Whether you are trying to buy your first house, looking for a new job, or simply paying the bills, just about everyone is feeling some effects of the “credit crisis”. Most of the news coverage seems to be focusing around the consequences of the slow economy on consumers and while many people know that sub-prime mortgages are the cause, it’s not always apparent why subprime mortgages are to blame for the economic downturn. The radio show This American Life recently teamed up with NPR’s business correspondent Adam Davidson and devoted an entire episode to the cause of the current credit crisis. For those who don’t want to spend an hour listening to the show (although I highly recommend it), here is a quick sum-up: it all boils down to irresponsibility from both lenders and borrowers.
With the Fed keeping interest rates low, groups of investors on the global level (which TAL refers to as “The Giant Pool of Money”) went looking for other places to invest their money at a higher return than the 1% that they were getting from the Treasury. Investors at this level tend to put their money into things like treasuries because of the very low risk associated with them, but with rates staying put, the Global Investors turned to residential mortgages. Residential mortgages, while not as low-risk as treasuries, were generally considered safe investments with a return of 8%-9% (much better than what they were getting from the Fed). They started buying mortgages from huge financial institutions like Bear Stearns and Goldman Sachs. They weren’t just buying individual mortgages, but were buying groups of thousands of mortgages. The demand for mortgages skyrocketed. Local mortgage providers started mass selling of their mortgages to the Bear Stearns types and then they turned around and sold the mortgages to the Global Investors. This process wasn’t necessarily new, but the amount of mortgages that entered into this chain skyrocketed. For the end consumer, it meant if you took out a mortgage from Joe’s Loans, you found out that suddenly you didn’t owe Joe’s Loans anymore, you owed Bear Stearns, and then later it turned out you owed your money to a fund operated by the Global Investors.
This wouldn’t have been all that bad except that Joe’s Loans made so much money off the deal that they started looking for new ways to give loans. Traditionally when you went to get a mortgage, the loan officer would sit down with you and go over your finances to see how much of a loan you could actually afford based on how much money you had in the bank and how much money you made. Since Joe’s Loans was making so much money by selling loans to the Bear Stearns of the world, they started giving loans to people by only looking at how much money they had in the bank and not verifying income. Then they started giving loans based on how much people said they made and how much they said they had in the bank without verifying anything at all. There were companies even going door-to-door in poor areas of town selling loans. Because people were getting approved for loans that they had no hope of paying back, foreclosures started rising.
This didn’t even slow down the process because lenders sold the high-risk mortgages in groups with low-risk mortgages to decrease their undesirable appearance. Housing prices were rising and the investors figured that even if they did have a few extra foreclosures, they’d own a house that had gone up in value since the loan. The turn around time on selling the mortgages was so quick that Joe’s Loans made money on mortgages that even missed their first payment.
Then the housing market fell.
With prices dropping, investors found themselves with lots of foreclosures on houses that suddenly were worth less than the original mortgage. They immediately put a halt on buying new mortgages…any new mortgages. The Bear Stearns types and Joe’s Loans suddenly found themselves with lots of mortgages with no one to sell them to. Complicating the matter was the fact that most of the mortgage companies had borrowed the money that they turned around and lent to homebuyers. Finding themselves in debt with a seemingly endless supply of depreciated homes, many companies went out of business overnight.
When the new homeowners started defaulting on their mortgages, whose monthly payments had increased by as much as $2000 because of variable interest rates, they stopped paying their other debt, too. Faced with large losses, car lenders, credit cards companies, and even student loan companies started cutting back on the amount of credit they started issuing. Which brings us to the situation we are in today with a slow economy and high fuel and food costs.
Because of the greed of the mortgage companies and their unethical lending practices as well as the dishonesty of the borrowers who misrepresented their incomes, a crash in one sector of the economy has caused a slowdown of the entire U.S. market as credit companies scramble to recover. Gen-y isn?t immune to the crunch, but hopefully as the rising generation in the workforce, we can learn from the mistakes of those ahead of us and move past them.
Tagged: credit crisis, crunch, housing, loans, mortgages, NPR, recession, This American Life