The Housing Crisis in 500 Words

We often hear terms like "housing bubble", "mortgage backed securities" and "sub-prime mortgages", but what are they exactly?

A person who wants a house gets a mortgage, usually from a broker.  The broker sells it to a small bank, which sells it to an investment firm.  This investment firm gets thousands of these and bundles them together.  He/she slices them up and sells them to investors on Wall Street. These are called mortgage backed securities.  Investors love these and want to keep buying them.  Because of that, they buy a lot and everyone down the chain (investment firm, small bank and broker) is happy.  

This process continues, but eventually everyone that would normally be approved for a mortgage has gotten one.  But, investors still want to buy more of these mortgage backed securities.  So, everyone down the chain is encouraged to get other people to get mortgage loans.  These are people that in normal times wouldn’t be approved for a mortgage loan.  These people have bad credit – lot’s of debt, not enough in savings and low income…. But the broker knows that he can sell a mortgage, regardless of if the person will be able to actually pay it off.  The individual himself loves the idea that he’s finally been approved for a loan and can actually get the house he’s always wanted. Because of this and the fact that everyone in the chain is getting paid, the process continues.

Meanwhile, housing prices are going up quickly.  Some people believe that housing prices in America will never go down.  This was a fantasy.  But, at some point people’s incomes don’t raise quickly enough to match the rising house prices.  Therefore, people begin to not be able to pay off their mortgages.  This means that all of the sudden, everyone in the chain (but most importantly the investment firms and investors on Wall Street) have millions of sub-prime mortgages.  Investment firms begin to lay people off and before you know it they are belly up.  Stocks drop and chaos ensues. 

In normal times, a person would get a mortgage from a bank and that bank would hold onto it for 30 years or so until that person paid it off.  In other words, it would stay in one place.  But, starting in the early 2000s banks and investment firms began to sell them as was mentioned above.  So, these companies began to only care about the short term gains rather than the long view of if the individual could pay off the mortgage or not.  It was always going to be “someone else’s problem”. 

Because of all of the financial pain that these companies went through, they eventually became very reluctant to lend credit.  This meant that people couldn’t get mortgages, people couldn’t get loans to start small businesses and even some countries have had a hard time continuing their modernization. That’s why the recession that we were in and the slow economic growth that we’re currently experiencing is called a credit crisis.  

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The Takeaway: Knowing this context, it’s hard to imagine the American GDP growing at or above 3% without a comprehensive solution to the ongoing  mortgage crisis.