I know it’s a pretty big thing over at the US, but lacking the knowledge of how mortgages work over there, I don’t fully grasp what actually is the subprime rate problem, what leads to it and why it should cause a recession. What exactly went wrong?
Not enough information was preserved along the multiple levels of indirection of the mortgages for the end buyers to tell how safe the mortgages were.
The banks lent to consumers, then packaged the loans together and sold them to investors. But the banks, and the oversight companies that were supposed to validate how safe the mortgage bundles were, (and the companies that were supposed to validate them, etc,) did not properly evaluate the risk because they assumed prices would continue to keep going up, among other things.
So the banks had no real reason to not write risky loans cause they were going to sell them anyway after collecting the fees. And the buyers of mortgages trusted the oversight companies and the banks. So when housing values did collapse, the end mortgage holders and their underwriters were screwed.
And now this is causing a credit crunch cause no one trusts the old system any more, having been burnt on it once. The banks are having a harder time turning around mortgages.
Per the story:
It basically boils down the fact that there was a fair housing social push and a federal mandate to intervene in the mortgage loan business, and get rid of overtly discriminatory loan practices (ie redlining). This worked at first as lenders proceeded carefully, but then broke down when investors in a low return environment developed an ever increasing appetite for the higher yield subprime loan bundles. This freed more money for these loans, and underwriting standards decreased to the point that lots of loans were made that had no business being underwriten as investors chased the juicy supbprime returns, and bankers threw ever increasing amounts of that money at unqualified sub-prime borrowers.
Unscrupulous lenders were giving mortgage loans to borrowers who had no business getting them. People with bad credit, not enough income, etc. were being approved for ridiculous loans at higher interest rates. In some cases, borrowers went into agreements where their net income was just barely enough to cover the mortgage payment, and these were adjustable rate mortgages.
Between this scenario and lots of high-end jobs going away, people are unable to pay their mortgages, which leads to short sales or foreclosure. Who eats that loan? The bank does. The crisis is that there are zillions of dollars tied up in these defaulted mortgage loans.
This may be a simplistic view (IANA economist), but I think that’s the gist of it.
To make it worse, a lot of these debts were securitized, essentially converted into investment instruments and then re-sold to investors who had little idea that they were backed only by risky mortgages. We actually had a safeguard against this, the Glass-Steagall act of 1933, passed in the wake of the Great Depression to prevent a repeat of those abuses. Unfortunately, the GSA was repealed in 1999, paving the way for the present financial quagmire.
I’d like to say we can lay this solely at the feet of the Republican robber-barons, but that wouldn’t really be true. Though it was introduced and passed along party lines in the House, it passed the Senate with bipartisan support and was signed by Bill Clinton.
What happened to upset the status quo? It could have gone on forever till a trigger event. I can’t seem to recall it (being distracted by examinations and such). Why is everything collapsing now?
I think this sums it up nicely.
The subprime primer - a powerpoint presentation
you’ll laugh…you’ll cry
Siskel and Ebert give it a two thumbs up.
I enjoyed this particular presentation on the subprime problem.
ack. I see Mongo Ponton beat me to it.
I don’t think you need a trigger event. People were buying houses with the expectation that in a year or two, they could sell them and profit. As soon as the market peaked (because there were no greater fools), they sold at what they could to cut their losses. There were no fundamentals to support the great price increases in the first place, so once prices started dropping, they fell hard, etc. etc.
Even the ones who didn’t intend to sell were betting (literally) that with their houses’ value climbing they’d be able to refinance a mortgage with beter terms (like converting an adjustable rate mortgage into a fixed rate one just as their ARM was set to adjust.)
MY ARM is set to adjust in just a couple of months. I’m in the process of getting a new mortgage right now. Fortunately, the balance we owe is small enough at this point that the decline in the house’s value won’t make a difference.
Followup question… how much influence did the President have over this problem? Could Bush have prevented it? Was he a direct or indirect cause?
The modern US financial system is deliberately designed so that risk is spread out to the largest possible degree. This is sort of like mountain climbers roped together for safety: the system works fine most of the time, but when someone is heavy enough that they drag the rest of the climbers off the mountainside with them, big trouble results. It’s similar to the S&L collapse some years ago. Every so often, some bunch of wiseacres come up with a new way to milk money out of the system. Eventually reality catches up and investors, depositors and the taxpaying public end up footing the bill.
