Economics For Beginners: The Subprime Mortgage Crisis
The Great Recession
If you ask 100 people about the Great Recession, you’ll likely get 100 different reasons for what caused it, and why, despite billions in stimulus spending, it’s still lingering. Depending on who you ask, everything from the wars in Iraq and Afghanistan, to the election of Barack Obama, to the wrath of God (seriously, you can't make this stuff up) is to blame.
In this article, we’re going to cover one of the real culprits behind the economic collapse and, how it led to a financial meltdown that we still haven't recovered from. Hopefully, by shedding some light on what actually caused the Great Recession, we can avoid making the same mistakes ever again.
To Get You In A '90s Kind Of Mood
Setting The Stage
To find out what happened, we need to go back a few years… actually quite a few years. We have to go all the way back to the 1990s. That’s right, the same decade that brought us grunge rock and 90210 also brought us an explosion in something called “Subprime Lending”. Basically, subprime lending boils down to loaning money to someone who will have a hard time paying it back.
So why would any bank ever loan money to someone that they knew probably couldn’t afford to repay it? Good question. The answer is, because the Government told them to. Now before you freak out, take a deep breath and relax: the Government actually meant well.
See, a long time ago, banks would set up branches in poor neighborhoods in order to take deposits, but they wouldn't actually lend any money to the people in those neighborhoods. In the late '70s, Congress stepped in and passed a new law called the Community Reinvestment Act (CRA), this law required banks to loan a certain percentage of the money they collected in a community back into that community. Enter President Clinton.
When President Clinton was in office, he wanted to increase home ownership and prosperity for people who, up till that point, hadn’t been able to afford to buy houses or start businesses, so President Clinton pushed for an expansion of the CRA. He thought that, if you could help people buy their own homes and create businesses in those neighborhoods, it would lead to more people achieving the “American Dream”, and he was right… for a little while.
President Clinton Talks About Subprime Lending
With the Government’s focus on home ownership, they started mandating that banks make homes more affordable. While a good idea in theory, they forgot one little detail… banks don’t control the price of homes, the owners selling them do. So since banks couldn’t control the prices of homes (which had been increasing every year), the only other option they had was to make buying those houses easier. How did they do that? They did it by selling “cheap” mortgages, and subprime lending.
Now I know I may have lost some of you there, so let me give you a practical example:
Meet Bob. Bob wants to sell his house. He’s retired now, and he wants to move to Florida and spend his days fishing and golfing. So Bob puts up a “For Sale” sign and waits.
Now, meet Sally. Sally is young, only 25. She’s only been working for a few years, and doesn’t make very much money yet, but she wants to buy Bob’s house.
So Sally talks to Bob, and they agree on a price of $200,000 for the house.
Now Sally doesn’t actually have $200,000. Sally doesn’t have any money saved up, and with student loans, she’s already pretty deep in debt. But Sally really wants to buy Bob’s house, so she goes to the bank to get a loan for the money. This loan is called a Mortgage.
Now normally, to qualify for a mortgage, Sally would have to put up part of the money herself; this is called a Down Payment. Traditionally, the down payment would be anywhere from 10 – 20% of the amount needed; in this case $20,000 - $40,000. However, Sally doesn’t have $20,000 in fact she doesn’t have any money to spend on the down payment.
The Government really wants Sally to be able to buy a home though. They think that everyone who wants a house should be able to buy one. So the Government tells the banks that they need to make mortgages more affordable for people like Sally, even though, they really can’t afford it.
So even though Sally doesn’t qualify for the loan: she has no money to put down, very little income, and no other collateral to offer, the bank tells Sally that she can have the loan with no down payment. This is called a Subprime loan. Sally buys Bob’s house, and everything works out great… for a little while.
This is an example of what happened; only it happened with millions of people. People who couldn’t afford to buy a house were suddenly given access to cheap credit, which lead to an increase in home sales.
“Objection: That’s Pure Speculation”
When the banks started offering cheap credit, and lots of people started buying houses, the price of those houses started to skyrocket. It’s called Supply and Demand, and it’s the most basic economic principal there is: when demand increases for an object, the price of that object goes up as well.
With the increase in the value of homes, two things happened: people started building more homes to keep up with demand, and more and more people started buying homes as investments. These two factors played a key part in the disaster.
First, let’s look at the people who bought homes as an investment. They used that same cheap credit (that was designed to help people like Sally), to buy homes and then them sell for a profit. This further increased the demand, and like we just learned, when demand goes up, so do prices.
This worked to make two problems even worse:
First there were the people like Sally, who were looking to buy a house to live in. Because of the rising home prices, they were forced to take out huge mortgages.
Then there were the investors. When people saw how much money was being made in Real Estate Speculation, more and more people decided to get in on the game and try to make a fortune.
I’m sure some of you can already see where this is going, but let’s go back to our example and check on Sally.
Things weren’t looking good for Sally. She still wasn’t making much money, and between her student loan payments, car payments, and living expenses, she just couldn’t afford to keep making her mortgage payments.
Eventually, the bank foreclosed and Sally lost her home.
Now while this is sad for Sally, remember: she wasn’t the only one who bought a house she couldn’t afford. There were millions of people who took advantage of the cheap credit offered by the banks. Now, as those people stated defaulting, the banks started foreclosing and putting those homes back up for sale. We learned earlier about Supply and Demand, and how when demand increases, so do prices. Now it’s time to learn about the other part of that equation: supply.
With all of these foreclosed homes flooding the market, there was a huge increase in supply. So suddenly, there more homes available than there were buyers and whenever supply exceeds demand, prices fall. Just wait… it gets worse.
Remember those investors we talked about? Well when housing prices started plummeting, not only did they not make any money on their investment, but now they were suddenly stuck with those investment properties (and the mortgages on them), with no way to get rid of them.
Then there were the people who bought homes when the prices were high. Because of the collapsing market, their homes were worth less and less; sometimes hundreds of thousands of dollars less than what they owed on them. A lot of people simply decided to walk away and stop paying for their houses, because of this. This added even more homes to an already flooded marketplace and, you guessed it, caused home prices to fall even more.
When the housing market collapsed, so did the construction companies that were building all of those new homes. When the construction companies collapsed, so did their suppliers. There was a domino effect throughout several sectors of the economy, one that we’re still trying to recover from.
Home ownership is great, for those who can actually afford it, but as we’ve seen time and time again, politics doesn’t always care about economic reality. So did we actually learn our lesson from the Subprime Mortgage Crisis? We can only hope, however, as Shakespeare said: “what’s past is prologue”.