Are you too embarrassed to admit you don’t understand what the subprime mortgage crisis is about? Read on to find out what the subprime crisis means and how it affects you.
So, “what caused the mortgage crisis” anyways? In case you haven’t heard, we’re going through one of the worst housing busts in our lifetimes, if not ever. And though that much is clear, the reason behind it is much less so. In fact, there isn’t just one cause, but rather a combination of forces behind the current crisis. I’ll attempt to list as many as I can think of here:
In the old days, banks used to make mortgages in house and keep them on their books. Because they held onto the loans they made, stringent guidelines were put in place to ensure quality loans were written. After all, if something went wrong with the loans, they’d be accountable. And they’d lose lots of money.
Recently, a new phenomenon came along where banks and mortgage lenders would originate home loans and quickly resell them to investors in the form of securities on the secondary market (Wall Street). This method, known as the “originate to distribute model,” allowed banks and lenders to pass the risk onto investors, and thereby loosen guidelines. The result was casual underwriting, less oversight, and more aggressive financing, which ultimately led to a lot of bad loans being made.
Banks and lenders also relied on distribution channels outside their own roof, via mortgage brokers and correspondents. They incentivized bulk originating, pushing those who worked for them to close as many loans as possible, while forgetting about quality standards that ensured loans would actually be repaid. Because the loans were being sliced and diced into securities and sold in bulk, it didn’t matter if you had a few bad ones here and there, at least not initially…
Fannie Mae and Freddie Mac
Of course, banks and lenders modeled their loan programs on what Fannie and Freddie were buying, so one could also argue that these two “government-sponsored enterprises” also did their fair share of harm.
In short, if the loan conformed to the high standards of Fannie and Freddie, it’d be easier to sell on the secondary market. And it has been alleged that the pair eased guidelines to stay relevant in the mortgage market, largely because they were publicly traded companies steadily losing market share to private-label securitizers.
At the same time, they also had lofty affordable housing goals, and were instructed to provide financing to more and more low- and moderate-income borrowers over time, which clearly came with more risk.
However, the private mortgage market took control during the lead up to the eventual crisis thanks to their bevy of high-risk mortgage products, so Fannie and Freddie had to ease their own guidelines to maintain market share.
As a result, bad loans appeared as higher-quality loans because they conformed to Fannie and Freddie. And this is why quasi-public companies are bad news folks.