What's the harm in paying a premium price for a house if you really want to make it your home? The house and yard are a comfortable size, the neighborhood is clean and safe, the schools are good, and the commute to your work is acceptable. Besides, housing prices in the area have been going up 15% a year for decades; you can make a deal with the bank to pay little more than interest, and still expect to refinance the property every few years to draw several tens of thousands of dollars of equity out.
And what's the risk to the bank of lending you most of the money you need to buy the house? They've got the property for collateral; if you don't keep up with the mortgage payments, they can always foreclose and sell the property.
In fact, why charge you more than very minimal payments--or check your creditworthiness carefully? The ever-rising prices of properties (in the area) make those unnecessary.
Moreover the bank doesn't even have to put several hundred thousand dollars on ice to buy your house for you. They just bundle several home loans and sell the package to Wall Street investors (keeping a small, appropriate profit). If someone defaults on a home loan now and then, that isn't often enough to substantially reduce the safety of the investment bundle. If you also work in a series of insurance-policy-type guarantees to cover the risks that you might die or lose your job (or that there might be a disproportionate number of home-loan defaults in some particular bundle), then the risks to everyone in the chain--to you, to the bank, to the mortgage-bundle handlers, and to the insurance companies--are so small as to be manageable.
It all makes such simple, solid financial sense--everyone is winning: you are living in the home of your dreams; its value is going up year by year; the bank has taken its origination-transaction fees and sold off the bulk of the indebtedness; and Wall Street investors are making a nice return on a safe, insured investment--everyone is happy; everyone is making money.
Then the inexorable rise in housing prices falters. Homeowners discover they can't simply refinance every few years to reduce their payments and take money out. Foreclosures begin to increase. Insurance companies have to raise their premiums. And distant Wall Street investors begin to feel the pinch--other investments are relatively more profitable--they start to take their money out--the prices of the mortgage bundles fall. Pretty soon banks find they can't resell mortgages very much at all, so they have less money to make new or renewed homeowner loans.
This sounds like an orderly retreat--like a contraction of an overextended market, right? The trouble is that the tangle of derivatives (bundles of bundles of bundles, plus the complex and obscure network of insurance) has grown, while no one was watching very closely (due to the lack of government regulation and extreme complexity) to tens of trillions--yes, TENS OF TRILLIONS--of dollars. Plus the system is all very liquid--it rather prides itself on its liquidity: a major investment bank or a major insurance company falters, and investors at their computer terminals worldwide can shift trillions of dollars in seconds. When Lehman Brothers and AIG faltered in mid-September, 2008, worldwide business hit the brakes like never before in history. Within a day or two the Port of Los Angeles was quiet due to canceled shipping contracts (down 80% in 48 hours); hiring lines and halls in New York City had no work to pass out; trucks and trains were sidelined with no loads and nowhere to go; seasonal replenishment of warehouse and retail store stocks stopped--just stopped--with no credit and no funds.
The causes--a series of simple, understandable steps; the result, worldwide financial meltdown.
Peeking into the shadows of the past, there appear to have been several fundamental problems:
(1) Primary lending institutions (banks, savings and loans, etc.) were making unwise loans to non-credit-worthy borrowers based on imaginary collateral.
(2) The financial derivatives from these loans (the bundles of bundles and the various stocks and instruments of indebtedness that were based on them--plus the related insurance network) grew to be impossibly elaborate and complex; no one could analyze them or evaluate realistically the risks they entailed.
(3) The risk-rating agencies (mostly Moody's and Standard and Poor's) rated the mortgage bundles and the securities they backed as AAA ("triple A"). As the derivaties became more complex (and more difficult--ultimately impossible--to rate), they continued this same rating level. This was complicated by the fact that the rating agencies were paid by the issuer of the financial instruments who could, to a certain extent, "shop around" for a better rating. The triple-A rating was important because some funds--some retirement and insurance funds, for example--were required by their charters to limit their investments to debt instruments with the highest ratings. If a rating slipped to double-A, those funds would be forced to divest their portfolios of (sell off) those instruments. Moreover, even if a fund were allowed to hold non-triple-A instruments, a lower rating might obligate higher margin requirements; in other words, if a particular bond's rating were downgraded, the holder might have to raise many millions (even billions) of dollars in capital reserves just to continue to hold those same bonds.
(4) The regulatory agencies (mainly the Security & Exchange Commission [SEC], but the others as well--the Commodities Futures Trading Commission [CFTC], the Federal Deposit Insurance Corporation [FDIC], the Federal Reserve Board, and the Office of the Comptroller of the Currency [OCC]), were not effective. They were either not specifically charged with overseeing these particular kinds of financial instruments and transactions, or they were underfunded, understaffed, and overwhelmed. This was intrinsically related to a small-government, deregulation attitude in Washington.
(5) The extreme liquidity in the financial market systems allowed rumors to ripple catastrophically around the world in seconds. Huge sums could change hands with the flick of a keyboard 24 hours a day.
Bun Gladieux, president of the Presssure Positive Company, has a blog with an interesting series of topics.
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