Finance and capital markets
Housing conundrum (part 4)
The virtuous circle of housing price appreciation making defaults go down making lending lax making housing appreciate even more. Created by Sal Khan.
Want to join the conversation?
- How does financing becoming easier cause house prices to go up?(6 votes)
- If housing prices routinely go up, a homeowner won't have to default on their loan if they can't pay it. Instead, they can simply sell their home (since the price of their home went up) and pay the bank its due in full.
Since the housing market became a surreal environment where everyone's homes were increasing in value at shockingly fast rates, the banks had little reason to deny providing a loan. If banks have good reason to assume that all their debtors will be able to repay what they were loaned, they will lower their standards for who they will loan to. Thus, financing becomes easier.(13 votes)
- Sal, you explain WHAT happened, but not WHY it happened
The Chinese want their currency to be cheap so that their exports are cheap. In order to make the yuan cheap they sell yuan and buy dollars. When they buy dollars they buy US Treasuries. This artificial buying of Treasuries drives interest rates down in the US and creates excess liquidity. The Fed could have counted this buying of Treasuries with their own selling of Treasuries to sop up the excess liquidity, but they did not.(3 votes)
- They didn't do it, because if I can get money on low interest rates, I can sell the money for high interest rates. Why should I give the money back? And the Fed is the institution where US Banks get their money from. And low interest rates are good for driving investements in the economy.
In short: China buys for 0.5% interest to Fed, Fed sells for 1% interest to banks, banks sell for 1.5% to companies. --> Cheap money for the US economy --> This is/was driving the economical growth.
It's your choice to believe this is working^^
Plus: Buying up your treasuries could create deflation which is bad for export, but this goes to far for now^^(4 votes)
- So why did the price for a house and the appreciation value fall in 2006?
Did people stop buying houses or were the standards raised for who
can buy loans?(3 votes)
- This can be looked at from both sides. On the demand side, there's only so many people willing to buy homes. Once credit has been extended to all, there's no more buyers left to bid up the prices, and the home prices stabilize. Then, when borrowers default, foreclosures happen, the investors lose money, and the whole thing comes crashing down. On the supply side, this whole thing is driven by investors. If the investors get cold feet and stop investing in these loans, that will cause a crash too(2 votes)
- what did Sal means with "Default rates go down" at3:40? what is Default Rates mean??
and what is "Perceived lending risk go down" at4:14? what is perceived lending risk mean??(2 votes)
- Default rates show what percentage of the loans the people can't pay back. Perceived lending risk is in connection with that, if there are fewer people who fail to pay back their loan, it's less risky to give loans.(3 votes)
- Aren't you missing the point, Kahn? The reason lending was lowered wans't because of all the trading between investment and commercial banks occurred. You are missing true causality in this instance. The true cause for low standards was Fannie and Freddie's willingness -- due to a quota from Congress -- to finance at least 42 percent of their loans to Community Reinvestment Act loans i.e. low income individuals. This was the first domino...the rest of was reaction to the initial gov't guarantee(0 votes)
- IMO I would agree that this was one of the first dominos, but what set the whole thing tumbling was not just the securitization of these mortgages but the fact that many of the big banks were given the thumbs up to use massive leverage to trade derivatives in these vehicles. Then, to hedge themselves, they were allowed to buy insurance swaps on leverage, which theoretically hedged their exposure. Except that so many banks traded these darn things on leverage that there was not even close to enough reserves to insure these losses if more than just a small percentage of these mortgages defaulted. When they started defaulting in large numbers, because all demand (especially artificial) will eventually taper off, the shortfall in insurance exposed that these claims couldn't be paid. So to lower risk the owners of all this garbage tried to dump these derivative vehicles, which destroyed that market with everyone headed for the exits at once and led to them now becoming the infamous toxic assets that couldn't be marked to market because there was no market! My understanding is that previous leverage amounts the banks could use was limited to 8x to 10x but that was ramped up to 30x and even 40x for some of the biggest banks in about 2003. THAT is what led to all the dominos tumbling. If it was limited to foreclosures on paper related to just Community Reinvestment Act loans, without all the derivative trading on leverage, it wouldn't have been that big of a problem. Also, the majority of people buying mortgages during this time, in my experience, were not low income individuals but rather the middle class of this country who saw easy money and an early retirement in buying and flipping properties.(6 votes)
- When would this cycle start to collapse?(2 votes)
- basically , from what i'm able to understand that the start of collapse was when in 2005 a no. of adjustable mortgages were maturing and the subprime borrowers inability to refinance their loan, was the actual time when it began to reverse and as andrew stated it reversed very quickly leading to a crisis no one could stop.(1 vote)
- what about people who did pay off the mortgage? were they packaged in the MBS and CDOs too?(2 votes)
- What does it mean when Sal says Default Loans.(2 votes)
- Default Loans typically means a loan that wasn't paid back. The company/person loaned money to the home owner, but the home owner was unable/unwilling to pay back the loan.(0 votes)
- did not the govt encourage and become part of the process of causing financial criteria to buy a home to decrease-did not Barney Frank and Clinton have a meaningful part?Did they not have Fannie/Freddie lower criteria(1 vote)
