THE 2007-2008 HOUSING BUST

A BASIC BREAKDOWN OF THE 2007-2008 HOUSING BUST

In order to comprehend current housing circumstances in the United States, it is first necessary to have (at least) a basic understanding of the cycle that led to the housing industry bust during the financial crisis of 2007 and 2008.

There were five groups of individuals mainly involved:

FAMILIES/HOMEOWNERS

To buy a home in the past, a family was required to save a 20% down payment. If this could not be done, they were required to purchase mortgage insurance.
An interested family would save their 20% down payment and visit a mortgage broker to buy a house

MORTGAGE BROKERS

A mortgage broker is an individual who connects potential homeowners to a lender.

While they are not always needed, a mortgage broker can often find better rates than those that are available to the general public.
Brokers get a commission for connecting buyers with lenders.

LENDERS

Lenders are the individuals/organization who have provided the money for the house.

These lenders can then sell these mortgages to an investment banker for a generous profit.

INVESTMENT BANKERS

As the banker collects the new homeowner’s monthly mortgage payments (with interest), he gains financial leverage. This can be used to buy even more mortgages and create even more money.

The investment banker organizes these mortgages into categorized packages. If the owners are likely to be able to make their payments, they are marked as safe. The other two categories are for okay and risky mortgages.

These packages are called collateralized debt obligations (CDOs).
The banker is able to sell these CDOs to investors.

INVESTORS

Investors that are looking for a safe source of income can buy the “safe” mortgages which have a lower return rate. This rate is not a problem for them though, because the payments are likely to keep coming in.

Riskier investors can buy riskier mortgages for higher rates. If they homeowners are unable to make the payments, they will have still gained a hefty sum from the high interest rate.

If the investor got stuck with the house, they could simply sell it for a higher profit as houses had not dropped in value since the Great Depression.

These five groups of individuals got immersed in what is called irrational exuberance. This is defined by Robert Shiller as a “heightened state of speculative fervor”.

Essentially, everyone was functioning on the premise that housing prices would never fall. Investors wanted more CDOs, so investment bankers needed more mortgages, and as such, brokers needed more potential homeowners.

To make buying a house easier, many lenders lowered the standards
required to obtain a mortgage. These types of mortgages were referred to as “subprime” as they oftentimes did not require a down payment or proof of income.

Once the mortgage was sold to an investment banker though, it was out of the lender’s hands. And after it was packaged into a neat CDO bundle, the investment banker would just sell it off to the next investor.

The whole process has been described as a game of hot potato in which everyone believed themselves to be secure.

But there was a problem.

People began to default on their mortgage payments and lose their homes. As more people did this, the number of available homes increased. This began to lower their value.

Homeowners who were making their mortgage payments saw the value of their home decrease, as neighboring houses were foreclosed. They were now stuck paying debts much larger than the amount their house was worth.

As a result, these paying homeowners also walked away from their mortgages, making the problem even worse.

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