Things you still don't quite understand about the financial crisis

What are some things you still don’t get about why the economy went sour?
I’m not talking necessarily about stuff like the complex financial instruments and various other exotic tricks employed by the banks, but mainly about why certain people did the things that they did when they did.
Personally, I’ve wondered about home refinancing, namely why someone would want to refinance on a home. I’m still, admittedly, a novice to the homebuying process, and only started seriously looking this year. So please excuse me if my inquiries sound somewhat naive.
But being able to refinance, I noticed, was one of the excuses people had for buying more home than they could afford.
“Don’t worry, when the monthly payments get too unweildy, we can just do a refinance and get a better rate.”
The only way I can see them getting a lower monthly rate is if the lender lowers the principle (which I can’t see happening), or they extend the amount of time you have to pay off the loan. In the case of the latter, you’ll still wind up paying more for the house than you would have originally.
I guess I’m just looking at the process through the eyes of my dad. One of his proudest accomplishments was paying off our house (in under 10 years no less). I can’t imagine him wanting to go back into debt on a house he had worked so hard to pay off for anything short of a medical emergency. And even then he would probably have exhausted all his other options first. Owning that home free and clear meant more to him than just about anything else in life other than his wife and kids.
Then again, this was 25 years ago, when you could still get a good starter home for under 40 grand.

Usually the reason somebody would refinance would be to lower their interest rate. If you’ve borrowed $100 from me at 5%, and you found out that Fred over there would loan you $100 at 4%, it would make sense for you to borrow the money from Fred and use the money you borrowed to pay me back. You can also refinance to turn an adjustable rate into a fixed rate or change the term of the loan.

I don’t get why anybody would buy a mystery box, having no idea what’s inside or how much it’s worth.

Why not just go to the casino instead and put it all on black?

Because it could be anything. It could be a boat!

What I quite don’t understand is more of an action that followed.

One of the problems I understand was banks lending large amounts for homes, which the mortgage owners then could not repay. The banks repossessed.

In Australia, the Govt did several things for stimulus-- one of these was doubling the “First Home Buyers Grant”. This is a grant to people buying their first home (obviously). It serves to give them more of a deposit etc.

So, in my simplistic view, people being unable to afford mortgage repayments was a problem. So what benefit is it in giving money to people unable to save a deposit? And with interest rates extremely low- when they go up aren’t these same people possibly going to have difficulty?

i burning your loan!

That’s better than having your Golden Retriever burned.

I would still like to hear, in laymans terms, how the government goes about stress-testing banks.

Actually, both of these happen.

The rates offered on a mortgage go up and down all the time. My SO and I use the rule of thumb that if the fees for refinancing can be paid off in 2 years or less, by the reduction in the interest paid each month, then it’s time to start looking into refinancing.

As for extending the time of a mortgage, I think today people are far less likely to actually stay in their house long enough to pay off the mortgage. So a mortgage goes from a debt that will someday be gone, to more like rent, where you have a benefit (equity) when you sell the house. That matches up well with hearing about people refinancing their homes so they can take some the equity out of it.

Not to be overly cynical or anything, but the political class does tend to be in the demographic which owns the most property (probably their own house, and quite likely somebody else’s as well). So they are likely to be fairly concerned to ensure that houses continue to be expensive. Pumping money into the housing market (doesn’t matter all that much where) is a good way to achieve that.

Also, the first home buyers grant was initiated when interest rates were relatively high. And now that they’re low, the grant is going away again (1st of July, I believe). So as far as that goes, it sounds pretty sensible.

It’s kind of like if you took your personal monthly budget and then ran scenarios where your rent or mortgage payments or other expenses increased by 10-20%. Could you get by or would you need to change the way you live.

If interest rates go down but you have a fixed rate mortgage, you can refinance and save money with a lower monthly payment.

That is correct. They assume if they can always change the loan structure on their home (or that they will be making a lot more money in the future).

Most people, however, are idiots. They focus on the monthly payment, not the equity in the house. Essentially they are renting-to-own from the bank. They don’t own the house, the house owns them.

Refinancing - base it on the assumption that everyone’s got fixed-rate loans, on which risk premia are charged (note - this doesn’t always work this way outside the U.S.). Pay off your mortgage for five years and:

  • interest rates may be generally lower, allowing a better rate
  • you’ve got more equity in the house (value up, debt down), so you’re a lower risk and can get a better rate
  • you’ve paid a mortgage successfully for five years and can get a better rate
  • You might get a honeymoon rate for a year or two on the new loan letting you pay less.
    So get a new mortgage, pay out your old one and pay less each month. But while you’re at it, why not borrow an extra $50K and buy some more STUFF! ™

Yeah. That’s why.
Stress Testing - It’s running a few worst-case, ‘what if’ scenarios and seeing if the bank has enough money to cope. The problem was that by the time the tests were run, the actual situation was in many ways worse than the aforementioned “worst case”.

The effects of helping folks with their down payments is that it props up home prices. Buyers can afford to pay more for a home thanks to the help from the government, so market prices for homes fall less quickly and hopefully stabilize at a higher level than they otherwise would. This benefits homeowners who need to sell their homes (for whatever reason).

But it also helps homeowners that risk falling into a negative equity situation, that is, situations where their current loan amount is greater than the current price of their home. Having negative equity limits your ability to refinance at better interest rates; no one is going to lend money to you when you want to borrow more than your house is actually worth. Further, when homeowners fall into negative equity on their homes, there is incentive to simply walk away from the home and allow the bank to foreclose. Why pay off a loan amount that is greater than the value of your home (a net loss) when you can just walk away and pay nothing more (neutral)? As the default and foreclosure rates rise, supply of housing increases, average prices decline further, and more people run the risk of going into negative equity on their homes.

The idea is to prop up home prices and prevent a flood of excess supply of homes during the economic downturn. Then, the government can remove the supports as economic conditions improve. Certainly, there are risks to this kind of plan.

As for rising interest rates, if you lock in your rate with a fixed rate loan, you can avoid the problem of rising monthly payments.

That’s one of the big things I was curious about. Did that many people really refinance not necessarily so they could have a lower mortgage payment, but so that they could go out and buy a new boat, big-screen TV, massage chair or some other junk that they didn’t need?

You know how they kept speaking about the extended global boom of both the nineties and the noughties being fuelled by American retail spending?

The answer is “yes”. It was also largely tied to the growth of credit-card and loan-based spending, but yes, refinancing for cash was very popular. Marketers called it “unlocking the equity in your home” and theoretically you could do it to fund an investment portfolio by leveraging off your home loan rate, most people decided that they really really needed renovations, a better car and something shiny to fill them both with.