As we have seen, overoptimism added to financial deregulation lead to a looser standard concerning loan credits which implied private over-indebtedness as well as a systematic undervaluation of risks. So what?
First of all, it is useful to speak some words about the mindset that was prevailing during this period. Many economists were convinced that we were living in a world where banking panics were something from the past. Thanks to Ranieri’s MBS, mortgages became very profitable but soon enough, banks ran out of mortgages to sell because, well there’s only a limited number of houses. As prices were increasing and the hypothesis of efficient markets was at that time widely spread, that is the prices couldn’t be overvalued and were thus only reflecting the true value, bankers started to sell mortgages to people with shaky financial situations. Thanks to the miracle of diversification, those second class mortgages that were regrouped in the CDOs were considered as low risk. Back at that time, the logic of financial engineers was to say that housing bubbles were locally possible, but couldn’t unravel on a global basis. For instance, housing prices could fall in Texas or on the East Coast, but not both at the same time.
When housing prices increase, as it was the cas prior to the crisis, mortgage loans are pretty safe. Let’s illustrate this with an example. Imagine you do not have any equity but you get a mortgage loan for a house that is worth $100,000 in t=1. If prices increase, let’s say your house will be worth $120,000 in t=2. Let’s imagine prices decrease by 20% such that your house is only worth $80,000 in t=2. You are then virtually in a situation where you cannot repay your debt. To resolve this issue, banks typically used to ask for at least 20% of equity before giving the mortgage. Out this manner, the house can lose up to 20% of its price without making you insolvent. Not asking for equity is not a problem as long as prices increase but become extremely risk when prices begin to decrease…
As we have seen, it is private over indebtedness with the help of banks that made the system pretty weak. It also interesting to note that the willingness of paying off one’s debt can in reality be self-defeating. During the subprime crisis, many individuals tried to repay theirs mortgages by selling their houses. This created one more downward price pressure which made reimbursement even tougher for the others since houses’ prices were even more falling. Even solvent people slowly began to become insolvent because the value of what they were owning was always decreasing. That was a vicious cycle.
Since CDOs and MBS were basically made of mortgages, the banks that were holding these assets quickly started to suffer heavy losses. More on this in the next article.