Updated: Mar 3, 2022
Table of Contents: -The housing market leading up to the financial crisis -Homeowoners refinancing with adjustable-rate mortgages (ARM) -The use of mortgage-baked securities -The use of credit default swaps
The rental market in the Unites States has been booming since 2008 which almost saw the collapse of the economy and the banking system in 2008. This was a time when the housing market was put upside down setting off a chain reaction not just in the United States, but globally. At its peak approximately in 2006, the there was huge growth and stabilization.
This was a time where individuals and investors were flipping homes for quick profit. The idea is to add amenities to a home in a short period of time which raises the value of and then it is resold for a respectable profit.
Adjustable Rate Mortgages
At the same time, many people who were refinancing their homes with adjustable-rate mortgages (ARM). (A thirty-year mortgage that begins with a short-term fixed rate after which the interest resets periodically with a variable interest rate that is often higher than the fixed period). With refinancing came the reduction of equity (the difference between the current market value of the property and the amount owed on the mortgage).
This money was used to buy other properties, improve the existing ones, go on vacations, or purchase any material item that was desired. Lastly, there were many good credit borrowers that took advantage of the profitable housing market but financial institutions wanted more profits, so they put more effort into selling loans to higher credit risk borrowers.
Eventually, the housing market began to deplete and with the economy gearing for recession, borrowers lost their jobs and were faced with ARM teasers (the initial loan periods that has a low fixed rate) that were going to expire. Consequently, these mortgages were commanding larger interest rates than the traditional fixed rate mortgages and with little or no equity in the homes, mortgage payments were defaulted on. This left the investors and financial institutions responsible with holding the bag with large amounts of unpaid debt.
Mortgage Backed Securities
This all stemmed from Wall Street when they began bundling loans together (a package of loans sold to investors whereby they receive the collected principal and interest form borrowers). In other words . . . a mortgage backed security (MBS) which is sold to institutional, corporate or individual investors. When Wall Street began selling the MBS’s to investors, they were making large profits; however, they ran out of borrowers with good credit and so they turned to risky borrowers.
Underneath the scene mortgage brokers had no reason not to sell a home regardless of poor financial assets and credit score which are the main determiners for a loan approval. In the past a credit score of 620 and 20% down was the criteria for obtaining a loan. The criteria changed to the low 500’s and no money down.
Many Americans weren’t financially savvy and lacked discipline with their money. Hence, they saw the carrot dangling in the form of the American Dream and took on loans they couldn’t afford. The amount of loans given amassed into the thousands and for most people they were hoping to refinance them at a later date due to the increase in home values.
Credit Default Swaps
The banks knew MBS’s were risky and so to protect their downside they took out insurance on them. So, if the mortgages defaulted the insurance company paid them to cover the losses. Hence, the term credit default swap (CDO) - the banks insure their potential losses to remove the risk off their books so they can invest more money and generate consistent profits.
AIG Insurance Pay Out and the Government Bailout
There were many insurance companies that partook in providing insurance with AIG being the largest of them. Their risk level was extremely high; however, they figured the market would continue to go up and with that they kept collecting millions in fees and bolstering their profits.
When housing prices receded and ARM teaser rates increased, homeowner's began to default on their mortgages. Then the MBS’s faltered and AIG was on the hook to pay the claims to the investors. With several banks ready to make claims at the same time AIG did not have the cash to support the payback and without governmental intervention the entire banking system would have collapsed.
Due to the severity in nature the government stepped in and provided funds to AIG to avoid the financial system from crashing. In total, the federal government provided $182.5 billion equating to approximately 80% ownership of the company.
On a high level, the crisis was the fault of the homeowner's, investors, mortgage brokers and insurance companies. The aftermath caused a glut of homes on the market which depressed housing prices and slowed the growth of new home building, home improvements and put thousands of home builders and laborers out of business. Moreover, additional foreclosures transpired for many months due to depressed housing prices combined with a high unemployment rate.
Consequently, the outstanding losses in the industry caused many banks to tighten their lending requirements; several banks and financial institutions merged with other companies or were bought out or went out of business.
The cruel irony is that the government bailouts are designed to extend credit for homeowner’s which is what got the financial institutions in trouble in the first place. In any event, credit will always be needed as housing is too expensive for people to pay for without assistance. With proper process and regulation, the idea is that a crisis of this magnitude can be averted in the future.