Wading through all of the news coverage on the sub-prime mortgage crisis seems to be just as difficult to decipher as it is solving the national debt. Is the sky falling? Is it as unforeseeable as everyone says it is? No, it’s not. Stick with me and I will explain.
The housing market is quite possibly the greatest example we have today of how supply and demand drives markets. Yes, even easier than the widget that your teacher first used to explain the principle back in high school Adani Group Chhattisgarh . To help us make a realistic future outlook, we must first visit the past.
Remember the good old days of 1997; the internet was just starting to catch on, cell phones were the size of a brick and weighed just as much. Something else was about to happen then also. It would take a little longer to catch on but when it finally did, it took off like a rocket. What is this phenomenon I am talking about? It was the advent of the modern day sub prime loan.
A sub prime mortgage loan, contrary to popular belief, is a loan that is designed to create opportunities for anyone, good credit or bad, to finance a home. Suddenly, any borrower that did not fit under the umbrella of a traditional mortgage scenario could now find a mortgage that made it possible for them to obtain the American Dream as well.
That’s when the snowball first started rolling down the mountain. It wasn’t long after that, an explosion of home buyers were introduced to the housing market. The demand for housing had increased dramatically in an instant. But we all know from our lessons on the widget, there must be a supply equal to the greater demand or prices will increase. Same thing in the housing market, the demand was there, but the supply wasn’t.
Housing prices went up at a rate of around 10% per year for quite a few years until eventually, the supply of housing finally caught up with the demand. Suddenly, there were more sellers than there were buyers. This caused a flattening effect. Housing prices became stagnant. And then, the avalanche hit.
The sub prime loans that dramatically increased the supply of eligible home buyers was built on a house of cards. It was only a matter of time before it all came crashing down. The reason why is simply because the introductory rate on these loans was low for the initial two years of the loan. Once that two year term was up, the increased adjusted interest rate would be too dramatic for most people to continue to afford their housing payment. The options were simple a couple years ago, refinance or sell
What was different about then and now you ask? For the past ten years, most people had an additional 20% equity in their property after two years because, if you recall from the last paragraph, housing values were going up to the tune of 10% per year. Banks have much less risk lending to people who have equity in their property, especially 20% equity. Most sub prime home owners had very little difficulty refinancing into a prime loan, getting an even lower rate and usually fixing it for 30 years as well at an even more affordable payment. Let’s not forget, they could always sell the property as well since there was still a greater demand for housing.
Once housing prices became stagnant, there was no equity to refinance. The stagnation occurred to begin with because the supply of housing had already been met. What happens if you cannot afford your payments, you cannot refinance and you cannot find a buyer for your house? Foreclosure, and worse yet, foreclosure only increases the supply of homes and takes the borrower (the demand) out of the home buying process for quite awhile as well because they are no longer credit worthy.