Credit Mess - Part 3

Of course, all of the problems that are being experienced in the lofty world of high finance come from very concrete root problems. So, this time, I wanted to discuss the very foundation of the recent troubles.

After 2001, the Federal Reserve lowered interest rates to 1%. This is ridiculously low, since inflation runs around 2.5%. Now, a lower interest rate could mean a lower house payment, but many people buy houses by asking the question, "How much house can I afford?" And they answer the question in terms of a monthly payment, which means that with a lower interest rate the same monthly payment can by more. So, people spent more, and more people spent.

This surge in demand, and the ability of people to pay more for a house, started a housing boom. A few years in, houses were going up faster and faster. People began to buy investment properties, either to rent or to "flip" (which is when you sell after holding for a short period of time), which added even more demand and drove prices even higher.

When people started to worry that houses historically have pretty much just kept up with inflation, and might be overvalued, others pointed out that the median U.S. house price hadn't fallen since the 1930's in the Great Depression. We weren't in a depression, so the party kept on going.

Everyone was getting rich. The mortgage brokers, the folks who actually help you fill out the paperwork and find a lender for you, were getting lots of fee income. So were the realtors, and the appraisers, and the inspectors, and everyone else involved.

Soon, the boom had exhausted the "normal" market, everyone who wanted a house had one. Mostly the folks who were left were not the sort that usually get loans, but after a boom period, expectations rise. The extraordinary becomes the routine, and there is great pressure to keep the good times rolling. What to do?

The list of things done ranges from stupid to fraudulent. Among them were loans called "NINJAS", which stands for "No INcome Job or Assets". Some lenders asked borrowers to sign the bottom of blank paperwork, and the numbers for income, house value, etc. were filled in later so the loan would go through. People were given loans not just for the price of the house, but for 120% of the price of the house, because it would surely go up another 20% and people "need" cash to furnish their homes. People signed up for adjustable rate mortgages (or ARMs) which start out with really low teaser rates, but a few years later "reset" to a much nastier one (which is happening now). And, appraisers valued homes well above their real value to justify larger loans.

All this is just the beginning of the story, because these irresponsible behaviors led to a whole host of other problems that I'll discuss shortly.