How the Sub-Prime Meltdown Went Global and What it Means to You
Sharon L. Secor
October 12, 2007
The deepening sub-prime lending crisis and the deflation of the nation's housing bubble are market events that are tightly intertwined. Each feeding off of the other, this combination of events has been largely responsible for the creation of a downward spiral in the nation's housing market, with foreclosure rates reaching record levels and the numbers still climbing. As foreclosure rates continue to rise, predicted by analysts to reach a figure of 1.7 million homes in 2008, the economic impact is being felt worldwide.
While the market mechanics that come into play in this crisis are quite fascinating, the current foreclosure crisis is unique in aspects beyond its record setting statistics. As these events play out, the effects of the financial machinations of big business on the average working class citizen have been exposed with an unusual level of clarity.
The housing bubble was created by a number of factors, with government regulations, low interest rates, the lending and real estate industries, and consumers all playing a role, but as with many economic bubbles in the past, the chief driving force was easy profit.
Housing Bubble Inflation: The Rush to the Top
Beginning in the 1970s, a series of federal banking regulation changes were made with the purpose of increasing the availability of credit to moderate and low-income consumers. These regulations were seen as a way to address the deterioration of low-income areas and inner cities by encouraging home ownership in these communities, which were considered as under served by the banking industry.
These changes were largely responsible for the rise of the secondary home loan market, making mortgage lending to average citizens no longer the exclusive territory of traditional banks. By 2005, just 37 percent of mortgages were placed in the hands of traditional depository institutions, the remaining 63 percent of home loans originated by mortgage brokers.
As the secondary mortgage market expanded, a wide variety of new loan products and looser lending practices became common. Among these, to name just a few, were jumbo loans, piggyback loans, interest only loans, and low document or no document loans. Low and no down payment loans became available, as did stated income loans, requiring little verification of income. Adjustable rate mortgages became commonplace, gaining market share against traditional fixed rate mortgages.
The increase in home ownership rates created by these looser lending standards and creative financing options created increased demand in the housing market, which drove prices steadily upwards. Market speculation became more common with low interest rates and the easy availability of financing, further inflating home prices.
Soaring demand and prices in the market were extremely lucrative for loan originators, spurring even looser qualification standards as lenders rushed to take advantage of these market conditions. Since most of these loans were immediately packaged for sale to investors, those originating them were not likely to be affected should the borrower default, leaving little incentive for mortgage brokers to be cautious.
These loans, once packaged into mortgage-backed securities, were sold to a wide variety of investors. Hedge funds and banks throughout the world have been among the largest investors in these mortgage-backed securities, and many pension funds, mutual funds, and 401K plans include them in investment portfolios. As the sub-prime market expanded, the percentage of sub prime loans included in mortgage backed securities packages increased accordingly, giving these investments a higher risk level than ever before. As the housing bubble was in its inflation stage, these investors profited handsomely in return for assuming this heavier risk.
Housing Bubble Deflation: The Slide Felt Around the World
Of course, the market could not support this pattern of reckless lending and inflated profits over the long term, as evidenced by the current foreclosure crisis and credit crunch. Reality began to set in during April of 2007, when housing bubble deflation began in earnest with foreclosure rates on the rise. As low teaser rates on ARMs expired, monthly payments increased substantially for many borrowers. Unable to meet these increasing financial obligations, a significant percentage of these borrowers defaulted on their loans.
In the months to follow, foreclosure rates skyrocketed to the highest level ever recorded in many states, contributing to a widespread and record setting drop in home values. This in turn caused the devaluation of many of the higher risk mortgage backed investments, causing widespread turmoil in markets around the world.
Investment banks and hedge funds are among the casualties of the declining market, reporting heavy losses on mortgage backed securities investments in recent months. The hedge fund sector alone has suffered a drain of roughly $32 billion in July and at least as much in August, wiping out gains reported in the first two quarters of the year in those two short months. Large hedge funds have been closed, failing under the pressure of heavy losses, and others have blocked withdrawals by their clients in preparation for closure.
Mortgage companies and sub-prime lenders have felt the heat as well, many going bankrupt as the burst of the housing bubble has taken its toll. Thousands have lost jobs in the mortgage industry as companies have been forced to lay off employees due to financial losses. Many sub-prime lenders have shut their doors completely, driven out of business by the effects of the foreclosure crisis.
Communities throughout the United States have certainly felt the sting of the housing market turmoil. According to RealtyTrac Inc., twice as many homeowners lost their homes to foreclosure in September 2007 than in September 2006. For sale signs are springing up like weeds in many of the nation's neighborhoods, as families attempt to sell their homes to avoid imminent foreclosures. Empty, boarded up homes are a common sight, especially in the lower income areas of the country where many homes were bought with the sub-prime lending market's creative financing options.
However, among all of the groups that are affected by the current economic climate, none are more devastated than the incredible numbers of individuals who are tallied in today's high foreclosure statistics. The human cost of this financial crisis is staggering, with countless families forced out of their homes. Damage done to the credit files of these consumers by foreclosure and the financial difficulties that often precede it can make recovering from such an event quite a challenge. Even finding a suitable rental home to move the family into can be difficult with poor credit scores, and many have depleted their savings in the effort to hold on to their homes.
