The Storm Leading The Economic Crisis
The US economy is apparently in bad shape. What is less clear is how we came here.
Opinions differ as to when and where the story begins, but many experts are tracking the origins of the current economic bubble on the real estate bubble that emerged at the beginning of the decade.
Housing prices rose more than 6 percent in 1999, rising rapidly and steadily over the decade, according to a Brookings Institution study.
“After the mid-1990s, real estate prices rose steadily in 2005, making residential real estate not only a great investment but generally a very safe investment,” the study said.
After all, prices are not in line with fundamentals like household income, and the bubble was formed, the study said. Read the full Brookings study.
At the time, two trends contributed to the housing bubble, experts said.
The Federal Reserve Board began tackling the recession of 2000-01 and the economic impact of the September 11 terrorist attacks and drastically cut interest rates.
Consequently, it was straightforward to borrow money, mainly if you wanted to buy a house.
In the meantime, global investors battling cash with the global economic boom of the 1990s and 00 have been waiting for the US economy to make more money.
“They have a growing group of people getting richer,” said Peter Rodriguez, an economist at the University of Virginia. “And they liked the idea of parking cash in the largest and safest economy in the world.”
Enter mortgage-backed securities
Wall Street companies sought sophisticated financial instruments to connect wealthy investors with the rapidly expanding real estate market.
These instruments – such as the mortgage-backed securities we’ve heard so much about – made it easier for investors to enter the real estate market, which increased the excellent price, Rodriguez said.
“It started a life of their own when people saw how much money they could earn in apartments,” he said. “It did not take long for everyone to push the momentum of this round.”
How do these mortgage-backed securities work and what role did they play?
Let’s say there are three potential home-buyers in a neighborhood. A local bank lends all three mortgages, then bundles the mortgages and sells the bundle to a large Wall Street firm, like the now-bankrupt Lehman Brothers.
Wall Street takes over its mortgage packages and offers them to investors. The investors make money from the interest payments of the original borrowers.
These tools helped to minimize the risk to the local bank, as they were no longer responsible for the loans they had given to local real estate buyers.
“You did not have to worry about getting a loan when you did it, you do not have to keep it in your books,” said Rodriguez. “The only caveat was how fast you can turn the loans around.”
It was an intoxicating era where you could quickly make a lot of money through the real estate market, through the “basic idea of leverage,” said Rodriguez.
He gave an example: You raise a mortgage of $ 100,000 and make a down payment of 20 percent or $ 20,000.
If the price of the home rises to $ 120,000, you have effectively doubled your money. If you sell at this price – assuming no transaction costs – you spend an additional $ 20,000.
Leverage also works for banks. They lend themselves to other banks or other institutions so that they can borrow more money and make more money.
“This promotes all kinds of risky behavior of people who want to buy homes and encourages them to lend money to banks because they also make a lot of money in an environment of rising prices,” said Rodriguez.
The housing market breaks down.
Economists say that not everyone can or should buy a home, but that has not stopped many homeboys, banks or Wall Street companies during the housing bubble, as the only way for prices and profits was.
Some banks and other institutions even endeavored to give potential home buyers money with bad credit and a boring financial history that would not typically be creditworthy.
These transactions are known as “subprime” mortgage loans. They usually have interest rates above the critical standards for borrowers with good credit ratings.
“Primary mortgages fell to 64 percent in 2004, 56 percent in 2005 and 52 percent in 2006,” says Brookings.
Nonetheless, many banks and brokerages combined the mortgages, many of them bad loans, and Wall Street bought them and sold them to investors. And the people who were able to contain the rising risk – the agencies that regulate the US financial sector – were not paying attention.
“As long as everyone was paying their mortgage, that was fine,” said Michele Thompson, Sandhill Finance‘s main business correspondent. “But we did not take these mortgages into account that people could lose their jobs, the interest rate could go up, and house prices could fall.
“Guess what? All three happened.”
Real estate prices were in decline and in 2007 the bubble burst.
“You are a homeowner or a bank, and you are trying to sell your property, but everything else on the block is also for sale,” Thompson said. “Everything collapsed as we’ve never seen before.”
The credit crisis
Knee-deep in lazy loans, many banks, and credit institutions panicked. Many of them are over-funded, experts say. Simply put, they had lied about that and were now on the hook.
Another way to understand this is that for every dollar a bank had in the deposit, $ 10 to $ 25 was floating in the lending market and much of that money was tied up in bad loans.
Banks tried to reduce this ratio by either eliminating bad loans or raising more money, Rodriguez said.
The problem with dumping loans in the market is that “it lowers the price, and everyone else who has them is suddenly in even worse shape,” he said.
It was a “deadly spiral of prices” and spread like a virus in the financial sector from related Wall Street companies like Bear Stearns and Lehman Brothers to local and regional banks and brokerage houses across the country, Rodriguez said.
When the shareholders learned about the bad loans of these companies, they withdrew their money. The markets have crashed.
In the meantime, the banks were paralyzed because they were paralyzed by their bad investments and eager to hoard cash. It did not matter if you were a right person, a healthy company or another bank.
The American financial system has been effectively frozen.
“It was a perfect storm,” Thompson said. “It was a lack of regulation, it was greed and creativity in the financial industry, and it was an American dream that came off the track.”