How did the credit crunch start?

Factual Questions
1

There are lots of divergant theories about how the credit crunch started so I thought I’d come here for the, well, y’know.

Anyway, my understanding of the credit crunch is undeniably primitive. It goes a little like this:

  1. Everyone, or at least everyone whose opinion counts, thought house prices were going to rise until the heat death of the universe.

  2. Because they thought this, the banks were more than happy to just chuck mortgages at anyone with a pulse.

  3. Because of this, a lot of homebuyers managed to get enormous mortgages that they couldn’t ever possibly have afforded to pay back. Moreover, these homebuyers knew from the outset that they couldn’t afford them it their present circumstances. But they thought that was okay for two reasons:

(3a) They, too, thought house prices were going to rise forever.
(3b) The banks had given them the mortgages. They’d been approved. The banks felt they were a safe bet. Therefore they were entitled to the opportunity to use their new monster mortgage to improve their situations.

  1. Inevitably, people started defaulting on payments. The banks were losing a ridiculous amount of money. Rates went up, foreclosures etc… The rest is history

My question is this: This may surprise you, but in spite of my penetrating analysis of the situation, I’m not an economist. However, I do know that what goes up must also come down. Why, precisely, did people think house prices were going to rise forever? And why did they fall?

Thanks in advance.

2

Well, it’s more complex than that. Congress and various interest groups pressured (read: threatened) lenders to give mortgages to avoid any Unpleasant Consequences (read: obnoxious legislation pertaining to race). And the principle of selling and buying mortgage securities is sound.

What happened more specifically is that banks were making the mortgage loans, then selling many mortgages packaged together as an investment security. This was awesomely cool from the original lender’s view: they got not risk and cash right now.

The real problem was the in the groups who bought those securities, because they had no idea what they were buying. They weren’t, and couldn’t, look at each individual borrower in each security to see if he or she was really going to pay back the home loan. Note that it’s not really the local banks who are in big trouble. It’s the big investment banks and lenders, who were buying and trading these securities on the long-term securities markets.

3

Thanks, smiling bandit.

4

And colluding in this were the credit rating agencies (like Moody’s) that gave these Mortgage-Backed Securities high ratings (indicating risk levels much lower than they should have been).

5

This is the first time I have seen this accusation leveled. I don’t often do this, but I’d love to see some cites.

So this is not free enterprise run amok? It’s the gubmint’s fault. They made us give mortgages to Negroes!

6

The actual start of the credit crunch can start all the way at the start of Fannie or Freddie, depending on how you view the New Deal. Look at this thread here: http://boards.straightdope.com/sdmb/showthread.php?t=484107&page=2, particularly post #51 and #70, especially most of Sam’s posts. I won’t go as far to say Fannie Mae and Freddie Mac started it, but they were the catalyst, and definitely exasperated the situation.

7

Eh?

Most of the bad lending in Sub Prime in the US happened via mortgage brokering by independents, largely for non-bank mortgage lender specialists. You are referring to the banking act that has deposit takers (banks proper) have to give a certain, not terribly stunning, level of lending to low income areas in their lending footprint.

This has nothing at all to do either sub prime lending or securitisation. It seems rather a racist fantasy that some of the uglier portions of the American media are pushing without any factual basis.

And the non-bank (non deposit taking) mortgage lenders, who apparently were involved in very bad (and perhaps corrupt) lending in the US.

8

That’s pure bollocks. The start of the credit crunch began when the securitisation machine broke down with the collapse of the sub prime / alt mortgage lenders. Which were private and not involved in governmental programs.

9

As was succintly expressed to me today - “The investment banks insisted that squashing loads of small pieces of shit together resulted in a grade-AAA security. Really it resulted in one big lump of shit.”

Lots of mortgages sold to risky customers (or at least, customers that would formerly have been considered risky before House Price Utopinomics came in) were bundled up and sold on to investment banks. The theory was that by splitting the risk among lots of clients, the overall risk was magically reduced.

But of course, customers started defaulting, the banks were left with bad debt. Once word got out that bank X had a load of dodgy debt, nobody else would lend them money, which meant they couldn’t pay their creditors, which meant nobody would lend THEM money, which meant…

10

I’d like to understand the situation as well. Following the OP’s lead of not really knowing but thinking it’s along the lines of…(fight my ignorance, please)

A certain percentage of borrowers will default, even in the best of times. The bank usually doesn’t take a total bath, though.

  1. If the borrower paid into the home for awhile, say for 5 years, when the lender sells the house, the lender will get most or all the money back even if it sells for less than it’s worth. The difference just comes out of equity that the owner had built up.

