The United States government dragged its feet in the years leading up to 2008 when it came to putting strict regulations on mortgage lending and predatory lending practices by lenders. Anyone who has been in the United States before and after 2008 knows that the economy suffered and almost brought down the global economy. What most do not know is that the economic catastrophe was caused by greed and speculation in the areas of home owning, mortgage lending and investing.
In theory, when a person chooses to purchase a home, assuming they don’t pay cash for it, they contact a mortgage broker. That mortgage broker then evaluates the buyer’s credit and income to ensure that that person can pay back the loan. If the broker concludes that this person is a safe investment then they contact a mortgage lender. The lender loans them the money and the homeowner pays back the mortgage every month along with interest. These are called prime mortgages.
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In reality, what happens is that once Greenspan lowers interest rates to one-percent in 2000, investors see better returns on mortgage investments so they seek out lenders to buy them from and the lender also sees potential in selling them so they agree. The lender then sells the mortgages to the investment banker who then borrows more money to buy as many mortgages as he can. The banker collects the mortgage payments and in the worst case scenario a homeowner defaults and he sells the home for a profit. These mortgages that this banker bought are split into three categories: AAA, BBB and unrated or safe, OK and risky. All together they are called a collateralized debt obligation or CDO (The causes and effects of the 2008 financial crisis). The risky mortgages receive less money so they are granted a higher rate of return, but also a high probability that they won’t be paid, making them a gamble. The AAA rated mortgages are safer but earn a lower rate of return. The safe mortgages are also insured at a cost called a credit default swap, the investment banker sells the safe mortgages to the investors who only care to purchase safe investments. The OK ones are sold to other banks and the risky mortgages are sold to hedge funds and risk takers who see the potential pay-off with the higher return as long as the mortgages are paid.
This works out fine until the investors want more mortgages. The investors contact the lenders, who contact the mortgage brokers, who, then at that time have no more mortgages. Since he cannot keep up with the demand because everyone who qualifies already has a mortgage he has to create a method to yield higher supply. The mortgage lender chooses to start requiring less qualification for a mortgage because in the ideal world if the homeowner defaults the owner of the mortgage can just sell the house. The new tactics are called predatory mortgage lending, they offer mortgages with no down payment and no proof of income. The mortgages begin with affordable rates for the homeowner but then burst into rates that are too high to pay back. These new less-safe mortgages are called sub-prime mortgages.
The process of selling off the CDOs works the same except when all of the homeowners who now have mortgages cannot afford default, the banker has to sell those houses. With more houses for sale and not enough people to buy them, the supply exceeds demand and housing prices decline.
So in simpler terms, Sandra and Adam are hard workers who have a safe mortgage. Adam goes to work every day and always makes his mortgage payments on time. While Sandra and Adam are able to pay back their mortgage, their neighbors are all defaulting on theirs. Sandra and Adam have a neighborhood with declining worth along with their own house. Now they wonder why they are paying back a mortgage for $450,000 when their house is only worth $200,000, so they move out even though they can afford to pay.
Now the banker has a large stack of CDOs that aren’t paying like they once were and the investors will no longer buy them. The banker now has CDOs that aren’t paying and a large debt from the money that he borrowed to buy these debt obligations. But the investors also have these unpaid mortgages and the mortgage broker doesn’t have a job anymore, so now everyone is in trouble.
This scenario is in short what happened in 2008. The large bankers were so big that when they failed, everyone failed. As Greenspan said, “If they’re too big to fail, they’re too big." It was so catastrophic that the Federal Government had to bail them out with taxpayer’s money. The Fed enacted a program called Troubled Asset Relief Program or TARP. This program spent $700 billion bailing them out in October of 2008.
The current solution is imposing new regulations and increasing power and regulation over banks to break up the larger ones so that they do not have the same impact upon failure as they did in 2008. This is not working hence the subprime mortgage market is making a comeback. Without some sort of action, there will be another economic crisis with the potential to be much worse. The proposals of focussing on issues of unemployment or social welfare are short-sighted. Focussing on the bigger picture of Mortgage lending will lead to a solution to a majority of the other economic problems. The failure to do so leading up to 2008 is what trickled down into a huge unemployment rate and social welfare checks being handed out.
