Sunday, January 10, 2016

Everyone wants houses until they don't — the subprime mortgage crisis

joão pestana

I'll start by assuming that if you opened this article then you want to know how the Great Recession that began in 2007 came to be. It has been classified as the worst economic event to affect the entire world since the World War II. It's closely related to both the financial crisis and the subprime mortgage crisis that struck the U.S.A. at the same time. Due to the open markets that exist nowadays, there is worldwide freedom to trade, so any individual or institution can make investments in any other country — not just domestic investments. That is the very basic idea of how an event that should be contained within a single country can propagate worldwide.

Why is this such a big deal? Mainly, because it affected everyone worldwide from investors — individuals, governments and institutions — to households (or the common folk). You probably felt it too, even if you are not an investor and didn't contract any kind of loan — not even for a mortgage. Banks are often also investors and when an investment goes wrong, they lose money. Let them lose enough money and they stop having enough money to give back to their costumers — that is, you go to an ATM and are not allowed to make a withdrawal!

What is the solution for a bank that ran out of money? The government steps in and bails the bank out so you, as a costumer, can have your money back. And where does that money ultimately comes from? Well... from you, as a tax-payer. In order to be able to do this, the government has to increase its revenues and it may do so by raising taxes or lowering wages. That's why even if you had nothing to do with the problem, you still suffer its from consequences.

How did it all start and how did investors and individuals get involved with each other? It all comes down to mortgage loans. If you want to buy a house, but can't afford to pay it, you can rent a house — but it's not your house. You go to a bank and realize that you can get a loan to buy a house and then pay a monthly fee to the bank close to what you pay for renting a house. You figure that a couple years from then you actually own the house, so it's a pretty good deal. It's also an investment, because the house has value in itself while renting a house is basically throwing money away. That's the reason why the house effectively belongs to the bank until you finish repaying the loan — it's a collateral, should you default on your payments.

So you contracted a loan for your house and told your friends about it and they think it's a good idea for them as well. The housing market is increasing in value — so it's a very good investment. They also go to the bank, contract a loan and buy a house of their own. Usually, the banks make sure you are able to repay your debt — they require a proof of income and perform other risk measures on you. No matter how thorough their risk assessment is, every now and then someone will default on their payments. There is no problem there, because banks know this and have money set aside as a buffer for these events. If someone repeatedly defaults, the bank sells the house to get their money back.

If all works so well, then what went wrong? Imagine that many people start going to the bank for loans to buy their own house. The demand for houses is on the rise, their price is increasing and the economy is doing great — jobs in construction are plenty, for instance. Overall confidence is high and there is no reason to assume the worst. Banks keep on granting loans and people buy more and more houses.

The problem starts when there are no more people with a good credit rating — those whom the bank assess can pay back their loans, called prime mortgages —, but there is still a very high demand for credit and houses. Because the overall confidence is high, unemployment is low and the economy is doing great, banks start to reduce their requirements to get a loan — no proof of income, no downpayment and so on — called subprime mortgages.

Of course, eventually, these people will not be able to pay back their obligations and start defaulting. The bank keeps their house and sells them to get back the money owed, but there are too many people defaulting and the bank ends up with a lot of houses. Because the bank wants to sell them as quickly as possible, there is a great increase in the supply of houses that exceeds the demand and the prices start to drop drastically. The bank also loses money with every house that is sold below the value of the original loan.

Up to this point, people that defaulted on their payments lost their house and banks are desperately selling houses to get some of their money back. The value of houses drops drastically and those other individuals that are still able to repay their debt also start to default, because now their house is worth a lot less that the loan they have to pay. Because of all this factors, some banks start to have problems with having sufficient enough capital to give back to their costumers when they demand it.

Usually, when a bank is lacking in funds, it can also get a loan from other banks or investors, but the other banks are having a similar problem and investors are now afraid that the bank will default or go bankrupt, so they refuse to lend money to the bank. This is what happened to many banks worldwide that had to be bailed out by governments in order to guarantee that their costumers didn't lose all their money.

By now, you should already have a not so bad idea of how the subprime mortgage crisis came to happen in the U.S.A. and the only things I didn't mention was why the investors refused to lend money to the banks and how did the banks become so careless with their loans. These two factors are related to each other and also with the desire for banks to increase their profits while reducing their exposure to risk. I'll explain that in a follow-up dedicated article.