Commentary: Confused by the exploding mortgage crisis? Here are some answers
By Alexandra Hazlett
October 13, 2008
The global financial crisis is an immensely complex issue, but it must be understood. Past failure to understand or recognize the roots of this current economic crisis is partly to blame for the consequences we face today. To begin to analyze the problem, and formulate a solution, we need to start at the source: the mortgage crisis.
The crisis in the housing market was caused by a convergence of several factors. However, they can be boiled down to the idea that banks made loans they would never have otherwise made to people who couldn’t pay them. This is because both sides believed that perpetually rising housing prices would save them.
Real estate is the main or largest investment for many, if not most, Americans. Home prices had been on a seemingly irreversible rise, and most average people, financial institutions and pundits believed that the trend would continue. All economic and finance models that predicted future return on investment scenarios and lending consequences were based on this premise.
Computer simulations also took another important behavior into account – past characteristics and qualifications of loans. Economics, the dismal science (a term that may enjoy a resurgence after recent events), is generally backward-looking. It relies on formulated explanations of past behavior to predict future outcomes. If the fundamentals of a situation are altered in a way that hasn’t been seen before, much of the analysis loses is relevance. This is exactly what happened, as banks seriously lowered their traditional standards for judging loans. At that point, all bets were off.
When a bank negotiates an interest rate on a mortgage, that rate is a reflection of the risk the bank is taking with that particular borrower. Think of the interest rate as a price you are paid when you lend the bank your money (in the form of a savings account, for example). The less likely you are to get all or most of your money back, the higher the price you demand for the use of that money. That risk level determines the interest rate, and high interest rates are only possible with increased levels of risk in investments.
Generally these rates are consistent because there is a lengthy and stringent screening process for loan applicants. When that screening process becomes lax, people who otherwise would not qualify for loans (and who may be much less likely to be able to repay them) are given huge, risky mortgages. Understandably, the interest rates on these loans would be very high.
This is one point where a moral argument presents itself. Banks ostensibly have a responsibility to make loans that they believe will be repaid. Throughout history, they have generally done so. But add in the upward trend of home values, and that means that even if the loan defaulted, giving the bank ownership of the house, it would now be holding an asset that was worth more than the amount of the original loan. There was an incentive to make loans to less financially stable individuals because of the belief that rising home prices would make the terms profitable even in the event of foreclosure.
To be fair, when applying for any type of loan, it is important to understand the terms and ramifications of what you are signing. Homeowners also benefited from the seemingly endless increase in their home values – if they couldn’t pay off the first mortgage, they could get a second for a larger amount because their home was now worth more. “Flipping houses” became common parlance, as people all over took advantage of rapidly rising home values to make a quick buck.
And then the unthinkable happened: home prices started to fall.
Banks, which had given loans to people who could never have hoped to repay them, were now stuck with houses from foreclosures that were worth less than what the people had committed to pay for them (i.e. the original mortgage value). General economic slowdown caused many homeowners to default on their payments, which then ballooned out of control as high interest rates kicked in. Now both banks and debtors were in a catch-22. The bank has no interest in owning a home that it will owe money to itself on, and homeowners have no wish to be forced out of their place of living, but can’t afford their payments. And even if the bank does take the property, who will buy it?
After an increasing rate of defaults on loans, banks swung back and became incredibly picky about whom they would lend to, in many cases refusing to lend at all. This “credit freeze” is what has prompted general alarm and intensified calls for government action.
This explanation fails to touch on the true ownership of mortgage debt and how larger banks and world markets have been involved. For an in-depth, easy-to-understand explanation of the financial crisis, look up the May 5 and Oct. 3 edition of the public radio show “This American Life” at www.thislife.org.
Editor’s note: Alexandra Hazlett is a senior at Ohio University with a double major in journalism and economics. She obtained most of this information from “This American Life,” articles and analyses in The New York Times, and information from OU emeritus economics professor Richard Vedder, who teaches a class in which Hazlett is a student.
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