In the last article, we finally learned about a period of financial calm in the USA. About time, right? During the Great Moderation, there were still a number of financial shocks, but they didn’t crash the economy.
At the end of the last article in this series, I left you pondering whether these shocks were too minor to cause a severe recession, or whether the shocks were less severe because the financial system had grown more resilient.
Now, we will take a look at a number of different shocks to the US financial system from the late ’70s to early 2000s. You’ll see that the US economy faced consequences, but a second Great Depression never resulted. Why? After you’ve read this article, maybe you’ll have some theories on this…
Latin American debt crisis
Remember how we learned about the oil crisis during the 1970s? Not only did it have a stark effect on the USA, but the oil price shocks created account deficits in many Latin American countries. Meanwhile, oil-exporting countries were doing well and had account surpluses.
At the end of 1970, Latin American countries’ debt totaled only $29 billion, but by the end of 1978, that number had skyrocketed to $159 billion. By 1982, it reached $327 billion.
At that point, the US decided to step in and “help” by providing the exporting countries that had account surpluses with a safe, liquid place to store their surpluses, and then using these funds to lend to Latin America.
As you may suspect, by lending to Latin American countries, US commercial banks were assuming a lot of risk.
Lo and behold, Latin American countries soon found their debt burdens unsustainable.
Mexico was the first country to tell the US that it was longer able to service its debt. Sixteen other Latin American countries followed suit, as well as 11 other third-world countries.
As the crisis spread, the US tried to help again by restructuring the countries’ debt. Moreover, the International Monetary Fund jumped in and lent these Latin American countries money to at least pay off the interest so that they could avoid defaulting on their loans. Meanwhile, the countries agreed to reform their economies in order to increase their exports so that they could then use that money to pay off the loans.
Desperate to pay off their debt, countries started cutting spending on infrastructure, health, and education, and they froze wages or laid off state employees, which led to high unemployment, steep declines in per capita income, and negative growth. As a result, many Latin American countries entered a deep recession.
Eventually, it became clear that these countries would not ever be able to pay off their debts at the rate they were going. So the US decided to forgive one third of the debt, and in turn, these countries agreed to make additional reforms to pay off the debt down the road. Latin American countries didn’t start to recover from this economic shock for a decade.
Clearly US banks overexposed themselves to bad debt, which put the financial system at massive risk. To help save the system, regulators had to weaken regulatory standards for large banks that were exposed to this bad debt in order to avoid a collapse. Banks got a free pass and didn’t face the consequences of their excessive risk-taking. This is one of many examples in US history where banks were bailed out.
Savings and loans crisis
Another “minor” shock to the economy during the Great Moderation was the savings and loan crisis.
S&Ls were thrift organizations established in Pennsylvania in 1831 to help Americans pursue home ownership. An S&L was a group of people who pooled their resources and loaned them to other members to help finance their homes. As the loans were repaid, funds could then be lent to other members.
S&Ls served a big role in the US mortgage market. In 1980, there were 4,000 thrifts with total assets of $600 billion, of which about $480 billion were in mortgage loans.
During the Great Inflation, when Volcker implemented high interest rates to help fight inflation, many S&Ls began to suffer. Instead of letting these S&Ls collapse, the government decided to step in. The government eased regulations to make it even easier to make new residential loans. Many insolvent thrifts were allowed to remain open.
As a result, the S&L industry grew even faster. From 1982 to 1985, the thrift industry assets grew 56%. These institutions went for broke, investing in riskier projects, hoping they would magically pay off in higher returns. Of course, if these returns didn’t materialize and they become insolvent, then guess who footed the bill? Taxpayers! Duh.
As you are undoubtedly expecting, the whole thing came melting down. By 1988, more than 40% of S&Ls had failed. It got so bad that it was cheaper to burn some unfinished condos that a bankrupt Texas S&L had financed rather than try to sell them.
Eventually, Congress decided to address the thrift industry’s problems by instituting a number of reforms to the industry. The main S&L regulator was abolished, as well as the bankrupt Federal Savings and Loans Insurance Corporation (which had served as the insurer for S&Ls). Ultimately, 747 S&Ls with assets of over $407 billion were closed. The ultimate cost to taxpayers was estimated to be as high as $124 billion.
