The Crash
What lead to the crash?
The main proponent of what lead to the crash of the housing market and the financial system in 2007 relates directly back to rising housing prices and actions taken as a result of this. As discussed earlier, the trend of rising housing prices for the decade or so leading up to the crash led Americans to believe that housing prices would continue to appreciate indefinitely into the future. As the graph below illustrates, this is certainly true up to mid 2005. However, the sudden downturn in housing prices that began to occur in late 2005 and early 2006 will eventually spell disaster for the American economy.
Due to the added equity in housing prices, many individuals began making poor decisions regarding home ownership and the transactions involved in such. People who were previously unable to obtain lines of credit, were suddenly given access to mortgages based on the notion that loan originators would be assured repayment in capital gains from housing appreciation if a subprime borrower defaulted. As is apparent in the graph below, subprime mortgage originations grew every year from 2001 to 2005. Additionally, the number of subprime mortgages that were securitized also grew both in volume and as a percentage of all outstanding subprime mortgages from 2001 to 2005. The implications of so many contracts with risk of default in the market will prove to be drastic for the economy and cause the severity of the crash to deepen.
At the same time housing prices began to decline in early 2006, many subprime borrowers were unable to make payments on their mortgage contracts, causing a world of hurt for the American economy. Not only did irresponsible lenders create questionable contracts, but it seems that all of the negative implications of various adjustable rate mortgages were coming to light. In essence, all that ARM's did was to further push out the date of default for risky borrowers. Unfortunately, all of this was coming to fruition at the same time housing prices began to decline, causing panic in the minds of all types of investors: households, banks, and investors alike.
What happens as a result of the crash?
With the crash in housing prices and the subsequent increase in default on mortgage loans, a world of financial hurt soon became a reality for the American people. Homeowners who rely on the added equity in their property began to feel financial losses. This is due mostly to the fact that many households began living well outside of their means. They began taking on more and more expenses with the confidence that they would be able to settle all balances after they had sold their home property for a price higher than they purchased it. Because rising housing prices was no longer the case, individuals began to see their financial security vanish almost instantly. Additionally, banks took significant hits to their balance sheets as a result of the aforementioned factors. With the increase in mortgage defaults, banks had enormous amounts of outstanding loans that were never to be repaid. In normal times, this may have not been all that bad, as banks could foreclose on defaulted properties. However, with the drop in housing prices, the acquisition of depreciated properties is hardly ideal. Not only were the properties worth less that previously anticipated (banks would have to sell properties for lower values), but with the drop in housing prices came the collapse of the housing market itself. Banks simply were unable to sell off these properties, even at undervalued prices. As a result, they had massive amounts of outstanding debt contracts and unsellable properties on their books.
The final group to get hit by this mess is investment banks and individual investors themselves. Because all types of investors began purchasing Mortgage Backed Securities leading up to the crash, many were left unscathed. As we have already discussed, most did not know the compositional makeup of these various securities when purchasing them, or all of the risks involved. With the rampant increase of default on mortgages and the decline in housing prices, these risks became a reality. Because borrowers were no longer making payments, securities that included these subprime borrowers drastically declined in value. Individuals who invested in these securities rely on the amortizing cash flows that are to be had from monthly mortgage payments. As we can see, without a constant stream of payments form the various borrowers, these securities essentially become worthless and obsolete. As we can see in the graph above, cumulative losses on the popular G SAMP Trust 2006-NC2 increase as time goes on. This alludes to the points we made earlier: 1.) the longer a loan is outstanding, the more it is in risk of default, and 2.) adjustable rate mortgages simply defer the time of default further into the future.