  2. The real estate market will absorb some foreclosures. When there are lots and lots of them, however, it drives prices down due to supply and demand. So lenders sold the home and lost money, or maybe it sat on the market forever, tying up their assets.

  3. While it’s tempting to think that only a bunch of fat cat CEOs got burned, it goes deeper than that. Investment groups, retirement funds, and John Q Public also had stock in the lenders and when that stock took a beating, those who had invested when the stock was devalued also lost big.

  4. There are people with money to lend. Some small fry put it into a CD for a year; some high rollers (e.g. a doctor) may have $250,000 they can lend for 10 years. The various banking institutions do some math and use each for various purposes. Some goes into car loans; somewhat secure, because they can usually repo the car if they have to—fairly short-term, moderate return. Some goes into credit cards; risky but profitable if you get it back. And of course, the home loan.

20 or 30 years of interest…sounds great. Should be secure—the house is the collateral, and they screen applicants to be reasonably sure they can pay.

And the last bit is where they fell down: the overvalued house didn’t necessarily reflect what was borrowed on it, so selling it off wouldn’t satisfy the debt. And the lenders, driven by greed, had lent money to people who couldn’t pay. Some bought in with an Adjustable Rate Mortgage, and when interest rates climbed, a 1% rate increase might have killed them. This involves compound interest and as my h.s. economics teacher said, "It’s called ‘amortizing’ because the debt dies so slowly.’ So they were already upside down on the home and had built no equity when it came time to refinance.

The greater issue, which I can’t quite verbalize, seems to be that we’re a debtor nation. I own a house and a car. Well, no, I don’t, but I’m paying on the loans so I “own” them. But when credit is tight, fewer people can buy. Next thing you know, Bob down at the Honda dealer and Rick over at ReMax can’t sell, so they’re out jobs.

The trickle effect builds into a ripple from there because people stop spending according to fear. Now I can’t retire for another 75 years because my retirement fund took a beating. No more of this dining at the Golden Arches Country Club, stuff…I have to save bones and make soup. People stop buying, which puts the people who produce the goods and services out of business.

And corporations can’t generate capital by selling stock if people shy away from the markets, due to the malfeasance or stupidity of those who burned stockholders who came before them.

Not a good scenario for a debtor nation’s economic growth and prosperity.

I wonder what it will do to the value of the dollar overseas: I got nothing.

11

I’m going to respectfully disagree with the previous posters. The first opinion proffered was that the root of the issue is that lenders made loans that could never possibly get repaid, and now that creditors are defaulting on their loans lenders won’t issue new ones. Frankly, that’s nonsense. When a creditor defaults, the lender absolutely takes a hit. Some lenders will get hit hard and some won’t, but they can make a pretty good prediction of what the default rate is going to be and plan around that, and in the meantime continue to lend money. Same deal with the “hunk of shit” analogy – those who bought huge piles of shit get hurt, but those who didn’t continue to do business.

No, the real problem here is that instead of making huge piles of shit, what people were doing was taking shit, forming into bars and labelling them as 100% pure grade-AAA Swiss Chocolate. Distributors of Chocolate were very impressed: AAA Swiss Chocolate at discount prices, what a deal! They bought huges volumes of the shit. Then people started creating variety packs by buying bars from different supplies, some who produced real chocolate and some who produced nothing but shit, and packaging them up together. Other people bought up these variety packs and made new ones by rearranging the selection of chocolate. Everyone was making tons of money on cheap, grade AAA chocolate and the new complicated arrangements of chocolate.

Then, one awful day, somebody opened up one of the chocolate bars and discovered 100% pure bullshit. In a panic, he starts opening other bars. Chocolate. Chocolate. Bullshit. Chocolate. Bullshit. Bullshit. Word gets out. And then the distributors realize, with creeping horror, that they own warehouses full of these bars – millions of them – and they have no idea whether they own chocolate or bullshit, and the only way to find out is to go to every one of the warehouses and open up every one of those bars and find out if it came from a cow’s ass or not. Until they know, they’re screwed. Nobody will buy the chocolate they already own, because an unknown proportion of it is bullshit. And they have to be very wary about going out and buying new supplies of chocolate. Not only do they have to make sure that they’re buying from a reputable producer of real chocolate, they don’t know how much money they’re going to lose on the bullshit they own. It could be 10% of their bars, it could be 50%. Until they know, they’re terrified to part with the cash they have on hand.

