Once Upon A Time: The Story of the Housing Bust, Subprime Meltdown, and Credit Crunch

I know I’m a little late to the game, here, but I’ve been meaning to write a post about a great article in the New York Times for a while now.  It’s from March 19, but it’s so good I’m going to write about it here anyway.

So the article is called “Can’t Grasp Credit Crisis? Join the Club.” It’s a really great explanation of how a housing bubble turned into a subprime meltdown that turned into an economy-wide credit crunch that threatens to turn into a recession.

Let’s start at the beginning:

The article says that it all started back in 1998, when two things happened:

1. “[L]arge numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain.”
2. “At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.”

• Those global investors, who could pool their money into investments, were willing to take on more risk in exchange for higher returns.  Wall Street’s answer: subprime mortgages, which carried a higher risk that the borrower would default, but also charged rates 50%, 100%, even 200% higher than conventional mortgage rates.

• Global investors bought into the subprime mortgages, but not directly (in other words, an individual wouldn’t purchase an individual mortgage).  Instead, Wall Street firms sliced the mortgages into pieces and bundled them into investments, otherwise known as collateralized debt obligations (CDO’s).

• “Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money.”

• Meanwhile, low interest rates (made possible by the Fed under Alan Greenspan) and booming markets on the urban fringes in places like Phoenix, Las Vegas, and Southern California drew buyers by the thousands.  First-time homebuyers and newbie investors alike could buy more house than they had dreamed without putting a penny down.

• Can you see the common theme?  The people who invested in collateralized debt obligations (and then leveraged them to the hilt) as well as the people buying homes with no money down, were all drawn by the same misconception: that real estate values would keep going up and up and up. . .  “People decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.”

• At the height of the boom, homeowners were doing the same thing that CDO investors were doing: leveraging their homes to the nth degree.  With prices rising, in some areas, $10,000 a month, it was too easy for homeowners to take out home equity loans against the rising equity in their home.  They thought they couldn’t lose because prices would keep rising.  And with interest rates so low, and enticing adjustable rate mortgages, many homeowners used creative financing (like interest-only loans and three-year adjustable rate mortgages that start off at low teaser rates and then rise by hundreds of dollars a month) to leverage their homes even more.

• Back on Wall Street, investors’ bets often weren’t huge, but they “were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything.”  That’s why venerable institutions like Bear Stearns, Merrill Lynch, Morgan Stanley, have fallen into hot, hot water.

• Now, the pendulum has swung far in the opposite direction.  “[F]irms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.”

So what can be done?

The Fed has stepped in to infuse some liquidity into the market (so that firms facing investors demanding their money back can actually pay it back) by allowing banks to borrow money from the Fed using their CDO’s as collateral.  It sounds crazy, but many economists think it’s the only solution.

The FHA has also stepped up efforts to meet the gap in mortgage lending.  I wrote in a post a while back that FHA loans have become a really good option, even for borrowers with strong credit and income. 

The story ends, as any good story does, happily.  The market rebounds and we move on – bruised but still kickin’ to live another day, enjoy another boom, and suffer another bust.  They are, after all, called cycles. . .