Often, the world of big business and investments seems to carry little weight in the day-to-day life of the average American. Many of us just glance at the latest financial and investment news with a passing curiosity, feeling no connection to the world of global finance where billions of dollars change hands every day. However, the housing bubble and its fallout are global finance issues that illustrate quite clearly how the wheeling and dealing that takes place in the world's markets can trickle down to have a very real effect on the life of the average working class person.
While the market mechanics that come into play in this crisis are quite fascinating, the current foreclosure crisis is unique in aspects beyond its record setting statistics. As these events play out, the effects of the financial machinations of big business on the average working class citizen have been exposed with an unusual level of clarity.
The housing bubble was created by a number of factors, with government regulations, low interest rates, the lending and real estate industries, and consumers all playing a role, but as with many economic bubbles in the past, the chief driving force was easy profit.
Housing Bubble Inflation: The Rush to the Top
Beginning in the 1970s, a series of federal banking regulation changes were made with the purpose of increasing the availability of credit to moderate and low-income consumers. These regulations were seen as a way to address the deterioration of low-income areas and inner cities by encouraging home ownership in these communities, which were considered as under served by the banking industry.
These changes were largely responsible for the rise of the secondary home loan market, making mortgage lending to average citizens no longer the exclusive territory of traditional banks. By 2005, just 37 percent of mortgages were placed in the hands of traditional depository institutions, the remaining 63 percent of home loans originated by mortgage brokers.
As the secondary mortgage market expanded, a wide variety of new loan products and looser lending practices became common. Among these, to name just a few, were jumbo loans, piggyback loans, interest only loans, and low document or no document loans. Low and no down payment loans became available, as did stated income loans, requiring little verification of income. Adjustable rate mortgages became commonplace, gaining market share against traditional fixed rate mortgages.
The increase in home ownership rates created by these looser lending standards and creative financing options created increased demand in the housing market, which drove prices steadily upwards. Market speculation became more common with low interest rates and the easy availability of financing, further inflating home prices.
Soaring demand and prices in the market were extremely lucrative for loan originators, spurring even looser qualification standards as lenders rushed to take advantage of these market conditions. Since most of these loans were immediately packaged for sale to investors, those originating them were not likely to be affected should the borrower default, leaving little incentive for mortgage brokers to be cautious.
These loans, once packaged into mortgage-backed securities, were sold to a wide variety of investors. Hedge funds and banks throughout the world have been among the largest investors in these mortgage-backed securities, and many pension funds, mutual funds, and 401K plans include them in investment portfolios. As the sub-prime market expanded, the percentage of sub prime loans included in mortgage backed securities packages increased accordingly, giving these investments a higher risk level than ever before. As the housing bubble was in its inflation stage, these investors profited handsomely in return for assuming this heavier risk.
Housing Bubble Deflation: The Slide Felt Around the World
Of course, the market could not support this pattern of reckless lending and inflated profits over the long term, as evidenced by the current foreclosure crisis and credit crunch. Reality began to set in during April of 2007, when housing bubble deflation began in earnest with foreclosure rates on the rise. As low teaser rates on ARMs expired, monthly payments increased substantially for many borrowers. Unable to meet these increasing financial obligations, a significant percentage of these borrowers defaulted on their loans.
In the months to follow, foreclosure rates skyrocketed to the highest level ever recorded in many states, contributing to a widespread and record setting drop in home values. This in turn caused the devaluation of many of the higher risk mortgage backed investments, causing widespread turmoil in markets around the world.
Investment banks and hedge funds are among the casualties of the declining market, reporting heavy losses on mortgage backed securities investments in recent months. The hedge fund sector alone has suffered a drain of roughly $32 billion in July and at least as much in August, wiping out gains reported in the first two quarters of the year in those two short months. Large hedge funds have been closed, failing under the pressure of heavy losses, and others have blocked withdrawals by their clients in preparation for closure.
Mortgage companies and sub-prime lenders have felt the heat as well, many going bankrupt as the burst of the housing bubble has taken its toll. Thousands have lost jobs in the mortgage industry as companies have been forced to lay off employees due to financial losses. Many sub-prime lenders have shut their doors completely, driven out of business by the effects of the foreclosure crisis.
Communities throughout the United States have certainly felt the sting of the housing market turmoil. According to RealtyTrac Inc., twice as many homeowners lost their homes to foreclosure in September 2007 than in September 2006. For sale signs are springing up like weeds in many of the nation's neighborhoods, as families attempt to sell their homes to avoid imminent foreclosures. Empty, boarded up homes are a common sight, especially in the lower income areas of the country where many homes were bought with the sub-prime lending market's creative financing options.
However, among all of the groups that are affected by the current economic climate, none are more devastated than the incredible numbers of individuals who are tallied in today's high foreclosure statistics. The human cost of this financial crisis is staggering, with countless families forced out of their homes. Damage done to the credit files of these consumers by foreclosure and the financial difficulties that often precede it can make recovering from such an event quite a challenge. Even finding a suitable rental home to move the family into can be difficult with poor credit scores, and many have depleted their savings in the effort to hold on to their homes.
Often, the world of big business and investments seems to carry little weight in the day-to-day life of the average American. Many of us just glance at the latest financial and investment news with a passing curiosity, feeling no connection to the world of global finance where billions of dollars change hands every day. However, the housing bubble and its fallout are global finance issues that illustrate quite clearly how the wheeling and dealing that takes place in the world's markets can trickle down to have a very real effect on the life of the average working class person.
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