In 2008, real estate prices fell dramatically, leaving many homeowners who had used the theoretical value of their home equity as collateral to default. Mortgages were made to borrowers with significant credit problems and household incomes skewed toward the lower brackets. They were euphemistically labeled “subprime.” Because these loans were riskier, they commanded higher interest rates than those paid by a homeowner with sound credit and income. Subprime loans carried a significant premium, ostensibly to account for the additional risk, but excessive enough they were considered predatory. Compounding this significant hurdle, many of the these loans made were of either the interest-only or variable rate variety, meaning that their monthly payments were subject to increases in the prime interest rate set by the Federal Reserve. At the same time, real estate prices plummeted, interest rates rose. As a result, a great deal of households that had mortgages, and in many cases multiple mortgages, owed more than their house was worth: They were underwater. The subprime mortgage crisis was caused by declining real estate prices, systemic over-leveraging of home equity, poor public policy, questionable practices in consumer and commercial lending, and flawed financial engineering by bankers motivated by short-term profit incentives.
The underlying assumptions behind the consumer lending practices were dubious. First, and most refutable in retrospect, was the notion that real estate prices only moved in one direction. It was commonly believed that, for the most part, real estate could only appreciate in value. Guided by public policy makers under the premise that home ownership should be encouraged, such as the tax exemption of interest on mortgage payments, home ownership was glorified as a way to realized the American Dream. Those more suited toward renting were therefore encouraged to buy real estate by procuring mortgages that typically last thirty years in duration (Bush, 2002).
The supply of real estate continued to increase, because the building of new homes operating relatively autonomously from individual lending practices, never ceased. The building of homes was sufficiently removed from the market for real estate that they overestimated the demand of new homes. The division of labor in the banking industry is organizationally bound to separate loans to individuals seeking to purchase a home from commercial lending to businesses. Because of this "Chinese wall", the home building industry financed commercial lenders at the same banks, who were also operating under the faulty assumption that real estate prices would continue to rise. While organizational boundaries kept these two business units separated, structurally the bank’s assets were interdependent, and exposed to the downturn in both the commercial and consumer lending businesses.
Traditionally, home owners received their loans directly from banks. Over time, however, an influx of intermediaries in both the appraisal and financing of a home purchase moved the bank further and further away from the borrower. Eventually, investment banks devised a scheme where mortgage payments owed to commercial banks would aggregate the expected cashflows from hundreds and thousands of individual loans, then divide them into different risk classes, called tranches. These loans were then recombined create complex financial instruments called Collateralized Debt Obligations (CDOs) meant to be traded on the open market.
This financial engineering by investment banks was purported to be a way to diversify, thus reducing the impact of toxic assets. Instead, it was essentially a way for third-party investors to bet on the likelihood of missing mortgage payments and default by homeowners. These instruments fared poorly on the market. As investment banks were encouraging their own clients to purchase the faltering CDOs, they were liquidating the bank’s own position, limiting their exposure. Most notoriously, investment bankers at Goldman Sachs were able to engineer financial instruments that would profit when the underlying assets decreased in value (Lewis, 2010, p. 53).
The market for real estate is subject to volatility and inherently risky. On the individual level, homeowners should realize that their home equity is not a revolving credit line. In the macro sense, too long has passed since the United States has made any meaningful regulation in the financial services industry. Meanwhile, the development of derivative investments has grown complex enough to warrant significant changes in regulatory policy. Left short of accountable, investment banks have constructed complex financial instruments that even the most sophisticated investors struggle to understand. Without adequate disclosure about the risks posed by these “financial weapons of mass destruction”, market failures are guaranteed to resurface (Buffet, 2003, p. 15).
Banks were subsidized by TARP and stimulus packages, leaving the taxpayers to bear the costs of a massive externality. The policy of “Too Big To Fail” has indeed failed (Lowenstein, 2001, p. 190). The only way to properly align bankers incentives to bear the cost of their risky behavior is to credibly threaten to break up large corporate banks that can’t demonstrate adequate risk management policies. Short of meaningful policy change, the painful lessons of the subprime lending crisis are doomed to repeat themselves.
AE - c. 2012 [updated 8.30.2018]
The Ambidextrous Economist is where the heart is. He can be reached at AmbidextrousEconomist@gmail.com.
The 2008 Real Estate Bubble was not 'tiny' by any means, Ho.