There is some amount of esotericism associated with understanding the economic crisis America is going through. Fact is, on absolute terms, I belong to the bottom half of the population in terms of understanding this crisis. But here’s what I have been able to figure out.
People bought homes in the 1995–2000, just like always. Mortgage companies (a.k.a lenders) did 2 things –
- They concocted the adjustable rate mortgage where mortgage consumers (a.k.a borrowers) are locked in to prevailing interest rates for anywhere between 1 to 10 years, after which the market rate takes over..
- They started giving away loans to people who otherwise don’t deserve it. Low credit scores, low-income groups, high revolving credit are signs of poor credit worthiness, but the banks chose to ignore it.
Neither of this would have, in absolute terms, made the lenders the bad people. They were doing what brings them more business and were just selling the American dream to a wider base.
The perfect storm happened, as I understand, because of the following:
- Because entry barrier was low, many people started opting to buy (vs rent) and as a result, the demand side was going up. With the supply being constant, the prices started artificially going up.
- Meanwhile, fed-dictated interest rates were going up and as people came out of their ARM period, they were forced to prevailing (high) market rate. All of a sudden, they could not afford and began to sell their houses, default on payment etc…In a market not immune to speculation, the values started dropping and sent the home-owners in a downward spiral. This is because on one hand, they could not manage the payments and on the other hand, they houses were worth less than what they owed to the bank. While this technically doesn’t matter unless they were selling, it shook their minds on the usefulness of making payments. Foreclosures, short-sales, payment defaults increased — to the point of pushing several lenders and borrowers into trouble.
Now, the part of the issue concerning financial markets is a little more complex, but I will try to generalize.
Lenders need capital from somebody to loan the borrowers. So they started selling mortgage portfolios to investment banks in exchange for cash. Which is not a new practice at all: the lenders would have made profits and shared it with the investors that loan capital. Except they did not, because of the mortgage issue. Not to mention, the banks partnered in a ponzi scheme, making unreasonable demands of modest and risky mortgage portfolios. The banks that architected the high risk investments were the first to fall, the lenders that had the poorest quality mortgages were the first to fall.
And then because the overall supply-demand equation was upset, companies started crashing, people started losing jobs and we are where we are.
Can this be further simplified? Am I missing something? Please let me know.
On the other hand, if you knew less and benefited from this post, please let me know too.