Financial Crisis 101: Housing bubbles, interest rates and bailouts

This article is the first in a two-part series on the ongoing financial crisis on Wall Street. Today’s piece will focus on the underlying causes of the problem; Monday’s piece will examine the proposed government bailout plan and the implications of the crisis as a whole. Click here to read part 2.

Wednesday night, President George W. Bush gave a dire and surprisingly direct warning to Americans in a televised address: Without action, he said, the nation’s economy is in danger.

It was the culmination of what have been a tense year and a harrowing week on Wall Street, with several major financial institutions collapsing in just a few days time. Last week saw the demise of Lehman Brothers, a major investment bank with holdings across the world, and the rushed sale of investment firm Merrill Lynch to the Bank of America. That night, the insurance company AIG came so close to floundering that the federal government stepped in to prevent its complete collapse.

But while the financial tumult has dominated front pages and water-cooler conversations alike for the past week, its causes and implications escape many Americans whose lives are far removed from hedge funds, interest rates and the high-risk investments of Wall Street.

So what exactly happened? Why is America in the midst of a “serious financial crisis,” as Bush told the nation Wednesday night?

According to Tufts’ economic experts, the situation stems from a web of complicated and interconnected factors — some that were foreseeable and some that weren’t — that put America’s financial intuitions at serious risk.

Hear more about this topic on this week’s epsiode of Tufts Daily Radio. Click here>>

A ‘mispricing of risk’

Boiled down to their simplest form, the financial problems originated from what Professor Enrico Spolaore, the chair of the economics department, called a “mis-pricing of risk.” As housing prices began increasing steadily several years ago, a phenomenon known as the “housing bubble,” large institutions began investing in risky loans to people who wanted to buy property, but didn’t have the means to do so.

The idea, he said, was that each property’s value would increase, allowing the borrower to pay back the loan and a large amount of interest. That system began collapsing in 2006 when real estate prices began to drop, rather than rise.

“Sometimes, people talk about the sub-prime mortgage crisis, because a lot of these mortgages were made to people with poor credit,” Spolaore said. “But the problem is even broader than that. There are also mortgages that are technically not ‘sub-prime,’ that also end up being made at conditions that would make them very hard to repay, especially after the houses stopped increasing in price.”

For example, some loans required low, virtually non-existent payments for several years, but then sharply increased interest rates later on — the idea being that borrowers would purchase a piece of property, live there for several years while their rates were low and then sell it for a profit before higher payments were required.

This process was made possible by a relatively new practice among lending companies of bundling thousands of loans into a package — known as a “security” — and selling it to investment firms like the Lehman Brothers. By combining risky loans with loans to more trustworthy borrowers, lending companies were able to lure investors into buying both types of loan, in the hope that, as a whole, the package would still increase in value.

“The basic idea was to package different types of loans so that even if some of the loans went bad, the overall package could still be profitable — as long as too many of the individual loans didn’t go bad,” said John Straub, an economics professor who specializes in econometrics, in an e-mail to the Daily. “Too many of the individual loans have been going bad.”

Spolaore explained that this approach — the idea of selling bundled loans — is a relatively new one.

“For many decades, typically the people who would lend you the money would be a bank that would also take over the risk; if you cannot make your mortgage payment, the institution lending you the money would also suffer,” Spolaore said. “But over the past 20 years, there’s been a process … so that, instead of holding the mortgage and taking the risk, typically the institution that lends you the mortgage would be able to sell the mortgage to somebody else, and then this would [go] into a security.”

But because bundled mortgages are complex — loans made to many different people with different means to pay them back — their value was hard to assess, according to Spolaore.

“And as you begin to create a bigger and bigger gap between the actual mortgage and the financial instrument, it seems that along the way, all of these people involved … lost a complete sense of what was really the underlying risk and value of the security,” he said. “So essentially it was a mispricing of risk — a misevaluation of risk.”

Bursting investors’ bubbles

From the mid-1990s to the fall of 2006, housing prices in the United States rose quickly and steadily. But in the past two years, some real-estate values in key markets, like parts of Florida and California, have begun to drop.

The result, according to Straub, has been a sharp increase in the number of homeowners who are incapable of paying their mortgage loans — a phenomenon that results in the lender seizing the house itself, which is known as foreclosure.

“Housing prices have not tended to increase over the last year or so — indeed they have declined in most markets,” Straub said. “A large number of sub-prime mortgages have gone into default. The result is a large number of foreclosures which means that banks are now in possession of a large number of homes which they are trying to sell. Since the current value of the homes is lower than the amount of money owed to the bank, the banks are losing money.”

This problem extends beyond the banks that initially sold the mortgages, however. Because so many mortgages have been purchased by investment companies, companies like Merrill Lynch and the Lehman Brothers were decimated when large percentages of their bundled loans were not being paid back.

“If people had kept paying their mortgages everything would have been fine,” Spolaore said. “But people stopped paying their mortgages because borrowers themselves were not completely aware, or were kind of deluding themselves into thinking they could purchase houses that were much bigger and more expensive compared to their income.

“The underlying hope by the borrowers, maybe by the lenders, was that the price of houses would keep going up,” he continued. “It went up until 2006, and then it collapsed.”

The result has been a sharp decrease in the value of many assets owned by investment banks and holding companies. According to Associate Professor of Economics Edward Kutsoati, that decline has left investors panicked.

“[At first] no one was certain and the extent of the damage wasn’t clear, and how fast collateral was falling wasn’t clear,” he said. “If you have a home for $600,000, and that’s in the asset division of your ballot sheet, and then it sinks to $550,000, and then $400,000, each reduction in the asset value creates the lack of confidence and the uncertainty that the problem is much bigger than that.”

As a result, many investors began backing out of investments from firms that owned large bundles of real estate loans — and the prices of those investments dropped vastly. The firms themselves lacked the money to pay back so many investors at the same time.

“The final thing that tends to collapse everything is if everybody says, ‘I want my money. I’m going to buy gold. I want my money,’ ” Kutsoati said.

Any financial institution, according to Kutsoati, relies on two key factors: trust and confidence. Consumers must have both in order for the market to remain stable.

“Suppose I enter FoodMaster and pick a whole lot of groceries … and I’m walking up to the cash register, and I produce a card. I have [the cashier] swipe the card, and I punch in a number and walk out with some groceries,” he said. “They have to be confident that the card would have some money … They have to trust that it is actually true that there is money that will flow into their account, and they will be paid.”

According to Kutsoati, the same principle applies to the financial market: When investors begin to lose confidence in their investments and trust in the institutions that hold them, they naturally attempt to remove their money from the market.

He gave the example of a friend of his who works at State Street Corporation, an investment company. When rumors began to swirl last week that large investors would be removing their money from the firm, its stock price began to dip.

“The market opens [at] 9:30 [a.m.], and by noon State Street has dropped from 69 a share to 44 a share,” Kutsoati said. “He goes to lunch, he comes back, State Street is sitting at 32 a share. After 30 minutes, it’s at 29 a share. And then they put out a statement to deny all of the rumors, and in two hours, between 2:30 and 4:30, State Street recovers to 59.”

According to Kutsoati, this is a perfect example of how investors’ confidence can severely dictate the financial markets. When the conventional wisdom began doubting the value of mortgages and home investments, investors’ confidence dropped severely.

“Such news, in times of uncertainty, is what you need to get all of the dominoes to fall,” Kutsoati said.