The economic collapse was not entirely unexpected (by a guy called Peter Schiff at least)…
Here he explains to a conference of mortgage brokers (note this is in 2006, before it all came to pass) how giving mortgages to people who can’t afford to pay them back will only work as long as house prices go up.
As he says, lending to people who can’t afford to pay it back does actually work if house prices go up because if people default, the bank gets the house and by then it’s probably worth more than the amount they originally loaned so they’ve made a profit on their original investment (any deposit plus the interest on mortgage repayments thus far plus the increase in value of the house). Easy returns for the mortgage lender – if the borrowers keep paying back the loan, they make money on the interest and if the borrowers default, they still make money as long as the value of the house has gone up.
Unfortunately nobody seemed to notice that this set up a positive feedback in the market:
- House prices go up
- People see that house prices are going up
- Houses look like a good investment so demand increases from two camps – speculators looking for quick returns on buying 2nd, 3rd, 4th, etc houses and first-time buyers who couldn’t previously afford a home but will overstretch to get on the ladder before the first rung moves even further away. Overstretching is ok because once the value of your house goes up you can effectively pay off some of the mortgage with that increase – any increase in the value of the house goes in your pot, not the mortgage lender’s (I’m gonna call this “positive equity” since it’s the opposite situation to “negative equity“, although I suppose it’s actually just “equity”).
- If demand for houses goes up and supply doesn’t increase, the price goes up
As long as the housing market as a whole goes up, the subprime mortgages are profitable for the lenders whether the borrowers default or not. Originally the market was going up for other reasons (second homes, buy-to-letters, etc) but then the lenders spotted this opportunity to make some extra money out of otherwise inaccessible customers who could hang on the coat-tails of the ever-rising market.
This only works when the market is going up.
With the price of houses going down the opposite situation occurs, a lender will lose money on a defaulted mortgage (they repossess the house but can’t sell it for enough money to recover their original loan) so they reduce their risk by increasing interest rates and suddenly a lot of people find themselves with increased repayments and an outstanding mortgage that they couldn’t pay back even if they sold the house. As more people default on their mortgages, more houses come onto the market – supply increases. Everyone sees that the market is falling – not a good time to buy a house now – demand decreases. The people that can afford to (the multiple home owners / buy-to-letters) jump ship and take the hit but this floods the market even further with houses that nobody wants to buy. Supply increases further, demand decreases further, prices go down further.
How far down remains to be seen.Tags: peter schiff, subprime mortgages