Gentlepersons:
Banks take in deposits from customers. Some of those deposits get sent back into circulation right away (people writing checks, for instance); some are invested for a longer period of time, in exchange for a higher interest rate. CDs are an example of that. Other moneys, while technically available to the savers at any time, are in fact not going anywhere. This would be your basic savings account.
The banks do some calculations as to how much of their liquid assets they need to have on hand to cover normal business, and they lend the rest out, plus interest. (There are also regulatory requirements as to how much of their money they need to hold as reserves.) The interest is compensation to the bank for taking the risk that the loans will not be repaid.
Some of these loans are short-term, and backed by small assets, like cars and boats. Others are larger, and are backed by larger-value, less-liquid assets like homes, commercial buildings, production machinery, and land. The bank uses some of its funds to purchase the asset; it then gives the borrower the right to use the asset as long as they (the borrower) are keeping current on payments on the loan. The bank then uses this inflow of cash from borrowers to either return money to the savers making withdrawals, or to lend out again.
In a normal economy, the bank only lends to people that have a good likelihood of paying off the loan. A certain small percentage will not; when that happens, the bank takes back the asset and sells it for hopefully some reasonable percentage of the remaining loan amount. If they make money, they're ahead; more often, they lose a little money but not so much as to offset the amount they're making in interest payments from all their other loans. (Are you with me so far?)
So, the theoretical transaction looks like this:
Home value of $100,000.
Homebuyer puts up $30,000.
Bank puts up $70,000 (principal amount).
Mortgage at 8% annual interest rate, term of note is 20 years. (Note: I am going to simplify the carp out of all interest calculations for the rest of this example; but the principle remains the same.) In other words, bank is charging 8% of the principal as its compensation for laying out the money all at once, and getting it back over 20 years.
The buyer (borrower) is now making a monthly mortgage payment of $583.34--$7000 annually--to "own" his home. When the bank receives that payment, it credits most of it to the interest due, and only some to the balance on the house. But, however small the "principal payment" might be, it represents new equity the buyer has in the house. (The buyer has the option of making additional "extra principal payments" that go directly to the amount of the house he owns, rather than the interest on the loan. That can make a huge difference in how much you pay in interest over the lifespan of the loan.) The bank owns the difference, and if the property is foreclosed, that debt is what the bank needs to cover with the net proceeds of selling the house.
Two things you probably noticed immediately: The total interest over 20 years is just about the size of the principal; and that the bank gets its interest income faster than it lets the buyer gain equity in the home. That's on purpose; its part of the bank's protection against ending up owning a house that is worth less than the money still owed from its purchase.
So, in a normal mode, the bank takes that $7000 a year for 20 years in exchange for lending $70,000 up front. This makes enough money back that the bank can afford to run its business, pay its employees, pay interest to its depositers, etc.
Okay, we finally get to What Went Wrong in the recent past.
1) Banks stopped treating real property as an asset. They moved instead into the business of re-selling the mortgages to other investors as "asset-backed securities". Because they no longer faced the risk of being caught owning a house rather than a stream of income from mortgage payments, they focussed on the money they could make from fees involved with the lending process. This gave them an incentive to make more loans, since the fee dollars are paid up front.
2) Homeowners stopped looking at houses as their primary savings. Instead of trying to increase their equity (the amount of the home's value they actually own), they focussed on either re-selling the house a few years later for a higher value--home prices were rising fast and steadily--or on maintaining a steady amount of equity and borrowing against the current value for spending money. (This is the infamous "cash out refinance", where you take out a new mortgage which reflects the current market value of (in our example) $120,000, pay off the old mortgage, and buy a vacation and a bigscreen TV with the extra money. ) So the same home is now supporting a larger amount of debt.
3) Underpinning both of these moves was an implicit belief that Home Values Only Go Up. Banks and mortgage companies were willing to lend more, and to less safe borrowers, because they believed that they (or actually, the investors buying those mortgages as securitized debt) could turn around and sell the house for more than was owed on it. The homeowners believed that, if they had to move or couldn't make the larger payments over time, they could sell the home for enough to cover the new, larger mortgage and get them back some equity.
