The first great financial crisis of the 21st century has begun. Nobel prize-winning economist Paul Krugman explains how it happened, and how it can be cured
Let's tell the tale.
The great US housing boom began to deflate in the autumn of 2005. As prices rose to the point where buying a home became out of reach for many Americans, sales began to slacken off. There was a hissing sound as air began to leak out of the bubble.
Yet house prices kept rising for a while. After an extended period during which prices had been rising sharply each year, sellers expected the trend to continue, so asking prices actually continued to rise even as sales dropped. By late spring 2006, however, the weakness of the market was starting to sink in. Prices began dropping, slowly at first, then with growing speed.
Even the gradual initial decline in house prices, however, undermined the assumptions on which the boom in subprime lending was based. Remember, the key rationale for this lending was the belief that it didn't really matter, from the lender's point of view, whether the borrower could actually make the mortgage payments: as long as home prices kept rising, troubled borrowers could always either refinance or pay off their mortgage by selling the house. As soon as prices started falling instead of rising, and houses became hard to sell, default rates began rising. And at that point another ugly truth became apparent: foreclosure isn't just a tragedy for the homeowners, it's a lousy deal for the lender. Between the time it takes to get a foreclosed home back on the market, the legal expenses, the degradation that tends to happen in vacant homes, and so on, creditors seizing a house from the borrower typically get back only part, say half, of the original value of the loan.
In that case, you might ask, why not make a deal with the current homeowner to reduce payments and avoid the costs of foreclosure? Well, for one thing, that also costs money, and it requires staff. And subprime loans were not, for the most part, made by banks that held on to the loans; they were made by loan originators, who quickly sold the loans to financial institutions, which, in turn, sliced and diced pools of mortgages into collateralised debt obligations (CDOs) sold to investors. The actual management of the loans was left to loan servicers, who had neither the resources nor, for the most part, the incentive to engage in loan restructuring. And one more thing: the complexity of the financial engineering that supported subprime lending, which left ownership of mortgages dispersed among many investors with claims of varying seniority, created formidable legal obstacles to any kind of debt forgiveness.
So restructuring was mostly out, leading to costly foreclosures. And this meant that securities backed by subprime mortgages turned into very bad investments as soon as the housing boom began to falter. By February 2007, the realisation sank in that the junior shares in CDOs were probably going to take serious losses, and prices of those shares plunged. By the end of the year, it became clear that nothing related to housing was safe - not senior shares, not even loans made to borrowers with good credit ratings who made substantial downpayments.
Why? Because of the sheer scale of the US housing bubble. Nationally, housing was probably overvalued by more than 50% by the summer of 2006, which meant that to eliminate the overvaluation, prices would have to fall by a third, and in some metropolitan areas by 50% or more.
http://www.guardian.co.uk/books/2008/dec/06/paul-krugman-financial-crisis-2008
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