There are several factors which make this an unusual crisis rather than merely the usual run of greed.
A normal downtown in the economy hits most of the country more or less equally. Recently, though, the housing market in the U.S. was divided into areas that were extremely hot and areas that were practically dead. In the hot areas, developers were throwing up huge subdivisions because of the perceived demand from people who thought they could make money not merely by buying a new house but by buying a house and then quickly selling it to someone else. For a while this was actually true. Many speculators entered the market. And so did legitimate buyers who were trying for once to get into something good at the right time.
The rule of thumb is that a foreclosure drives down the value of other homes within an eighth of a mile by 1%. Normally this is insignificant. Not today. In certain subdivisions, whole streets may have a number of foreclosed houses on them. If you have 20 nearly houses in foreclosure, the survivors have their home value decreased by 20%. What happens when they need to legitimately sell? Often they can’t at all. Few people want to live on a street with foreclosed homes, which are not well kept up, and if they do want to buy, getting a foreclosed home at a bargain trumps minus 20% for a lived-in home.
Whole sections of formerly well-to-do suburbs, therefore, are seeing the equivalent of inner city blight - lowered taxes but increasing demand for police and fire services - with no hope of getting out from under for years. This is a long-term crisis that hits innocent people, something that always draws cries for government intervention.
The flip side is the financial industry. Their purpose in life is to reduce risk and increase return. Normally these two goals are incompatible. The safest investments carry a low return because not much incentive is needed. High risk demands a commensurately greater return to tempt investors to take the chance.
Mortgages historically were a known quantity. They were safe, because they were only given to people whose credit histories and future ability to pay were investigated. Your local bank normally sold off mortgages to larger companies. That got them their money right away but were freed from the clerical work of collecting payments, sending out monthly bills, and going after delinquents, which were subject to enormous economies of scale. So your local bank probably isn’t much affected at all by the defaults.
The bright boys (and in all the articles I’ve read I can’t remember seeing a single female name) at the larger firms looked around them at the red-hot housing markets and saw home prices zooming upward. They saw an opportunity. Presumably delinquencies would be very low even to poor credit risks because even morons could get their money back by selling their houses for more than they paid. So why not resell these secondary mortgages as an investment? You suddenly have the magic formula: high returns with low risk.
Companies sprang up that dealt in such investments. They weren’t morons, though, and they knew that their customers, people who got into the latest, greatest, and most complicated financial ventures, weren’t either. They weren’t going to take just anybody’s word for how safe these investments were.
They did what they always did. Turned to firms like Standard & Pooh’s and Moody’s, who sole job it is to rate investment risk. And those firms, in an apparent abdication of common sense, looked at these ridiculously bad mortgages made in an obvious bubble, and said, hey, looks good to us. They gave them the usual assortment of ratings, but even their lowest ratings were what’s called investment grade, which is a normal guarantee of relative safety.
The investment companies sold off their mortgages by rating grade (creating the tranches, meaning slices, that tremorviolet noted) and everybody was happy, with huge returns pouring in.
But the investment gradings were wildly overblown. The lowest ones tanked immediately. Even the highest rated ones are sinking fast.
So who’s to blame now? Standard & Poor for bad ratings? They were rating something that never existed before in history, which makes it rough to get right.
The investment buyers? They’re rich and presumably know how to take care of themselves. But they were mislead.
The investment firms? They saw an opportunity and thought they were providing a fair service, backed up with what normally was high grade stuff.
The banks for reselling the mortgages? Spreading risk around and raking in the returns is what they do and how they stay in business.
What happens if they don’t stay in business? The old saying was that if you owed the bank $100 they owned you. If you owed the bank $100,000,000 you owned the bank. (You can see how old this saying is by the piddling numbers.) Same thing today on a much larger scales. If banks owing $100,000,000,000 fail then the problem ripples outward throughout the economy and, same as the houseowners, sinks entirely innocent people along with the greedy guilty.
Where do you draw the line? Who steps in where? How to determine who’s innocent and who’s guilty? No two people will agree on any answer.
But since the higher rate on adjustable rate mortgages take 18-24 months to kick in, and the dumbest, riskiest loans were being made up through June of this year, we haven’t seen anywhere near the worst yet. That’s why everybody panicking. It’s already awful, and everybody wants to keep the bottom from dropping out, especially in an election year.
That’s why the political pressure is overwhelming and will not be ignored. And who’s to say it should be ignored? I’m just glad this is one problem I don’t have to answer for.