We have all seen a lot on the sub-prime collapse, but it is hard for many to get their heads around it. I recently found this explanation that works really well.
The subprime mortgage collapse is another tale of unintended consequences.
The crisis has its roots in the Community Reinvestment Act of 1977, a Carter-era law that purported to prevent “redlining” - denying mortgages to black borrowers - by pressuring banks to make home loans in “low- and moderate-income neighborhoods.” Under the act, banks were to be graded on their attentiveness to the “credit needs” of “predominantly minority neighborhoods.” The higher a bank’s rating, the more likely that regulators would say yes when the bank sought to open a new branch or undertake a merger or acquisition.
But to earn high ratings, banks were forced to make increasingly risky loans to borrowers who wouldn’t qualify for a mortgage under normal standards of creditworthiness. The Community Reinvestment Act, made even more stringent during the Clinton administration, trapped lenders in a Catch-22.
“If they comply,” wrote Loyola College economist Thomas DiLorenzo, “they know they will have to suffer from more loan defaults. If they don’t comply, they face financial penalties . . . which can cost a large corporation like Bank of America billions of dollars.”
Banks nationwide thus ended up making more and more subprime loans and agreeing to dangerously lax underwriting standards - no down payment, no verification of income, interest-only payment plans, weak credit history. If they tried to compensate for the higher risks they were taking by charging higher interest rates, they were accused of unfairly steering borrowers into “predatory” loans they couldn’t afford.
Trapped in a no-win situation entirely of the government’s making, lenders could only hope that home prices would continue to rise, staving off the inevitable collapse. But once the housing bubble burst, there was no escape. Mortgage lenders have been bankrupted, thousands of subprime homeowners have been foreclosed on, and countless would-be borrowers can no longer get credit. The financial fallout has hurt investors around the world. And all of it thanks to the government, which was sure it understood the credit industry better than the free market did, and confidently created the conditions that made disaster unavoidable.
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2 users commented in " A Brief Explanation of This Sub-Prime Crisis "
Follow-up comment rss or Leave a TrackbackMake no mistake about it, the banks were not innocents trapped in a “Catch-22″ foisted upon them by the Government. Certainly, goverment incentives to artificially inflate home ownership contributed mightily to the current financial crisis. But banks profitted handsomely during the explosion in lending by creating a huge volume of loans and then selling these loans off almost immediately to Wall St. investment banks, who turned around and sold securities based on these loans to investors. Banks also fueled this overheated credit market by using these securitizations to take on more and more leverage, in attempts to generate even greater profits. Many got burned when the market for these securities disappeared overnight, and they were left with inadequate reserves to support their outstanding loans. But not before bank executives walked away with millions from all of the fat years.
You can read more about the causes of the financial crisis at http://subprimeshakeout.blogspot.com/search/label/causes%20of%20the%20crisis
Let’s not forget that no one told the banks what terms they should impose in meeting the requirements of the CRA. The banks intentionally imposed terms that would require borrowers to refinance over and over - until refinancing was no longer possible because the equity was no longer there.
Sadly, the same areas in which banks previously refused to lend were the areas most targeted by crazy subprime loans. Redlining never went away, it only changed form.
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