It’s the total lack of information that’s causing paralysis in the credit market. The subprime market blowing up was the trigger, but if the holders of the mortgages knew how much money they are going to lose, they could plan for the future. They don’t, and so they’re sitting on their hands until they can make an informed decision about their future.

12

I recommend The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, by Charles R. Morris to anyone who wants to go past the ridiculously inadequate explanations that one paragraph on a message board can possibly give, including any of mine. Not that I’ve been quiet lately.

Anyway, Morris explains the process by which mortgages were packaged (and re-packaged and re-re-packaged) and sold off in bunches to people who were willing to accept various levels of risk. Accepting higher levels of risk in return for a higher rate of interest is as old as financing. You can argue that all capitalism depends on people doing this.

But it also depends on failure, that people who take chances understand that they can get wiped out by them. That forces them to do due diligence to accurately determine what the risks might be. Which in turn forces everybody down the line to be as truthful as necessary so that the risks are made as public as possible. All good and sensible, and that’s why every deal comes with a many page prospectus that lays out all the ways it can horribly go wrong.

What happens if you take the risk away?

Anyone sensible would normally say that the system falls apart. If there is no risk that why not put all your money in the places that will give you the highest return? Why be truthful about those places in the first place? Just say that they’re wonderful and will pay a lot and you can’t lose money. That gives them every incentive to do as many deals as possible whether they make sense or not.

That’s exactly what happened. Various mechanisms were put into place that would ostensibly insure even the riskiest segment of repackaged mortgage loans. To give you an idea of what they were dealing with, these loans were once referred to as “toxic waste.” With the returns even on toxic waste guaranteed, the system generated trillions of dollars of these loans. Companies leveraged themselves as much as 50 times. It doesn’t take advanced math to realize that when you are leveraged 50 times, just 2% have to go bad to wipe out your equity. We’re running at 13% IIRC. The ostensible insurance didn’t exactly work out the way they thought. From there a death spiral becomes inevitable. (I won’t even try to explain how mark-to-market accounting exacerbated this, but it’s important.)

BTW, this is from today’s Paul Krugman column:

13

According to Lou Dobbs on CNN the Community Reinvestment Act and Acorn bears some responsibility for the mess. (Actually he feels that they have a LOT to do with it)

14

I remember listening to a radio interview with the head of <government-mortgage-corporation>, before all the recent problems, and he spent a lot of time talking about making mortgages and housing available to everyone. He considered that the mission of his organization. That view had a lot of support in congress. Part of that was a reaction to red-lining, where people in certain neighborhoods, typically minority, couldn’t get mortgages from local banks due to a combination of racism and risk avoidance. In an ideal world, that sounds like a good thing, making mortgages available to everyone. In the real world, it helped inflate the bubble in the housing market and the secondary mortgage market removed the accountability from lenders. Who cares if the mortgage is at high risk of default if it can be immediately sold to someone else.

I’m interested in what would have happened if the federal government had refused to save GNMA/FNMA/etc. I used to hear that the federal government had a “moral obligation” to guarantee their securities.

15

Insofar as all the data suggests that the main lenders that caused issues were non-bank mortgage lenders (the major purveyors of the sub prime toxics), and not the deposit takers subject to such Acts, and that the small community banks seem to have retained more loans… the conclusion seems rather iffy, eh?

All the data I read indicate this is an irrelevancy.

16

Well, you’ll have to take up with Lou. I haven’t a clue. (My God! that rhymes)

17

Please find the “This American Life” podcast of the episode “The Giant Pool of Money”.

This should be heard by every student in the country. It’s probably not the end all and be all of the explanation, but it’s a very good start.

18

I have a question regarding the part about how the banks started losing money. I would assume that people with these mortgages are obliged to repay them, and so the banks would eventually get the money back. What is the catch?

19

If people don’t have the money they can’t repay, hence the default. This is not supposed to be a big problem, as mortgages are secured on the house, so if you default, the bank can take the house instead. However, if house prices fall, the house may well not be worth as much as the loan - and if lots of people are defaulting, then the mortgage lenders are left with lots of houses on their books, which they have to try and sell to recover their money, which floods the market with houses, which makes prices fall even further.

Basically it all stems from the deregulation of the financial services industry in the 80s, which encouraged lenders to offer people massive mortgages. Naturally if Joe Shmoe could get a mortgage for 5x his salary instead of 2.5x, he would want a bigger and better house. Sellers knew there was more mortgage money in the market, so prices rose, which meant more demand for bigger mortgages and so on.

It’s positive feedback in both directions.

20

I understand that they take the house, but since that doesn’t cover the entire value of the loan, what happens with the rest of the debt?