You’ll probably want to read Weakon 231: How the Mortgage Industry Works (or Worked!) first.

We stand here over a year after the sub-prime crises began.  The sub-prime crises lead to the credit crunch, the credit crunch lead to slowed growth, slowed growth killed the stock market, the down market sent people into commodities, which drove up the price of oil, making economic growth all the more difficult.  All this because of some houses?  There must be more to it than that!

Well, not really.  In the past it wasn’t possible for the real estate market to have such an impact on other parts of the economy.  As recently as the 1990s, investing in real estate was a great way to hedge your risk in the stock market.  Whereas gold, oil, and the US dollar tend to work inversely (one goes up the other goes down) with the stock market, real estate has never had much of a correlation with either of those investments.  Many people like this prospect.

Naturally, too many people liked it.  The tech-bubble popped in the early 2000s leaving many investors scarred from the experience.  They wanted something more stable than the stock market and there was still plenty of money floating around.  Money was also cheap, as interest rates were at their lowest, making borrowing easy.

With steady rates of return on real estate, and the prospect of owning rental properties, America went to work in real estate like black ants at a picnic.  Banks slowly noticed an influx of applications for second and third mortgages.  Previously the purchase of real estate was limited to savvy investors that understood the types of financing available to them.  The flexible terms allowed them to save cash and make payments later.  For example:

I could buy a $100,000 “fixer-upper” putting no money down and making only the interest payments each month.  With the money I would have used on a down-payment and on the principle payments each month I can fix up the house.  All this would be done for about the same monthly outflow of cash as a 30-year fixed rate.  At the end of the loan I would make a big payment.  This is known as a balloon mortgage.

But Weakonomist guy, why would someone not want to pay off the principal of the house?  House flippers don’t care about paying off the house, and the interest they’ll pay over the maximum year they’ll own it is negligible.  If they can sell the fixed up house for $150,000 they’ll be able to close the loan and take a profit.  This always assumes the value of the property would go up, what happens when real estate prices fall?  Well you still have to pay the interest, but with no income because you can’t sell the house, you just let it go into foreclosure.

Here’s another example:

I own my house and its value is $400,000.  I used it as collateral for some HELs (home equity loans) to buy 2 condos at a total price of $350,000 in a beach town.  I ran the numbers with my bank and so long as I can rent them out at a certain price, I can make my payments.  I plan on selling the condos in a few years for a nice profit.  The problem arises when again I can’t sell the property or no one wants to rent them because there are hundreds of other unrented condos in the area.  Worse still my HEL isn’t at a fixed rate.  Its an adjustable rate that was due to reset next month.  When it resets from 3% to 6% I’ll no longer be able to afford the payments.  There is no way it can be sold for a profit so again it goes into foreclosure.

This really wasn’t a big deal for many years.  Very few people were involved in these circumstances so when something went wrong, only they were effected.  But now everyone and their mother was involved in real estate.  Balloon mortgages were typically reserved for commercial projects, but people were jumping into them for their primary homes because of the cheap payments.  With a balloon or adjustable rate (called an ARM) I could get into a much more expensive house because the payments were less.  The thought process was never long term, because at some point their payments would go higher, much higher, doubling in some cases.  I guess they always assumed they would be making more money by then or could at least turn around and sell the thing, possibly for a profit.

Combine all this with the mortgage people (my bank included) being incented to offer these types of loans more than fixed rates and you have a recipe for disaster.  You basically had too many people buying homes that were too expensive, which is why the average price of a home spiked so much.  With the Fed gradually increasing rates over time, more and more people were just getting by even in half million dollar homes.  The breaking point occurred when people just stopped buying.  The bubble deflated slowing in the Spring of 2007, but by Fall everyone was trying to get out.  Investors in these loans suffered (that became all of us), construction jobs were lost, and many people lost their homes.

The shame goes to the greedy people that first got into loans they couldn’t afford.  I’m sorry you were taken advantage of by the mortgage officer, but if you didn’t understand that your loan would reset after 1, 3, 5, 7 or more years that was your fault.  The shame can go to the mortgage folks that lied on mortgage applications about income, but that wasn’t common.  The shame can go to the greedy banks (mine included) that offered these terrible loans to regular consumers and gave bigger commissions to the loan officers for selling them, but then again the corporate types always do this.  The shame can go to the hedge fund and pension managers that bought risky mortgage backed securities without fully understanding their risk.  But mostly the shame goes back to your typical American, always trying to upgrade their life.  Looking for fast money, or a nicer house, we fall for every scheme or advertisement that makes us the materialistic snobs the rest of the world hates.  Way to go US.