Yikes! And yet, the economy didn’t go under.
The failure of Continental Illinois Bank — the first “too big to fail”
Another shock to the economy occurred in 1984 when Continental Illinois National Bank and Trust Company failed. With $40 billion in assets, the bank was the largest commercial and industrial lender in the United States. This was the largest bank failure in US history (until the 2008 financial crisis). This was when you first started hearing the term “too big to fail.” Or maybe a lesson from the Titanic should have been applied…“unsinkable.” Not quite.
Why did the bank fail?
Simple. The bank made incredibly risky investments, such as purchasing $1 billion in speculative energy-related loans that originated from the 1970s oil and gas exploration boom. When that boom ended, the underlying risk in those loans became apparent, and the bank faced steep losses. The bank had also invested in developing countries like Mexico, who were going through the previously discussed debt crisis in the early ’80s.
By 1984, Continental Illinois Bank’s nonperforming loans went from $400 million to $2.3 billion. When the depositors of the bank learned about this, there were massive bank runs. Of course, the bank wasn’t able to give depositors their money, so it borrowed $3.6 billion from the Federal Reserve. In addition, the bank received a $4.5 billion line of credit from sixteen of the nation’s largest banks.
You may (justifiably!) be wondering why the failing bank was given so much money.
Well, because the banking system is incredibly intertwined. A collapse of the largest bank would likely mean the collapse of the whole system. In this case, 2,300 banks had invested in Continental Illinois. And 179 of those banks had invested more than half of their equity capital in the bank! Moreover, almost half of the invested funds were greater than $100,000 (which is the upper limit for what FDIC insures).
So if the bank failed, it would wreak havoc on the system. Even all this support, though, wasn’t enough to save the bank. So the Fed went even further. The FDIC announced that it would protect creditors with accounts greater than $100,000 (even though this is not what the FDIC is supposed to do) and on top of that, the FDIC infused $1.5 billion capital into the bank.
The bank tried unsuccessfully to find a buyer, and then the FDIC committed to purchasing up to $4.5 billion in bad loans from the bank. In the end, the FDIC protected all bondholders and depositors, while all equity holders were wiped out. The government then bought the bank and held the asset until 1991. In 1994, Bank of America purchased the defunct bank.
I will leave it up to you to figure out whether it was a good idea for the FDIC to provide such unusual support to save a sinking ship. Do you think it would have been better if the bank were allowed to fail? Or was it better to save the bank so that creditors and depositors who didn’t contribute to the problem wouldn’t have to face the consequences? These are important questions to consider, even if they have no easy answers.
Next shock: Stock market crash of 1987
Stock market crash of 1987
On October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped 22.6% in one trading session. To this day, it remains the largest one-day stock market decline in history, aptly known as “Black Monday.”
The US economic crash caused a chain reaction across global stock exchanges within hours. The financial crisis spread like a virus, from market to market. People stayed up all night to watch the Japanese market, hoping to predict what might happen in the next session of the New York market. It revealed just how interconnected the global markets had become in the decades following the world wars.
“There is so much psychological togetherness that seems to have worked both on the up side and on the down side. It’s a little like a theater where someone yells, ‘Fire!’’ — Andrew Grove, CEO of Intel Corp in New York Times
All of the twenty-three major world markets experienced a sharp decline in October 1987, nineteen suffering a decline greater than 20%. Hong Kong, for example, saw a drop of 45.8%.
So what caused Black Monday?
There were a few different causes.
1) Increased investments from international investors in the US market
2) Extensive use of new and complex financial products (e.g., options and derivatives) that had a cascading effect because of how intertwined these financial products were
3) Stock, options, and futures markets used different time lines for the clearing and settlements of trades. This meant some accounts went into negative balances and were forced to liquidate.
How did the Fed respond?
Behind the scenes, the Fed encouraged banks to continue to lend on their usual terms in order to prevent widespread panic and the possibility of bank runs.
Luckily, the strategy worked because there was no economic recession or banking crisis following Black Monday. Within two trading sessions, the DJIA regained 57% of the losses during Black Monday. And within two years, US stock markets surpassed their pre-crash highs.
