How a 'perfect storm' led to the economic crisis

[classicman]

The U.S. economy is clearly in terrible shape. What is less clear is how we got here.

Opinions vary on when and where to begin the story, but many experts trace the origins of the current economic situation to the housing bubble that came about earlier this decade.
Housing prices jumped at a rate above 6 percent in 1999 and increased rapidly and steadily as the decade turned, according to a recent study by the Brookings Institution.
"After the mid-1990s ... real house prices went on a sustained surge through 2005, making residential real estate not only a great investment, but it was also widely perceived as a very safe investment," the study said.

The prices eventually moved "out of line with fundamentals like household income" and the bubble formed, the study said. Read the complete Brookings study

There were two trends developing at that time that contributed to the housing bubble, experts said.
The Federal Reserve Board, to combat the recession of 2000-01 and the economic effects of the September 11 terrorist attacks, began drastically slashing interest rates.
Consequently, it was very easy to borrow money, especially if you wanted to buy a home.
Meanwhile, global investors -- flush with cash from the worldwide economic boom of the 1990s and '00s -- were looking to the U.S. economy to make even more money.

"You have a group of people growing richer by leaps and bounds," said Peter Rodriguez, an economist at the University of Virginia. "And they liked the idea of parking some cash in the biggest, safest economy in the world."

Enter mortgage-backed securities

Wall Street firms sought to connect the rich investors with the rapidly expanding housing market with the help of complicated financial instruments.

These instruments -- such as mortgage-backed securities we've heard so much about -- made it easier to move the investors' funds into the housing market, which fed the extraordinary price sprial, Rodriguez said.
"It began to really take on a life of its own when people saw how much money they could make in housing," he said. "Before long, everybody was pushing along the momentum of this train."
So how do these mortgage-backed securities work and what role did they play?

Let's say there are three prospective homebuyers in a neighborhood. A local bank makes mortgage loans to all three, then bundles up the mortgages and sells the bundle to a big Wall Street firm, like the now-bankrupt Lehman Brothers.
The Wall Street firm takes its bundles of mortgages and offers them to investors. The investors make money off the interest payments from the original borrowers.
These instruments helped minimize risk for the local bank because it was no longer responsible for the loans it made to the local homebuyers.

"You didn't even have to worry about a loan once you made it. You didn't have to keep it on your books," Rodriguez said. "The only limitation was how fast you could turn the loans."
It was an intoxicating era when you could make a lot of money quickly through the housing market, and you did it through the "basic idea of leverage," Rodriguez said.
He provided an example: You take out a mortgage loan for $100,000 and make a 20 percent down payment, which would equal $20,000.

If the price of the house goes up to $120,000, you've effectively doubled your money. If you sell at that price -- assuming there are no transaction costs -- you walk away with an extra $20,000.
Leverage works the same way for banks. They borrow from other banks or other institutions so that they can hand out more loans and make more money.
"This encourages all sorts of risky behavior by individuals looking to buy homes, and it encourages banks to lend because, in an environment where prices rise, they're making lots of money, too," Rodriguez said.

Very interesting read