Subprime Crisis and Housing Bust in a Nutshell

Hello Hampton Roads,
By now everyone has heard of the subprime crisis and related housing bust—but what started it—what was the cause?

In a nutshell, it began with Fed’s low interest rates which encouraged borrowing and subsequently spending. Many people made lots of money when credit was easy and money cheap and housing prices appreciated and everyone foolishly believed it would never end. With low interest rates and easy credit, people found out that they could buy more house than then they thought they could afford and in some cases, several houses instead of just one. The demand for real estate pushed prices higher which meant more equity which could then be used to purchase even more houses. In an appreciating market, people never worried because they knew they could always sell their house for more money to someone else. Many people bought homes with “0” down.* People with marginal credit (who probably shouldn't be buying homes or at the very least, buying homes that they couldn’t afford) were approved for loans.

So Wall Street bought millions of dollars of these risky loans and re- packaged them into residential mortgage backed securities (RMBS), that magically (aka financial engineering) got AAA ratings. The AAA rating allowed many financial institutions throughout the world to purchase these securities and borrow against them because of the lower perceived risk. Unlike the traditional corporate bond, in which the debt is paid by one company, it is actually 1000s of homeowners paying their mortgages all underwritten by different lenders (like NovaStar and New Century Financial, who went belly up) and it worked well when housing prices kept rising and interest rates were down, but not so well when rates began to rise. In 2006, the cycle began to shift –the Buyer failed to close on that next home, the Seller couldn't sell for a profit, ARMs reset, defaults increased, home values dropped, people owed more money on their homes than they was worth preventing homeowners from refinancing which led to more foreclosures, and the RMBS (holding these foreclosed mortgages) were downgraded, and in turn their prices fell.

Institutions which owned these securities faced margin calls from creditors; when they liquidated these securities it further pushed the price down which caused more margin calls on other institutions forcing them to sell and causing prices to drop further. Soon there was a no bid situation for these securities; there were all sellers and no buyers. Liquidity dried up. Major financial institutions like Bank of America, Citigroup, and UBS, suffered huge losses. Firms that were able to meet their liquidity needs did so at a steep price. Sovereign wealth funds came into the picture--ADIA (Abu Dhabi Investment Authority) took a 4.9% stake in Citigroup, and Singapore Investment Corp. has the option to own 10% of UBS in two years based upon the $10 Billion they loaned to UBS at 9% interest.

Banks, mortgage companies, and hedge funds that weren’t able to meet their liquidity needs, went bust.

The full repercussion of these events is still yet to be seen as millions of loans are due to reset this year through 2010.

* Common sense dictates that when people have no vested interest in a property, i.e. when their own money is not at risk, it is very easy to walk away when the going gets tough. To see how socially acceptable “walking away” has become, check out!

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