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.
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.
The U.S. government just gave first-time homebuyers and other budget-minded house shoppers a big boost with a sweeping rule change that provides federal backing to mortgages with down payments as low as 3 percent. The change manifests in two parallel programs: Fannie Mae’s My Community Mortgage and Freddie Mac’s Home Possible Advantage.
The programs both offer fixed-rate loans for candidates’ primary residences. My Community Mortgage, which opened to buyers and owners in early December, offers loans to applicants with credit scores as low as 620. Its refinancing component will initially be limited to candidates who currently hold Fannie mortgages. Home Possible Advantage, which begins in March, may be open to buyers with even lower credit scores and includes a no-cash-out refinancing program open to all mortgage holders, not just current Freddie customers. It also doesn’t establish a hard credit score floor for purchase loans, broadening the pool of potential borrowers.
First time buying a home? You just got a huge boost from the U.S. government
These programs represent the government’s latest effort to assist first time homebuyers and other qualified borrowers to enter the market and become homeowners, but they’re not exactly groundbreaking. Private companies like Prospect Mortgage, a leading national independent mortgage banker led by Fannie Mae veteran (and former CEO) Michael Williams, have offered HUD eligible purchase and refinancing products with low down payments for years.
During Williams’ tenure, Fannie Mae faced down an existential crisis—the quarter prior to his tenure saw a shocking loss of more than $23 billion—and emerged with its strongest balance sheet and loan pipeline in years. After serving as Board Chairman for over a year, Mr. Williams took on the additional role of CEO at Prospect Mortgage in mid-2014) shortly after returning Fannie to a $5 billion quarterly profit, cementing his reputation as a fearless reformer.
The new Fannie and Freddie programs build on the foundation Mr. Williams laid during his tenure as Fannie CEO. Both promise to reduce barriers to entry for first time homebuyers currently priced out of the housing market.
Despite surging profits at Fannie and Freddie, the housing market recovery remains patchy, disproportionately favoring higher-income buyers and those who already own a home. According to the New York Times, the U.S. homeownership rate currently sits near 64 percent, a multi-year low. And first time homebuyers make up just 29 percent of the pool of prospective buyers, far below the 40 percent historic average.
Structural factors, such as stagnating wage growth at the lower end of the income scale, account for some of the discrepancy. But other factors, including traditional mortgage issuers’ overly strict lending criteria and onerous down payment requirements for first-time buyers and refinancing candidates, are a direct legacy of the recent housing bust.
My Community Mortgage and Home Possible Advantage could significantly improve buyer access at the lower end of the income scale, though experts are divided on just how much help they’ll provide. And Andres Carbacho-Burgos, a respected Moody’s economist, warned that any broadening of access would have to be accompanied by a renewed focus on mortgage monitoring and buyer counseling programs to safeguard against a rise in default rates.
Visit Fannie Mae and Freddie Mac online to learn more about their respective programs for first time homebuyers and refinancing candidates.
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