Buying a home is extremely expensive, and since most people don’t have access to millions upon thousands of dollars, they must rely on a mortgage. This type of loan usually has low interest and is repaid over a long period of time, between 15 and 30 years. Traditionally, a lending institution, such as a bank, would make this loan after carefully determining whether the borrower would likely be able to repay the amount. This was done using a series of qualifying statistics, such as annual salary, credit score, and credit history. If it was considered unlikely that a person would repay the amount borrowed, the mortgage would be denied. But, this practice changed sometime after World War II.
Certain economists insisted that the key to a financially stable life was having a home of your own; however, much of the United States had bad credit or no credit at all. So the government began a campaign to pressure financial institutions to relax guidelines on granting mortgage loans. The issue became truly dangerous when Congress repealed the Glass-Steagall Act. This law created firm restrictions on what banks could do with the money invested with them, separating them from riskier investment houses and brokerage houses. When the law was repealed, any bank could engage in high-risk investment practices. This situation led to the subprime mortgage crisis.
A subprime loan is slow for people with bad credit at initially low monthly rates, so they can start living in their own home. After a while, the monthly rate increases and borrowers must pay a series of large “balloon” payments. In most of these situations, the borrowers ended up in default and then lost their homes to foreclosure. So why would banks make these bad loans?
This is where the loss of the Glass-Steagall Act comes into play. The possible future payment of these loans represented an asset. Since assets have value, they can be sold. In turn, the banks combined hundreds of bad loans with a few good loans and sold them as mortgage securities. The S&P gave different ratings to these securities, but due to the sheer volume of securities and a number of paperwork-related diversions, it was never entirely clear how toxic a given security was. Finally, the truth came out. As millions of people began to lose their homes to loan defaults, securities became increasingly toxic, sparking panic. The massive losses in these securities caused the collapse of a major institution that had been insuring the investment against this exact event.
The overall impact was a dramatic loss of wealth for the poorest Americans, as well as massive losses in retirement accounts, because the money in those accounts had been invested in toxic securities. In addition, multiple violations of regulations for the paperwork surrounding mortgages have left millions of homes in foreclosure but unsaleable. The recovery will take decades and people have lost faith in many of the major banking institutions.
