How did we get to the point of near economic collapse? There is no simple answer to the question. It can’t be broken down into a short sound bite that can be repeated by politicians or pundits on the air. As there is no simple answer, it is more than obvious that there is not a ready solution, one that can be put into place and get us magically out of this financial quagmire that we find ourselves in. Even worse, or so it seems to many people, there is not a true political side to pick and join with. No definitive left or right, pro or con, black or white, conservative or liberal.
Yet, here I am, trying to make any possible sense of all of this in an online column. Foolhardy, I know. Yet, I think if we all look back and see just what got us to this juncture, we might be able to see what we need to do to help us out of this mess. Let us first take a look at the housing market, as we have heard a lot about why this is an important part of the financial crisis.
We have heard the term ‘housing bubble’ thrown around. However, what does that necessarily mean? Well, over a period of time, starting in the ’90s but taking place primarily between 2001 and 2007, real estate values soared. People were seeing the values of their homes double, sometimes triple, over the course of just a couple of years.
One of the reasons behind these inflated values was that lending institutions were doing anything they could to make loans for anyone and everyone. With more people able to purchase homes, more homes were sold, and thus, the values of the surrounding homes were able to go up. Therefore, people who had owned their homes for a while now saw equity that they thought would take much longer to obtain. So, while lending institutions were making more purchase loans for people, they were making even more refinance loans for those who were taking cash out from their homes due to the newly increased equity they had come across.
These lending institutions (banks, mortgage companies, etc.) made a conscious decision, in the interest of short-term profits, to make more ‘sub-prime’ loans. Now, once again, we have heard this term bandied about, yet what is it? Basically, a sub-prime loan is a loan made to a person who under normal guidelines would not qualify for a loan, based on a number of reasons. These reasons could be one of the following: lack of verifiable income and/or resources to pay back the loan, poor payment history, not enough money for a down payment or lack of equity to refinance. Any of these things, or a combination along with other variables, would normally prevent someone from obtaining a mortgage loan.
However, more and more, lenders decided that this was an untapped market and, basically, a shitload of money could be made. And, in the short term, that is very much true. As these borrowers didn’t really have a choice (other than not getting a loan at all), the lenders would make these loans at much higher interest rates, as well as higher fees assessed at closing. Much of the time, the loans were set-up with the interest rates adjusting after 2-3 years, meaning that the interest rate would in all likelihood increase sharply after that time frame.
Even if not set as an adjustable rate, the rate would still be much higher than what normal, credit-worthy borrowers were able to obtain. And to boot, the lender would have a pre-payment penalty placed on the loan, meaning that if the borrower were to try to payoff the loan within 1-2 years from origination (usually thru a refinance with another lender), then there would be a large dollar amount added to the payoff of the loan.
These sub-prime loans were a boon for lenders. They were able to somewhat justify these loans under the auspices that they were giving these borrowers that were not deemed credit-worthy under previous underwriting guidelines a foot in the door of re-establishing credit worthiness. If the borrower could not verify income thru tax returns or other documentation, that was not a problem either, as you would just need to a pay a higher interest rate and we will just go stated income, where you just tell us how much you make.
When looking at it now, it seems the height of irresponsibility. Why give someone that has been shown to have problems paying loans back a higher payment and a tougher time getting out from under the loan? It was true short-sightedness. The payments being made on these loans were so high, and it was almost all interest, that they figured that no matter what the default rate was, it would be sustainable.
Of course, the best way to make quick money on these loans was to bundle them up and sell them to someone else. What happens to those loans after that? Who cares? You made the short money. Now, that doesn’t mean that you won’t retain some of these loans, or perhaps even buy a bundle yourself, because collecting payments is still income over the long term, right? Regardless, this was all just easy money. Until it all started falling apart.
Eventually, all of this irresponsible lending would catch up, and not just with the original lenders themselves, though that will wait for another column. With all of the quickly inflated values of homes and people both purchasing and refinancing these properties, defaults on these loans started piling up. The simple explanation is people were given loans they could not afford. On top of that, even if they were able to struggle to make the payments, property taxes were climbing at a rate homeowners were not used to, as with the inflation of property values came the increase in taxes assessed.
And, so it started…the point where defaults on these loans became too much to sustain and created a downward spiral. While the lenders felt that defaults, no matter what, could be sustained due to the high interest rates and other fees, something that was not given much thought was how property values would be affected. See, when a home is foreclosed on, the lender will try to sell the property for the value they feel the house is, or at the very least what is owed on it.
However, they also do not want the house sitting there vacant for a long period of time as they are not receiving anything at all for that particular loan. Thus, in the end, they will sell it to the highest bidder (many times the only bidder) and take whatever they can get. This, in turn, brings down the values of the homes around it. Enough of this starts to occur and not only do you see a slow down in the appreciation of home values, you start to see depreciation set in. Once you get to a certain point where homeowners see that they owe more on their house than it is worth, you start seeing even more defaults occur.
And this is how we see a large amount of wealth disappear. However, this was a wealth that was artificially created. There was nowhere to go but down when we see such a sharp spike in appraised values of homes. And let’s face it: the lenders did not want to rock the boat, especially when for a short while this was a golden goose.
So, in the end, is this why we are where we are? It is not the entire reason, but it is a significant portion. Combine this with large, mostly unregulated financial institutions and you have a recipe for disaster. Combine the hubris and greed of too-big-to-fail banks with a live beyond your means mentality of many Americans and you might start seeing how we could be on the brink of another Great Depression.