The Housing Crisis Explained

I wanted to learn about what caused the housing crisis, so here’s what I found based on some discussion from an investment mailing list and online sources. Hope it helps.

Background

1980s

  • Someone at JP Morgan invents a way to split a mortgage loan into multiple shares which can be sold separately
  • This allows everyday investors to buy into mortgages instead of only banks, who gave out the loans

1990-2007

  • China, Korea, Taiwan become rich with money from exports
  • Russia and Persian Gulf countries become rich with money from oil
  • These countries look for good investments for their trillions of dollars
  • The Internet and other technological advances increase the speed of financial transactions

2001

  • US recession causes Greenspan to cut interest rates as low as 1% in 2002
  • This eventually meant that people would pay less interest on new or refinanced mortgages
  • This spurred more house purchases
  • More house purchases (more demand) caused housing prices to increase

2001-2007

  • Derivatives become popular. An example is an investment in an instrument that:
    • Returns 300% if housing prices go up 10%
    • Returns its original value if housing prices increase between 0% and 10%
    • Returns nothing (you lose it all) if housing prices fall

The Build Up

  • Investment banks were deluged with investments (much from those rich countries)
  • Because the interest rates were low from Greenspan’s cuts, the banks couldn’t make much money from normal loans, so they channeled all the money into the housing market
    • The banks sold investors shares of the mortgages
    • The liability of the mortgages went from the bank to the investors
  • Since they didn’t have any risk on mortgage defaults, banks gave out loans easily (no income verification, no money down, etc.) and gave out riskier loans (option arms, etc.)
  • Since loans were easy to get, more people bought houses
  • Since more people bought houses, housing prices increased
  • Since housing prices were increasing seemingly without stop, banks put lots of money into derivatives
    • To make even more money, they borrowed money from other places at the low interest rates to be able to bet it on derivatives
    • This makes sense: if you could borrow money at 1% to make a 300% return from a derivative, you’d borrow as much as possible

The Crash

  • Loans were given to riskier and riskier borrowers
  • Many borrowers started to default on their mortgages because they couldn’t pay
  • Banks reacted by making it harder to get a loan (require income verification, money down, etc.)
  • Foreclosures caused housing prices to drop
  • Fewer people could qualify for loans
  • Demand for housing went down, which caused prices to go down
  • Housing prices going down caused many of the derivatives that banks were invested in to return nothing
  • Worse yet, the loans that banks took to invest in the derivatives still needed to be paid off
  • Investment banks that were heavy into derivatives were no longer able to pay the bills

Current Events

  • US government stepped in to take control of companies like Fannie Mae and Freddie Mac
  • US government decided not to step in to take control of Lehman Brothers, causing it to declare bankruptcy
  • Investors in all three of these companies lost a lot of money from their stock prices nosediving

5 thoughts on “The Housing Crisis Explained

  1. ben61a Post author

    haha depends how you define recession. we haven’t seen two quarters of economic contraction yet, so technically no. but all of the practical signs are there, like high unemployment.

  2. Ed

    So, why was there a sudden spike in forclosures starting Summer “07? I recall at the time, there was talk about certain kinds of risky loans having payments that would be increasing, and that was causing the spate of loan defaults. Were these simply ARMs that were increasing because the Fed began raising rates? If so, why didn’t they go back down after the Fed dropped rates again?

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