THE AMERICAN DREAM

In 2007, the U.S. economy entered a mortgage crisis that caused panic and financial turmoil around the world. The financial markets became especially volatile, and the effects lasted for several years (or longer). The subprime mortgage crisis was a result of too much borrowing and flawed financial modeling, largely based on the assumption that home prices only go up. Greed and fraud also played important parts.

The American Dream
Owning a home is part of the 鈥淎merican Dream.鈥 It allows people to take pride in a property and engage with a community for the long term. However, homes are expensive (at hundreds of thousands of dollars 鈥 or more), and most people need to borrow money to buy a home.

In the early 2000s, that dream came into reach for a record number of people. Mortgage interest rates were low, allowing consumers to get relatively large loans with a lower monthly payment (see howpayments are calculated to see how low rates affect payments). In addition, home prices increased dramatically, so buying a home seemed like a sure bet. Lenders believed that homes made good collateral, so they were willing to lend against real estate and earn revenue while things were good.

Cashing Out
Things were good forfirst-time home buyers, but existing homeowners also benefited from easy money and low rates.

With home prices skyrocketing, homeowners found enormous wealth in their homes. They had plenty of equity, so why let it sit in the house? Homeowners refinanced and took second mortgages to get cash out of their homes’ equity. Some of this money was spent wisely (on improvements to the property securing the loan). However, some homeowners used the money for living expenses and other needs, keeping a comfortable standard of living while wages stayed stagnant.

Easy Money Before the Mortgage Crisis

Banks offered easy access to money before the mortgage crisis emerged. Borrowers got into high-risk mortgages such as option-ARMs, and they qualified for mortgages with little or no documentation. Even people withbad credit could qualify as subprime borrowers.

Risky borrowers:Borrowers were able to borrow more than ever before, and individuals with low credit scores increasingly qualified assubprimeborrowers. Lenders approved 鈥渘o documentation鈥 and 鈥渓ow documentation鈥 loans, which did not requireverificationof a borrower鈥檚 income and assets (or verification standards were relaxed).

Risky products:In addition to easier approval, borrowers had access to loans that promised short-term benefits (with long-term risks). Option-ARM loans allowed borrowers to makesmall paymentson their debt, but the loan amount might actually increase if the payments were not sufficient tocover interest costs. Interest rates were relatively low (although not at historic lows), so traditionalfixed-rate mortgagesmight have been a reasonable option.

Fraud:Lenders were eager to fund purchases, but some home buyers and mortgage brokers added fuel to the fire by providing inaccurate information on loan applications. As long as the party never ended, everything was fine. Once home prices fell and borrowers were unable to afford loans, the truth came out.

Sloshing Liquidity
Where did all of the money for loans come from? There was a glut of liquidity sloshing around the world 鈥 which quickly dried up at the height of the mortgage crisis. People, businesses, and governments had money to invest, and they developed an appetite for mortgage-linked investments as a way to earn more in a low-interest rate environment.

Secondary markets:Banks used to keep mortgages on their books. If you borrowed money from Bank A, you鈥檇 make repayments to Bank A, and they鈥檇 lose money if you defaulted. However, banks now sell your loan, and it may be further divided and sold to numerous investors. These investments are extremely complex, so many investors just rely onrating agencies to tell them how safe the investments are (without really understanding them).

Because the banks and mortgage brokers did not have any skin in the game (they could just sell the loans before they went bad), loan quality deteriorated. There was no accountability or incentive to ensure borrowers could afford to repay loans.

Early Stages of Crisis
Unfortunately, the chickens came home to roost and the mortgage crisis began to intensify in 2007. Home prices stopped going up at a breakneck speed, and prices started falling in 2006. Borrowers who bought more home than they could afford eventually stopped making mortgage payments. To make matters worse, monthly payments increased onadjustable rate mortgages as interest rates rose.

Homeowners with unaffordable homes were left with few choices. They could wait for the bank toforeclose, they could renegotiate their loan in aworkout program, or they could just walk away from the home anddefault. Of course, many also tried to increase their income and cut expenses. Some were able to bridge the gap, but others were already too far behind and facing mortgage payments that simply weren鈥檛 sustainable.

Traditionally, banks could recover the amount they loaned at foreclosure. However, home valuesfell to such an extent that banks increasingly took hefty losses on defaulted loans. State laws and the type of loan determined whether or not lenders could try tocollect any deficiencyfrom borrowers.

The Plot Thickens
Once people started defaulting on loans in record numbers (and once the word got around that things were bad), the mortgage crisis really heated up. Banks and investors began losing money. Financial institutions decided to reduce their exposure to risk very quickly, and banks hesitated to lend to each other because they didn鈥檛 know if they鈥檇 ever get paid back. Of course, banks and businesses need money to flow to operate smoothly, so the economy came to a grinding halt.

Bank weakness (and fear) caused bank failures. The FDIC ramped up staff in preparation for hundreds of bank failures caused by the mortgage crisis, and some mainstays of the banking world went under. The general public saw these high-profile institutions failing and panic increased. In a historic event, we were reminded thatmoney market funds can 鈥渂reak the buck.鈥

Other factors contributed to the severity of the mortgage crisis. The US economy softened, and higher commodity prices hurt consumers and businesses. Other complex financial products started to unravel as well.

Lingering Effects
Lawmakers, consumers, bankers, and businesspeople scurried to reduce the effects of the mortgage crisis. It set off a dramatic chain of events and will continue to unfold for years to come. The public got to see 鈥渉ow the sausage is made鈥 and was shocked to learn how leveraged the world is.

The lasting effect for most consumers is that it鈥檚 more difficult to qualify for a mortgage than it was in the early-to-mid 2000s. Lenders are required to verify that borrowers have the ability to repay a loan 鈥 you generally need to showproof of your incomeand assets. The home loan process is now more cumbersome, but hopefully, the financial system is healthier than before.