- Both parties played their part in this whole fiasco. If we view this from a partisan perspective it will divide us when what we need to do is hold all our leaders accountable to We The People - All of Us!(1 vote)
- Correction: Where is Housing Conundrum #5 that you refer to in #4?(1 vote)
- mortgage-backed securities is the next video(1 vote)
I'll now explain to you why, from 2000 to 2005, we had very low defaults on mortgages. Let's say that I buy a house for $1 million. I buy a $1 million house. So let's say the bank gives me $1 million. And then I'm willing to pay a percentage on it. So this is from the bank. This is me. And I use that to buy a house. I don't know if these diagrams help you. But you get the general idea. And the bank does that. And let's say, I don't know, a year later I lose my job. I just can't pay this mortgage anymore. So I have a couple of options. I can either sell the house and pay off the debt, or I guess I could just tell the bank, well I can't do anything, and I'm going to foreclose. And that would ruin my credit. It would hurt my credit. And I would lose all my down payment. So what are the circumstances that I can sell the house? Well, if I borrowed $1 million, as long as-- and let's say I didn't put any money down, just for simplicity. If I can sell the house for $1.1 million, well I would do it, right? Let me sell for $1.1 million. If I sell for $1.1 million, I pay the bank-- let me switch colors. I pay the bank $1 million, and I net $100,000. And everyone's happy. The bank got their money back, so they didn't lose any money on the transaction. I made $100,000. And so the whole reason why this worked out, even though maybe I was a credit risk, is because the housing prices went up. So when you have rising housing prices, the banks will not lose money lending you. Because if you can't pay, you just give back the house, the bank can sell it. Or, you won't even give back the house. You'll sell the house and you'll pay it off, even though you can't pay the mortgage anymore. The only situation where I would foreclose is if the market price of the house goes less than my loan. And that's actually the situation that we're facing now. So if, let's say that I can only sell this house for $900,000. Well, then I'm just going to give the keys back to the bank. That's actually called jingle mail, because you just mail the keys back. And then the bank sells the house for $900,000. And then they would take a loss. So when housing prices go down, that's the only situation where really you should have foreclosure. When housing prices soon. go up, the person who borrowed it is just going to sell the house and pay off the loan. And they are actually probably going to make some money. So there was every incentive to buy a house. So let's think about this whole dynamic over the last several videos that we've been building. So we said, from 2000 to 2004 housing prices went up. Let me do it like this. Let me change it a little bit. We can even say, from 2000 to 2006. So we know that housing prices went up. And why did why did housing prices go up? Well, we saw the data. It wasn't because people were earning more. It wasn't because the unemployment rate went down. It wasn't because the population increased. It wasn't because the supply of houses were limited. We disproved all that. We realize it was just because financing got easier. The standards for getting a loan went lower and lower. Financing got easier and easier. And because housing prices went up, what did that cause? We just said when housing prices go up, default rates go down. You could give a loan to someone who's a complete deadbeat. But as long as housing prices go up, if they lose their job, they can still sell that house and pay you back the loan. So housing prices going up makes sure there's no foreclosure, so defaults go down. So then the perceived risk goes down, of lending. Perceived lending risk goes down. So that makes more people willing to lend. And the corollary of more people willing to lend, is you that the actual standards go down. That's financing easier. We could actually write that. Standards go down. So you had this whole-- I guess you could argue whether this is a negative or a positive cycle. But you had this whole cycle occurring from the late '90s, but especially, it really got a lot of momentum at around 2001, 2002, 2003. That financing got easier, despite the fact that people were earning less, population wasn't increasing that fast, that there were all of these new houses. And that caused housing prices to go up. Housing prices went up, then we had a lot fewer people defaulting on their loans. No one would default on their loans if they could sell it for more than the loan. Then a lot more people said, well these are super safe. And so the ratings agencies, Standard and Poor's and Moody's, were willing to give AAA ratings to more and more, what I would argue, are risky loans. So the perceived lending risk went down. Then more and more people liked this asset class. They said, wow, this is great. I can get a better return than I can get in a bank, or in Treasuries, or in a whole set of securities, even though these are very low-risk or perceived low-risk. So I want to funnel more and more money in here. And so the mortgage brokers and the investment banks said great, the only way we can get more volume to satisfy all these people who want to lend money-- the only way we can find more people to lend money to, is by lowering the standards. And this cycle went round and round and round. And it really started because this whole process of being able to take a bunch of people's mortgages together, package them up, and then turn them into securities and then sell them to a bunch of investors-- this was a quote-unquote innovation in the mid-'90s, or early '90s. I forgot exactly when. And it really started to take steam in the early part of this decade. So that's essentially why housing prices went up. And why kind of all of this silliness happened. And in the next video, I'll talk a little bit more about maybe who some of these investors were. And I'll tell you what a common hedge fund technique. And I think it's very important not to group all hedge funds together. There are some good ones. But what a common hedge fund technique was, to take advantage of this virtual cycle, to make the hedge fund founders very wealthy. I'll see