The causes of this ‘great recession’ we are in is quite a confusing topic for the vast majority of people, which is unfortunate, because it affects so many people, so directly.
One of the key factors leading to the stock market crash in late 2008 was the crash of the American Real Estate Market that preceded it in the spring of 2007; however, as of mid 2011, this downward trend has been continuing.
How did this all happen? Everything was so rosy in 2007. So rosy in fact that banks had absolute certainty that everyone would be able to repay their debts. So certain that they were offering ANYONE a loan.
An unfortunate consequence of the psychology of business is the longer and more consistent a period of economic stability, the more certain people become that this trend will continue in the future. A common statistical measure in the financial world is ‘Maximum Drawdown’ in the past 5 years, 10 years, or 20 years. Because if nothing horrible has happened in the last 20 years of data (a huge data set when using daily data), analysts would argue there is virtual certainty that nothing horrible will happen in the future.
Back to the major culprit of the real estate crash. The worst of the loan products issued by major banks was a popular contract called the ‘2 / 28 Adjustable Rate Subprime Mortgage.’
A few significant details about this product include:
- No money down
- The loan funded all of the property
- The first 2 years of the agreement had below-market teaser interest rates, which later increased
- Optional full interest payments (possibly leading to negative amortization)
Because of these attractive contract details, these products served as the most popular mortgage agreements for Americans with bad credit pre-2008 (the sub-prime market).
This essentially served as a call-option on the value of the home, except with no premium cost. Where there would be no downside risk to the borrower, but a lot of upside potential.
The lack of downside risk is because there are no upfront costs, and meagre interest requirements in the first two years. Additionally, in the event that housing prices fall, there is no incentive for the borrower to continue making payments, so the borrower would simply discontinue the mortgage agreement.
However, there is great upside potential, because if the housing prices increase, the borrower can cash in on the appreciation by selling the home. This produces a great return due to the insignificant capital requirement to produce these high payoffs, leading to some substantial consumer leverage.
Who would be stupid enough to create these subprime loans?
The answer is many of the biggest banks in America. A financial system, which at the time, had criticized the rest of the world’s tight credit rules. To the Americans, a tighter credit system implied a stunting of a nation’s growth potential. However in hindsight, tighter credit rules in the USA would have let their economy hit the sides on its way down, instead of a straight free fall.
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