How did this housing crisis happen?
In any crisis situation it is difficult to point to one cause. The same is true with housing market. Here are some possible causes of the housing crisis:
In the last 5 years, there have been a lot of irresponsible loans - exotic mortgages with negative amortization, interest-only loans, and adjustable rate mortgages. The increase and easy access to this credit caused a boom in the housing market and properties began to appreciate. As a result of the increase in value, people began withdrawing money from the equity in their homes through equity lines and other types of loans where people would re-finance their homes and use the money to pay off credit cards, improve their home, take vacations, etc. That mortgage equity extraction that occurred caused the housing market to appreciate to a point where it was no longer sustainable.
The Pay-Option ARM
The Pay Option ARM gave the borrower a choice at the end of every month of making 3 payments:
- Principle and Interest
- Interest Only
- A Payment amounting to less than Interest-Only
The Problem: People were getting approved on the lowest of the 3 payments which automatically put them in a losing position unless their homes continued to appreciate. Which now, looking back in hindsight, obviously didn't happen. These Pay Option ARMS are now adjusting and in turn are presenting huge payments to the borrower compared to their initial low rate. Experts predict over 8 million foreclosures coming from ARM loans in 2010-2011 from homeowners who started these loans within the last 5 years.
Credit MentalityAccording to the Federal Reserve Bank, 40% of American families spend more than they earn. The buy now / pay later mentality of Americans has greatly contributed to the idea of living the "American Dream." In 2009, Americans owed $917 billion on revolving credit lines and $69 billion of that debt was past due. While many people going through pre-foreclosure are there largely because of a change in their income or unexpected emergencies, the trend of buying homes that are too much of a financial risk is largely due to this credit mentality.
Legal / Political Initiatives
The Community Reinvestment Act (or CRA, Pub.L. 95-128, title VIII, 91 Stat. 1147, 12 U.S.C. § 2901 et seq.), first issued in 1977, was a United States federal law requiring banks and lenders to offer credit throughout their entire market area - prohibiting them from targeting wealthy neighborhoods for lending while ignoring poorer communities. The purpose of the CRA was to provide credit, including home ownership opportunities to underserved communities and small businesses. The Clinton administration, in 1995, brought back attention to this act and strengthened its impact so poorer citizens and small businesses could afford their own properties. In 2002, the act was revisited and generous rules benefiting the Federal Home Loan Mortgage Corporation (Freddie Mac) were enacted - allowing it to issue loans while only having 2.5% of the amount in actual capital (instead of the normal 10% required for banks). By 2007, Fannie Mae and Freddie Mac owned or guaranteed nearly half of the $12 trillion U.S. mortgage market. Thus leading to the our problems today of having so much debt not backed by actual cash - leading, undoubtedly, to a crash.