This created a scenario where the people making the loans didn't have as much incentive to really check if the borrowers would go for the money; the investors couldn't, but thought they didn't have to because of the inflation of home values; and the borrowers were sure they weren't taking a big risk. Everyone in the game had a vested interest in rising home values--and that led to assessors who gave larger valuations getting more business than the cautious ones. The bank wanted to make the loan, so it could make its fees; the homeowner wanted to spend that chunk of cash.
But real estate prices don't always go up; like any other commodity, homes reflect supply and demand. When an area has a growing number of residents, there is more demand for housing, which pushes prices up. When prospective buyers have more money to spend (say, from their software company stock), they will bid higher to get the house as opposed to looking for another. The assessor can thus find higher sales prices for "comparable homes" to validate the inflated value--which, since that refinance is technically a sale and a purchase, will then itself support the higher price quoted for the next home. This became a spiral of increasing home prices based upon nothing but the belief that home prices would go up.
But then the banks and investment firms that had bought those mortgage-backed securities needed to be able to re-sell them. To do that, they had to know what the backing houses were actually worth; and in many cases, the securities had been re-package and resold, in some cases to the actual banks that originated the loans. Suddenly the question of how likely the buyers were to repay became a real issue again; and the news wasn't good.
When the economy began to stutter, the flow of eager buyers vanished, and the less-capable buyers started defaulting. The mortgages went from being a stream of future income to a physical building in a development--and those rosy market prices turned out not to be close to valid. The banks /investors/re-investors were suddenly holding "assets" on their books that weren't worth what they thought they were.
The homeowners who took out the refinances and/or home equity loans found out that they couldn't resell their house for enough to cover the mortgage--or, that they got out of the house with less money than the downpayment they'd put in. They either didn't buy a home but turned to renting, or they bought a much smaller, less expensive home.
Now the cycle of pricing-based-on-comparable-sales has turned to a downward spiral. Banks and mortgage firms are selling at lower prices, because they don't want (and can't afford) to do maintenance on the property; they price the house to sell immediately, to get it off their hands. They will have to swallow the loss on the interest income they expected to realize, and may have to sell for little more than the principal outstanding--and perhaps less than that. Other would-be buyers start looking for bargains, instead of paying a premium to buy "before the price goes up more". Houses stay unsold, or drop their prices in order to sell. People are no longer seeing increased home values to borrow against or cash out; in some markets, they find themselves "under water", that is, they owe more on their mortgage than the home can be sold for. If they sell the house, they'll have to actually pay the bank the difference out of their savings.
But the bank is losing money, too. Remember, they were expecting mortgage payments including that lovely interest for 20 years; now they get a lump-sum of just the principal. The bank has to "write down" the value of the asset for the difference. Multiply that by enough mortgages, and the bank is in trouble. Remember, banking is based in part on the idea that Everybody Doesn't Want Their Money Back Right Away. But if depositors start fleeing a bank they think is unsound, the bank has to give them their cash back; and that means selling some of its assets. Which, since it has to be a quick sale, contributes to the downward spiral on prices.
The fees the banks/mortgage brokers were happily collecting are somewhat based on the amount of the loan; lower values = less income per transaction. And fewer transactions, as the people "underwater" decide not to sell, and the people who would like take out loans against their home's increased value have no increased value to borrow against. So the lenders are being pinched; they have to lay people off. More layoffs = fewer people able to buy; and more homeowners defaulting on their loans.
In other words, part of what is going on here is that a lot of the "value" that people were getting actually money for was completely imaginary. It worked for as long as other people believed it. But now the child has shouted that the Emperor has no clothes, and the bottom has fallen out of the market.
The problem with 'giving people their homes outright' is that it screw the depositors whose money the banks invested--not all that wisely in some cases--into lending to buy those homes. If the bank loses its right to those homes, it can't repay its depositors.
It is rewarding people who bought homes they couldn't really afford with a gift of the value of the property, by taking the savings of people who had money in the bank that made the loan. That's tremendously unjust. (BTW, I think most of the 'solutions' discussed have this same flaw, just not as openly.) The profligate--those who lied or misled on their loan applications; those who bet they could refinance for more before their balloon mortgage got to the big payments; the people who used their home as an ATM rather than an investment in their own future; and the people who bought homes to "flip" them for a big return--represent a large portion of the past-due mortgages. The prudent savers whose money was used for those loans should not be punished for being prudent.
I hope this offered some insight, Miss Kitt
