What was the connection between the house price movements, the growth in subprime mortgages, and securities backed by these mortgages on the one hand on the other hand the difficulties encounters by some financial institutions during the 2007 -2009 financial crisis?
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The increase in the price of houses was fueled to a large extent by the loans that banks gave to customers for buying new houses without thoroughly evaluating the capacity of the borrower to repay the loan. They were helped here by financial instruments called credit default swaps that allowed banks to pass over the risk they were taking to other financial institutions. The rise in the increase of houses could not go on for ever and when the bubble that was created burst, it affected the institutions to which banks had transferred their risk more than the banks that had initially taken on the risk.
There are two sides to this question:
- Government forced banks and lenders to allow high-risk and fraudulent loans, resulting in the bubble and the collapse as people couldn't or refused to pay, which led to the bailouts.
- Predatory banks intentionally lent money to high-risk borrowers because they knew they could later foreclose, thus keeping both the paid interest and the properties to sell again.
The one thing you will probably not find on the Internet is any sort of agreement on the subject; I tend to the former, others tend to the latter, and there is no consensus even among economists. Here are some links to read and research; always be skeptical of emotional arguments and try to see the objective facts without bias.
Let's not forget the irresponsible government, that began the "Housing for All!" movement back in the 1990's. After government removed restrictions on certain banking practices, greedy banks put their snouts in the trough. Those that didn't (and I'm happy to say my little local bank did not) survived just fine, wisdom guiding their actions rather than greed. Those banks that willfully engaged in what they knew to be poor business practice got hurt, but then again, the "too big to fail" philosophy was in play and government once again was there to forgive. Government allowed for certain banks to act fraudulently, and bailed them out with your tax dollars when they got caught. The bad banks should have all gone out of business, and the politicians who changed the law to allow for such bad practices to occur be punished.
Subprime mortgages were basically an unethical way of banks to lend people vast amounts of money that represented a massive financial risk to them. This had the impact of driving up house prices which made the inevitable crash, when it came, so much more terrible. One of the roots of this problem therefore lies in the way that irresponsible banking practices were the cause of so many of the root problems of this situation.
I remember driving around in the early 2000s and asking myself, "Self, who is going to buy all the new houses I see being built?" To me it seemed that there was far more supply than was needed to meet any possible demand, but I also remember thinking to myself, "Self, the people in real estate are a lot smarter than you are and they must know what they are doing." I also remember getting statement after statement after statement saying that our mortgage had been "sold" from one company to another and another. I remember thinking to myself, "Self, this doesn't make any sense. Why did this sort of thing never happen in the past?" Again I remember assuming, "well, they must know what they are doing."
The moral of this story is that if even I, who have absolutely no financial expertise, felt that worrying things were happening, why did not most economic "experts" have the same reaction? A few did -- N. Roubini being the most famous -- but I am astonished that so few did. I recall reading an article by Ambrose Evans-Pritchard (a British economic journalist) a few years before 2008 in which he essentially predicted exactly what subsequently happened. I remember thinking at the time, "this fellow is an alarmist; this can't be true." But he was dead right. I now read his columns with great interest.
Put it this way. If you owe the bank 1 million dollars and you cannot pay, you have a problem. If you owe the bank 500 million dollars and you cannot pay, then the bank has a problem. When it comes to housing, people overspent - plain and simple. They could not afford the homes that the purchased. So, when the financial crisis hit, and people could not pay, the banks would have to take a huge loss. This created a situation where the banks could not weather the housing defaults. We are still not out of the woods.
Mortgage firms packaged up and sold sub-prime mortgages to investment banks. When, in 2007, many of the holders of those mortgages began to default, the value of these investments dropped. As these investments ate into the capital pools of these banks, they began to deny credit to each other, and to the public. This led to the "credit crunch" of 2008.
Home prices went down as the crisis started. This meant that more and more mortgages were "under water." As this happened, the securities that were backed by those mortgages came to be worth a great deal less than they had been. As they lost value, the financial institutions that invested in them came to be in serious trouble.
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