The economy is still slowly recovering from the 2008 housing crisis; hundreds of thousands of US homes go through foreclosure every year. A new movie by Adam McKay, writer and director of Anchorman and Talladega Nights: The Ballad of Ricky Bobby, tells the story of how the housing crisis happened. It’s called The Big Short.
The 2008 crisis started with the banks, but those who really suffered were the people on the street who had purchased homes and ended up in foreclosure. What exactly happened during the crisis and what does it mean for homeowners today?
The Big Short
The movie, which will be released in the US on December 11, charts the stories of several of the key players in the mortgage and collateralized debt obligation (CDO) market leading up to the crisis. It also highlights the credit default swap market, which bet against the CDO market and profited hugely when the market crashed. That bet against homeowners is called the Big Short.
The linchpins of the crisis were subprime mortgages, CDOs, and credit default swaps. These financial instruments haven’t disappeared in the wake of the crisis – they’re still around and still affect homeowners today.
The whole story starts with the subprime mortgage crisis, the realization by banks and governmental lenders that a large portion of the mortgage debts they had issued would not be repaid. It ends with the people who lost their homes and are still struggling to recover.
It’s not easy to buy a home. It’s the biggest purchase most homeowners ever make. Because homes are so expensive, most people need to borrow money to make the purchase – a mortgage loan. Like other types of loans, mortgage loans require a credit check to determine the risk that the borrower is going to default. The housing crisis started when lenders started to offer large numbers of loans to borrowers with low credit scores.
In order to understand why that caused such a financial disaster, let’s take a look at the banks’ side of the equation.
What Is A Subprime Mortgage?
A subprime mortgage is a type of mortgage loan given to borrowers with very low credit scores – usually under 600. These borrowers would not qualify for conventional loans because of their credit. Because borrowers with low scores are considered riskier than those with higher scores, “subprime” loans have interest rates higher than the “prime” rates on conventional loans.
The most common type of subprime mortgage loan is an adjustable rate mortgage (ARM). This type of loan starts with a fixed interest rate but switches over to an adjustable rate after a set period of time, usually 2-3 years. The adjustable rate rises and falls as general interest rates rise and fall, so the switch usually results in much higher monthly payments.
These loans are offered as a way to buy a home with low credit, with the idea that the borrowers will be able to improve their credit and refinance into a conventional mortgage before the switch to adjustable rates. In the years leading up to the financial crisis, interest rates were low and lenders gave out a lot of ARMs.
Big lenders make their money by analyzing and charging for the risk of various types of loans. Charging subprime rates was one way to manage the risk of default in subprime mortgages. Another was creating a CDO – a collateralized debt obligation.
A CDO is a big pool of debt that is linked to a set of assets; it’s a type of asset-backed security (ABS). It was originally used for corporate debt but came to be used in the mortgage markets. Lenders would combine all their debt into one pool and then divide it up according to risk. Each risk-level is called a “tranche” and can be sold to a different company. The lowest-risk tranches would receive payment first and the high-risk tranches got paid last, but at higher rates to compensate for the increased risk. This setup was used as a way to spread out the risks, making it easier and safer for lenders to offer subprime loans. The CDOs used for mortgage loans were called mortgage-backed securities (MBSs).
If the mortgages were collected into big pools and sold off in tranches, the lenders would no longer have to bear the risk of default. That made it easier for them to make money on the loans, so they started offering more and more.
Because lenders gave out so many subprime mortgages, the CDOs were no longer really protecting them or anyone else from the risk. Ironically, it was the CDO system that encouraged them to offer so many of those loans in the first place. The subprime mortgages were profitable, so lenders gave out too many, too fast and the subprime tranches of the CDOs grew much faster than the others, greatly increasing the overall risk level.
Credit Default Swap
Some people believed that the whole system would soon collapse. They knew that the lenders’ exposure to bad debt was too large and that a small increase in the number of defaults could potentially set off a catastrophic series of financial consequences. They decided to bet against the lenders (and the homeowners) using a credit default swap, or CDS.
A CDS is a financial tool that is meant to insure a lender against defaults on a loan or set of loans. The buyer of a CDS is usually the lender; they make regular payments to the seller of the CDS based on current interest rates. If the loans default, then the seller of the CDS pays the buyer to cover that loss. Essentially, a CDS buyer pays the seller to take on the risk of a given loan. If the loan is repaid, the seller gets to keep the premiums. If the loan defaults, the seller has to pay.
In the case of the 2008 crisis, the CDSs were used as insurance against default on the mortgages that made up the CDOs.
Subprime Mortgage Crisis
From 2006-2008, the rate of default on subprime mortgages skyrocketed as the ARMs switched over to adjustable rates and borrowers could no longer afford their payments. That in turn affected the owners of the CDOs. People flocked to buy CDSs because the CDSs would pay out huge amounts of money if the defaults continued to rise and the CDOs started to collapse. That was the start of the subprime mortgage crisis.
As it turns out, default rates did continue to rise and the market panicked. The CDOs became worthless and the sellers of CDSs couldn’t meet all their obligations to cover the defaults – although they did pay out billions of dollars. The ones who bought the CDSs made a whole lot of money and the CDS sellers, CDO owners, and original lenders lost and received a bailout from the federal government to stay afloat.
The mechanisms of most of the crisis happened at the big business level, but the people who were most affected were those who had bought homes and ended up in foreclosure.
The last piece of the financial crisis puzzle is why so many homes ended up in foreclosure: underwater mortgages. The spike in lending in the early 2000s led to a corresponding spike in home prices – higher demand causes prices to rise. Then when the market collapsed, the value of the homes fell. In some cases, they fell so low that the mortgages ended up “underwater,” meaning that the homes were worth less than the owners owed on their loans.
When people owe more than their homes are worth, they’re more likely to stop paying the bill, leading to default and foreclosure. That’s true for both prime and subprime borrowers. Subprime borrowers also had the added pressure of the switch to variable interest rates increasing their payments.
The whole country ended up in a vicious cycle as the subprime mortgage crisis crippled the economy, leading to job loss, which led to more underwater mortgages and more defaults.
What Have We Learned?
There have been some regulatory changes since the crisis. Banks are now required to keep their loan portfolios healthier, meaning they must give out fewer subprime loans. In general, however, subprime loans are still available, as are CDOs and CDSs. The ingredients are all still there for another problem.
In other words, we’re not sure if lenders have learned a lesson or not. Borrowers, however, may be able to pull a few lessons from the crisis. First, financial instruments can be deceiving. You should never sign on to a mortgage unless you’re completely certain about all the terms and conditions. Second, foreclosure is always a potential risk if you have a mortgage loan. The best way to protect yourself is to educate yourself about your loan and your options.
Many borrowers are still struggling to recover from the effects of the crisis and many still face foreclosure. The good news is that you have options for avoiding foreclosure. For example, you may be able to refinance your loan through the HARP program or file a bankruptcy to get your payments back on track. Our Mortgage Warriors are standing by to help you get your mortgage back on track and keep your home. Contact us today for a free consultation to learn about your options.