That this comes at the same time as skyrocketing petroleum prices and a weak dollar makes it all the worse.
In all of this, much as it hurts to point it out, the individual home buyer deserves some of the blame, at least.
A loan that you know damn well you will not repay is a pipe dream. Borrowing more than you can afford is stupid. Yes, unscrupulous lenders are to blame too, but it take two to do the dance.
Tris
Fannie Mae and Freddie Mac are the ones who securitize the mortgages, but they guarantee the loans, even if the mortgagor defaults. So the investors have very little risk. However, Fannie and Freddie are in deep shit. This makes it harder for them to continue to buy mortgages to securitize (you need cash), causing some of the market meltdown.
The answers are none, no, and neither.
Americans want houses in desirable locations, desirable locations usually defined as those where jobs are growing. They will pay nearly any amount to live in those areas. That’s why the subprime crisis and the resultant foreclosures are concentrated in a few urban areas and are almost nonexistent in much of the old industrial northeast states and in the farm-heavy midwest. No President created the decades-long shift of population from the northeast to the south and west. Air conditioning, the collapse of the industrial economy, and the ease of building in wide-open spaces caused the population to flow south like a cake pan tipped in the oven.
There have been several previous housing bubbles, especially in California, where housing prices are the highest in the nation and keep going up. They are inevitable as long as people will compete for housing by bidding up desirable locations.
The current situation is a result of the extremely low interest rates that the Federal Reserve Bank set. (The Fed sets a rate for loans to the financial community; these are the lowest possible rates. Other rates, such as mortgages, are usually some set increase over these rates. See “prime” rates.) When the prime rate hit 1%, mortgages followed. That brought huge numbers of new buyers into the markets. The predators followed them.
A couple of authors have recently published books saying that Alan Greenspan, the former Fed Chair, should have known that these rates were foolhardy because they were saying at the time that his policies would have this result. One that has been getting good reviews is The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, by Charles R. Morris.
George W. Bush did reappoint Greenspan, but he had first been appointed by Ronald Reagan in 1987 and reappointed by Bush I and Clinton in the interim. Most everybody gave him glowing reviews until the day he retired in 2006. It’s hard to blame Bush for treating him the same way everybody else did.
Other aspects of the crisis is the result of poor governmental oversight, but that’s another long-term issue. The U.S. government generally declines to provide any real regulation of the finance industry until after a meltdown, and then the messages are generally half-hearted. This is because an industry that works in the hundreds of trillions of dollars of investments and hundreds of billions of profits has tremendous incentive to be as regulation-free as possible, and so will use as much influence as it can bear - a huge amount - to stay that way and because it’s in the DNA of America to encourage money to slosh around freely. No President will ever rein in Wall St. or the big banks or the hedge funds or any of the thousand other financial powerhouses because everybody in American wants to make money. The government will step in to prevent outright fraud and criminal behavior, but the money people outnumber their counterparts in the government and get the smartest graduates because if the choice is between a government salary of $128,000 or a hedge fund earning of $128,000,000 which would you take?
At most, a President’s policies can drive the direction of the economy. You can always say that a President is an indirect cause of any crisis. Realistically, though, no President has any real influence over what the financial industry is doing at any given moment. It’s too big. The Iraq War may cost two trillion dollars over a decade. In most senses of the word, that’s a huge amount of money. But the stock market can gain or lose that much in value in a year’s time. The total value of housing is many times that. And the world’s total value in investments at any moment may be a quadrillion dollars.
It’s possible that the world economy has grown too huge to be comprehensible by individual minds. If so, expect to see a lot more crises, all over the world, in the future, no matter who is president, who is Fed Chair, who controls the Deutsche Bundesbank or who is selling oil.
Virtually no influence or power. Heck, the entire federal government together could probably nto have prevented it once the bubble started to grow. Part fo the problem was that it mostly happened without anyone realizing what was going on. Too many people making too many scattered choices.
Mortgage securitization long preceded G-S repeal.
The Bush and, to some extent, Clinton administrations actually tended to be adversarial to Fannie and Freddie, resisting attempts to broaden their portfolios, for instance. But Fannie and Freddie are extremely well connected in Congress.
That’s pretty awesome.
No mention yet of the Giant Pool of Money?
Also, it’s good that you’re trying to understand this. It isn’t just an American problem, I’m afraid.
However lenders actively resisted regulations requiring borrowers be able to actually afford the loans, so one would suspect they were making what turned out to be bad loans on purpose.