a lot of speculation going on. People and businesses would buy homes not for the purpose of living in them, but just to hold them for awhile and then flip them and make money. This, of course, created more demand, and caused prices to go ever higher. Over time, people who actually want to buy these houses to live in them get priced out of the market because they aren’t getting investors together to invest and flip, they’re just paying the mortgage out of their bank account, so they can’t compete with investors pooling their money together. The balance of buyers driving this crazy amount of demand shifted heavily toward speculators. This is called a bubble…when the demand shifts from organic to synthetic, stable to volatile, it can collapse all at once, and the basic assumption the entire system is based upon—that “real estate value always goes up”—is suddenly no longer true.
That’s the ground level understanding of all this stuff before all the complicated financial instruments come into play. The financial instruments are important to understand too, though, because these are what made it possible for all this nonsense to proceed. Generally speaking, bubbles like this can only go so far before the few participants involved in a transaction start to get worried. What these instruments did is increase the number of participants dramatically, and remove the people funding this process several steps from what they’re funding, so they don’t perceive that risk.
Here’s how it worked. Banks rolled together these risky loans into bundles, and then “securitized” them, turning them into bonds (“mortgage-backed securities”). Because “real estate always goes up,” these bonds got AAA rated by regulators based on the above argument that “even if everyone defaults, we take over the properties and they continue to go up and we sell for a profit.” This process of the bank taking responsibility for defaulted loans was put into the form of other financial instruments, the “credit default swap” and “collateralized debt obligation,” each of which allowed another repackaging of risk into tradable financial objects that got AAA ratings. Thus banks again would take these and sell them off to firms like Bear Stearns and Goldman Sachs. Other big buyers of these objects were pensions and 401K funds investing people’s retirement money which is usually put into very safe, AAA-rated investments, that pay lower interest than riskier investments. This high rating meant that holders could be paid lower interest rates for objects that are actually very risky, allowing investment firms and banks in the middle to collect the difference. Thus everyone along the way is motivated to continue doing what they’re doing as things spin farther and farther out of control.
Finally, after all this was set into motion and running for many years, too many homeowners started opting out by not paying, and there were no longer enough buyers left to keep demand propped up, as prices had gone too high in this speculation spiral. Suddenly, everyone began to realize they were holding bonds that would not pay out, and they would lose their investment. The biggest holders of these instruments went out of business or had to be bailed out by the government.
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