By now, you’ll have heard of the Financial Crisis of 2007 to 2008. Financial crises are rarely caused by one thing. They are usually a culmination of several things. For example, the main reasons for this crisis were the stock market crash and the housing market crash. Why did the housing market crash occur? Here is what you need to know.
The Players
In the beginning, there were three leading players in the housing market. There was the homeowner who wanted to buy a home, the bank which lent the homeowner the money to buy the house, and investors with a lot of money who wanted to invest in an asset or assets that had high returns. The general assumption was that the price of homes was and would always be going up.
Then, what went wrong when the housing market crash happened?
Home Owners Borrowed from a Bank
When the average citizen decided that they wanted to become a homeowner, they saved the amount needed for the down payment and found a home they liked. They then approached a bank that would be willing to lend them money to buy the house. For the bank to have the money to lend to homeowners, they had to take loans from federal reserves. They paid them through the interest rates on the mortgages. Initially, the banks only offered loans to prime borrowers. They had good credit, proof of income and proved that they would pay back the money they borrowed.
Investment Banks Bought Loans from Banks
Investment banks approached the banks about buying the mortgages from them. The banks agreed to this because it transferred most of the risk to the investors. The investment banks took loans and bought many mortgages from the banks. Banks used this money to pay off part of their loans. The investment banks then package the mortgages into structured products called collateralized debt obligation, which they sold to investors. They were sold in slices to investors with different risk appetites.
Banks Started Giving Loans to Subprime Home Buyers
There were no more prime buyers; therefore, the banks started giving loans to subprime home buyers. They had bad credit, no proof of income and sometimes no papers. The idea was that if a person defaulted on their payments, they could sell the house again to someone else. However, more and more people – particularly the subprime buyers – were unable to pay their premiums; therefore, more and more homes become foreclosed.
Houses Foreclosed, House Prices Fell
With more houses foreclosing, the supply for houses began to exceed the demand. This consequently led to the fall in prices of the homes. When prime buyers saw these lower prices, they saw no value in paying premiums for overpriced houses, and they too stopped paying their premiums. Now, investment banks had CDOs they would like to sell off to investors who don’t want to buy. Banks also had mortgages they wanted to sell to investment bankers who didn’t want anymore.
Banks and Investment Banks Went Bankrupt
A crash occurred because banks and investment banks could no longer pay the money they owed and declare bankruptcy. The investors informed the homeowners that they had no money to pay them back as the value of the assets had dropped, and the investment banks could not pay them back. In the end, a lot of people lost their money, people and institutions went bankrupt, and it was a while before the economy recovered.
