We are a commune of inquiring, skeptical, politically centrist, capitalist, anglophile, traditionalist New England Yankee humans, humanoids, and animals with many interests beyond and above politics. Each of us has had a high-school education (or GED), but all had ADD so didn't pay attention very well, especially the dogs. Each one of us does "try my best to be just like I am," and none of us enjoys working for others, including for Maggie, from whom we receive neither a nickel nor a dime. Freedom from nags, cranks, government, do-gooders, control-freaks and idiots is all that we ask for.
Following the 2,000 Dot Com crash, then Fed Chair Alan Greenspan brought Fed Funds rates down to ultra-low levels. Under 2% for 3 years, and 1% for more than a year.
Rates this low — and for that long — were simply unprecedented. They wreaked havoc with the traditional fixed income market. Bond managers scrambled for yield, and found it in investment grade, triple A rated residential mortgage-backed securities (RMBS). This better interest rate was created by securitizing mortgages with an unhealthy slug of higher yielding, riskier, sub-prime mortgages.
The demand for RMBS paper was nearly insatiable. Wall Street sucked up as much sub-prime paper as could be legitimately, then illegitimately produced. Lend-to-securitize-nonbank mortgage writers responded to the demand by abdicating traditional lending standards. 30 year mortgages were given to people who in no conceivable way could afford them. The hope was a non-default over the warranty period of the mortgage, typically 90 or 180 days.
The Greenspan Fed, in charge of supervising financial lending institutions, looked the other way.
The net result of this was a credit bubble and a housing boom. (A true housing bubble formed only in a handful of places). The credit bubble allowed 10s of millions of Americans to become, albeit temporarily, home owners.
In 1992, some 4 million homes per year were being purchased. A decade later, that number had risen 25% to 5 million. A mere 3 years later, annual sales were 7 million units — a 40% increase. From 2002 to 2007, the abdication of lending standards — who cares about credit scores, incomes, debt load, assets, even job! — created millions of new homeowners. And thanks to the ultra low rates, prices had exploded. The combination of brand new, unsophisticated buyers and rapidly rising prices was a dangerous combination.
Buyers of limited financial means who en masse overpaid for their houses at ultra low rates was a recipe for disaster. The Fed began its cyclical tightening, price appreciation slowed, then reversed. Sales plummeted, and prices fell. Five million of those buyers were foreclosed upon, with another 5 million likely to come.
The income-less borrowers could afford the mortgage because they could always refinance at their home's new higher price when the higher payments started. They'd have had income equal to the equity increase.
So the collateralized securities are really a bet on rising house prices, the income of the borrowers not actually mattering.
They traded, though, on the historical default rates for mortgages and a faulty statistical model (that defaults are independent events).
Actually I think Fannie and Freddie looked at the effect of a price plunge of 20% in the 80s and decided not to abandon the 20% down mortgage standard; but went into subprime after the Wall Street competition started making money on them.
This version of the story carefully avoids political cause and effect. The credit boom depended on the political decision to have Fannie and Freddie guarantee loans whose numbers and risk factors didn't work - thereby skewing free-market corrections.
Ben-David ... I hazard a guess that you aren't going back far enough in our history when you seek the original cause of our mortgage foreclosure difficulties. Hark back to the 1970s [1978, I think] and the Democrat proposed and passed the Community Reinvestment Act, which tried to satisfy the Liberal meme that everybody ought to own their own home, even if they didn't have the money to pay for it or the smarts to take care of it. During President Clinton's presidency, the Act was modified and enlarged to include damn near everyone who wasn't living on a street corner or a subway grating.
The Democrats own this stupid decision and resulting crisis. Grown-ups have learned that you can't own what you can't pay for, and if you make $40,000 a year, you shouldn't even try to buy a $300,000 house, because you won't be able to keep up the payments.