Ever since we went into this spiral of economic downturn, everyone has been having a traumatic flashback to the 2008 economic crisis. So, are we really gonna have a season 2 of our collective trauma? I can’t see the future, but we can get educated from the past.
First, before we get into details, there’re a few keywords you should know.
Mortgage: An agreement between the borrower and the lender that gives the lender the right to take the property if the borrower fails to repay the borrowed money plus interest.
Default: When a borrower fails to repay the loan.
Credit score: A credit score is a number from 300 to 850 that rates a consumer's creditworthiness. The higher the score, the better a borrower looks to potential lenders.
Mortgage-backed securities (MBS): An investment secured by a collection of mortgages bought by the banks that issued them.
Sub-prime mortgages: A home loan to individuals with poor, incomplete, or nonexistent credit histories.
Adjustable-rate mortgages (ARM): A home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
The Domino Effect
Like everything, it started with good intentions. It all began in the early 2000s when the housing prices in the US began to fall and everyone celebrated. Don’t have a home, get one or two if you want! More and more people started getting mortgages and investors saw the housing market as a favorable low-risk, high-interest opportunity. So, they bought what it’s called an MBS which is created when large financial institutions securitize mortgages.
What are these exactly? Investors basically buy many mortgages, bundle them together, and then sell shares of that pool to investors. So investors jumped on that chance like vultures feeding on their prey. Why? Because they would get interest on their investment either way; whether from their investment or even if the rent default.
The Housing Bubble
But since it seemed like a risk-free chance, everyone wanted a piece of that cake! And so, banks offered subprime mortgages. While it should seem like risky business, financial institutions like S&P, Bear Stearns, AIG, and Moody’s backed the banks and gave AAA ratings to these securities. It was said that they did so because they were either paid by the companies that issued the securities or they didn’t do their due diligence and didn’t properly investigate the risk of the underlying assets that backed the securities they were rating.
Combine all these factors together and BAM! You’ve got a recipe for disaster! People started taking mortgages and subprime mortgages. Housing prices started to surge more and more. Buying a house seemed good at first but with ARM (for borrowers), everything went south. So, people couldn’t keep up with their mortgages payment and they defaulted on paying their rent, so more houses were put on the market for sale. However, there was no one to buy them which means there was more supply than demand. Then the housing prices went down and borrowers had a mortgage debt that is way more than their houses’ value.
The Consequence$ of Greed
All of this has led financial institutions to stop buying sub-prime mortgages but their lenders were left with bad loans and some even declared bankruptcy. You’d think this is the end of it, but it’s not! What made everything worse was something called credit default swaps which is basically insurance against MBS. AIG sold millions of dollars without actually having the money to cover any possible loss.
This “insurance” was turned into other securities which allowed traders to bet big money on whether the value of mortgage securities would increase or decrease. Which is what the movie “The Big Short” is all about. And so, everything fell down! Trading and credit market stopped, the stock market crashed, and now the US has entered its first millennial recession.
Bank Bailout
This was a huge mess that, unfortunately, impacted us all, but how did they survive this catastrophe? Well, the Federal Reserve decide to loan banks $700 billion but ended up spending $250 billion on the banks. In 2010, the Dodd-Frank act was put in place which worked to reduce predatory lending.
