Journalists are very good at reporting the problems caused by the credit crisis - foreclosures, plummeting property values, destroyed credit ratings - but not so good at giving a jargon-free explanation of how this happened. So here goes...
In 2001, the US was officially in a recession. What helped pull us out was an upswing in residential real estate purchases and an overall increase in consumer spending. This was fueled by easy credit. People were tapping into their home equity to pay for everything from college educations to Hawaii vacations. As more people borrowed, lenders drooled over the money made from loan fees and wanted more. So new loan products flooded the market, each of which required less from the borrower in order to qualify - less down payment, less income verification, less credit-worthiness.
These sub-prime loans became prevalent because banks were no longer the driving force behind the lending industry. That role was turned over to non-bank (and non-regulated) financial institutions who packaged these loans into large bundles called mortgage-backed securities (one security typically holds 1,000 mortgages), and sold them to investors.
But why would investors buy these securities if they included risky loans? Because some Wall Street analysts designed risk-pricing models which said that loans are less risky when bundled in large groups then when held individually. If you invest in one real estate loan and the borrower defaults, your investment is in trouble. But if you invest in 1,0000 loans and one defaults, the loss is easily absorbed into the profit from the 999 good loans. And the underlying premise of those models was that, since the Great Depression, US real estate values had never gone down year-over-year on a national basis. Investors knew real estate-backed securities would always be a safe bet.
And what about the borrowers? Why would they take out a loan they could not afford? They knew that, when their 1% adjustable rate loan jumped to 9% in a few years, they would not be able to "pay the piper". Like the Wall Street analysts, borrowers were also aware that real estate was a sure thing. They knew they would be able to sell the home and make a great profit. Would-be homeowners who, a few years before, would have waited to save up a down payment, jumped at the chance to buy now with nothing down. Real estate speculators figured they could buy with cheap money and sell at a profit before their loan rates increased. Everybody would make out OK because everybody was sure that real estate values would continue to increase.
And then the rates on these loans started to rise. As the "teaser" rates expired and the "real" loan rates started to adjust up, the homeowners did exactly what they had planned. They put their homes on the market and waited for the buyers to come flooding in so they could sell the house, pay off the loan, and pocket a nice profit.
But there were just too many loans adjusting upward at the same time, so there were too many sellers trying to move their properties at the same time. In order to get rid of the homes, sellers started to drop their prices. Eventually, prices became so low that, even if they did sell, the proceeds would no longer cover the debt owed on the home. So some sellers walked away from the property, letting the bank foreclose.
Banks are not in business of owning real estate, so they were eager to get rid of their foreclosed properties as quickly as possible. These institutional sellers dropped prices even lower. This forced individual sellers to follow suit. This spiral continued until now, for the first time since the Depression of the 1930's, property values have dropped throughout the entire country.
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