The market's troubles began with rising defaults on subprime U.S. mortgages, home loans made to borrowers with questionable finances. Most of the problem loans were made toward the end of the housing bubble that ended around the beginning of this year, and defaults have been rising on those mortgages. Bonds backed by those mortgages, many of which were purchased by the lightly regulated investment vehicles known as hedge funds, have become difficult to trade, since their value is hard to calculate.
The problems in the mortgage market have also caused some of the companies that make the initial loans to fail and put others under severe financial pressure. With commercial banks linked to these problems in various ways, many investors have become wary of committing money to anything less safe than government bonds.
Basically, it boils down to poorly calculated risks -- by both lenders and borrowers.
First, let's explore what happened on the lenders' side, particularly with respect to subprime loans. Another article in Forbes from earlier in August discussed the bankruptcy of American Home Mortgage in the context of the subprime market in general:
The subprime sector boomed in the past two years as rising home prices prompted lenders to offer liberal mortgages for eager borrowers. Loans were issued with two-year teaser rates allowing borrowers with limited assets and income to buy homes that might have been beyond their means. The idea was that rising prices would permit borrowers to sell or refinance before their monthly payments rose. That strategy came undone when prices leveled off and interest rates increased, and subprime borrowers began defaulting on their loans.
Subprime lenders took a gamble that their credit-impaired borrowers would be able to make the low monthly payments at the initial rate, and then get out before the rates went up -- either by refinancing (with a lower fixed rate, having improved their credit score by making all of those payments on time) or by selling at a profit.
Some borrowers defaulted before the initial rate expired, in spite of the low monthly payments. And some borrowers defaulted when the rates went up, and they could neither refinance (certainly not at a fixed rate they could afford) nor could they sell at a profit. Either way, as the defaults accumulated, the lenders were left with rising debt. They couldn't finance more loans, and they couldn't collect on the ones they already had. Bankruptcy was the logical next step
(As a side note, large investment firms such as Goldman Sachs and UBS purchased bundles of these loans as investment securities, primarily in hedge funds. The demise of the lenders has had a ripple effect through these firms and other banks such as Chase and Citifinancial.)
Now let's see what happened to the borrowers. Caught up in the housing boom, homeowners saw an opportunity to get ahead. Conventional wisdom has always been to buy as much house as you can afford, because real estate typically appreciates. However, the proliferation of subprime lenders and lending practices often characterized as "predatory" -- lenders stretching the constraints of loan approval in order to increase profits -- meant that more people were buying more house than they could afford.
The lenders made poor business decisions by taking these risks, but the borrowers also made poor business decisions by accepting terms that they could not comfortably fulfill, particularly in the long-term when their rates would inevitably rise. Mortgage brokers have an obligation to act in good faith, but home buyers must take responsibility for educating themselves and assessing the level of risk they're willing to accept.
What will happen next? Unfortunately, there's no quick solution. The Federal Reserve has cut the discount rate (which helps lenders) and may cut the short-term interest rate (which will help consumers). But at the individual level, some homeowners have yet to see their mortgage rates rise; when they do, more defaults are expected, which will add to the number of homes on the market (as well as add to lender debt). Even those homeowners who have mortgage payments that they can easily make are at risk, for they would likely have a more difficult time selling their homes in the event of a change in their financial situation or a job-related move. Finally, those who are able to sell may very well take a loss, thanks to declining home values as a result of nearby defaults.
Just as in the dot-com stock boom, where day traders and venture capitalists alike rode the wave as long as they could, today's lenders and borrowers are starting to crash onto the shore. Some took calculated risks and profited well. Some got far too caught up in the promises and were left high and dry.
Julie is a former Air Force officer and professional project manager turned web writer. She spent four years at the Pentagon and five years in New York City, and her suburban life in Colorado seems pastoral by comparison. She's no political pundit, but she is an objective thinker in a sea of partisan propagandists. She writes for The Mom Slant, Cool Mom Picks, and is co-founder of The Parent Bloggers Network.
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