Home Buyers Go Shopping
The home has long been touted as a key to financial security. Government policy encourages home ownership by providing federal income tax deductions on mortgage interest and requiring that lenders issue mortgages in poor neighborhoods. Renters are eager to buy and many homeowners trade up several times during their lifetime.
Interest Rates Fall
Interest rates fall to rarely seen lows, allowing the same monthly payment to support a larger loan. This makes homes affordable for people who previously had rented, and it allows homeowners to move up to properties that are more expensive.
Home Prices Rise
By allowing people to borrow more, low interest rates allow them to offer more when they bid on homes, driving home prices up.
Home buyers finding prices getting out of reach resort to subprime and other adjustable-rate loans that start with low “teaser” rates allowing a person with a given income to qualify for a larger loan. After one, two or three years, rates reset by tracking an index of prevailing rates, causing monthly payments to rise.
Before issuing a mortgage, a lender requires that a property be appraised to assure that it is valuable enough to serve as collateral on the loan. Appraisers come under pressure from lenders and real estate agents to support the rapidly increasing home values, despite a growing belief that home prices are in a bubble.
Lenders Relax Standards
As home prices grow faster than incomes, it gets harder for borrowers to qualify for loans under traditional standards. To keep the volume of lending up, lenders gradually reduce down payment requirements from the traditional 10 percent of sales price to zero. They also stop requiring that borrowers prove they have enough income to make their loan payments.
Investors Seek Yield
With interest rates at unusually low levels, institutional investors — such as hedge funds, pension funds, endowments and insurers — hunt around for higher yields with investment-grade ratings. They are eager to buy securities backed by mortgages, since these pay more than U.S. Treasuries. Securities backed by subprime loans pay even more, since subprime borrowers are charged extra-high interest rates.
Securities Firms Comply
Banks and other securities firms such as Bear Stearns feed the yield-hungry investors by repackaging mortgages into mortgage-backed securities offering generous yields. Through this process of securitization, the mortgage lenders’ risk is passed on to investors around the world.
Ratings Agencies Help
Ratings agencies work with mortgage issuers, such as banks and other lenders, and loan packagers to find innovative ways to give investment-grade ratings to risky mortgage-backed securities. While ratings involve an assessment of the chance that borrowers will default, there is little track record for gauging this risk with the new types of securities, so ratings agencies and other participants rely on theoretical computer models.
Interest Rates Rise
As rates go up, resets cause monthly payments on adjustable-rate mortgages to soar, reaching levels many homeowners cannot afford.
Home Prices Fall
Higher interest rates mean a borrower with a given income must settle for a smaller mortgage. As fewer people qualify for big loans, home prices begin to drop.
Borrowers in Trouble
Rising interest rates push up monthly payments on adjustable-rate mortgages, and growing numbers of homeowners fall behind in payments.
Securities Lose Value
The growing mortgage delinquency rate exceeds expectations in the computer models, causing prices of mortgage-backed securities to plummet. Financial institutions that invested in them suffer enormous losses.
Credit Markets Freeze
Financial-market participants worry that institutions losing money on mortgage securities – the list includes investment houses and large institutional investors – may be forced to sell securities based on other types of debt, such as bonds, to raise money. That would cause a flood of supply that would depress prices. Investors thus become leery of all types of debt securities, causing prices to drop and making some nearly impossible to trade.
The Economy Slows
As it becomes harder for individuals and companies to borrow, economic activity slows. The economy heads toward recession.
Homeowner Feels Impact
Growing numbers of homeowners find they cannot afford their higher mortgage payments, and many discover their homes are no longer worth what they owe on their mortgages. As the economy weakens, unemployment rises. More and more homeowners fall behind in mortgage payments and enter the foreclosure process. They lose their homes, their jobs, or both.
Credit Markets Freeze
Financial-market participants worry that institutions losing money on mortgage securities may be forced to sell other types of securities to raise money. That would cause a flood of supply that would depress prices. Investors thus become leery of all types of debt securities, causing prices to drop and making some securities nearly impossible to trade.