The US was able to swiftly recover over time, but Japan’s economy has been struggling to regain ground ever since.
Now, let’s move onto the next shock.
The Asian financial crisis in 1997
A financial crisis started in Thailand on July 2, 1997, and spread across East Asia, wreaking havoc on local economies. It started when Thailand devalued its currency relative to the US dollar. Thailand was at a balance of payments deficit and the stock and real estate markets were weakening, so the country devalued the currency to save the sinking ship. Malaysia, the Philippines, Indonesia, and South Korea eventually faced the same Asian Financial Crisis.
The global economy was stunned when this happened because prior to the crisis, these countries had seen strong growth rates in GDP.
However, the Asian Financial Crisis revealed that the countries’ rapid growth through risky loans came at a cost of resilience. As these economies started heating up, they started to rely more on borrowing from foreign countries, which exposed the banks to significant amounts of external debt.
The vulnerabilities of the local banking sector had ripple effects, causing foreign creditors to start pulling out, which further escalated the crisis.
The IMF, the World Bank, the Asian Development Bank, and governments in the Asia-Pacific region, Europe, and the United States all came together to mobilize $118 billion worth of loans to Thailand, Indonesia, and South Korea. The goal was to help these countries rebuild their reserves and buy time so that policy adjustments could be made to stabilize and restore confidence in the floundering economies.
The aid was contingent on these countries making policy reforms to clean up and strengthen their financial systems.
What role did the Fed play?
The Fed closely monitored the risks the crisis posed to US banks and encouraged banks to act in their collective self interest in helping these countries avoid a default. For example, US banks decided to roll over short-term loans into medium-term loans. The Fed also helped the Treasury arrange a bridge loan for Thailand in the early stages of the crisis.
Ultimately, the unexpected crisis was contained, and the US did not face a major recession in spite of the economic bump in the road.
Onto the next shock…. I told you this was a long post 😉
The collapse of Long-Term Capital Management in 1998
On September 23, 1998, fourteen banks and brokerage firms invested $3.6 billion in Long-Term Capital Management (LTCM) to prevent the firm from collapsing.
LTCM was founded by former Salomon Brothers’ vice chairman John Meriwether in February 1994 and was known to use sophisticated mathematical models to make above-average returns. LTCM generated returns of 20% in 1994, 43% in 1995, 41% in 1996, and 17% in 1997, which was well above average hedge fund returns at the time. LTCM would leverage its positions with debt. And since LTCM had above-average returns, more creditors were willing to loan the company money. By the end of 1997, LTCM was holding about $30 in debt for every $1 of capital.
In 1998, the Asian Financial Crisis started, which motivated investors to move their assets to safer places. At the same time, LTCM’s performance was tanking, and the fund lost 44% of its value in August 1998.
The fund sought out additional capital to stay afloat. When that didn’t work out so well, the fund reached out to the Fed for help.
How did the Fed intervene?
The Fed inspected LTCM and became aware of the dangerous scale and scope of LTCM’s positions. They were afraid that if people started exiting LTCM’s positions, there would be a fire sale that would negatively affect the economy.
The Fed tried to gather four financial firms to come up with a strategy to save the sinking ship. However, they couldn’t agree on an approach. Then Warren Buffet offered to both buy out the firm’s partners for $250 million and inject $3.75 billion into the fund. However, this deal did not go through because of legal issues.
The Fed went back to the drawing board. Eventually, fourteen financial firms agreed to put up $3.6 billion in capital in exchange for 90% ownership of LTCM. The LTCM partners were then required to turn around the ship (with significant oversight) so that they could pay off $3.6 billion, which they managed to do by the end of 1999. The partners and investors of LTCM suffered great losses, but they managed to prevent a collapse of the firm.
In effect, the Fed was able to avoid investing its own funds to save the sinking ship. Instead, it got its creditors to coordinate the rescue plan. If the Fed had invested its own funds, the money would have come out of the pockets of people like you and me, and that would have been very controversial.
It’s worth thinking about why LTCM was allowed to get into such an untenable position. Why should hedge funds be allowed to take such large risks but then get rescued when things go badly? Another question for you to ponder. Yes, there are a lot of them!
And now onto the final shock….
The dot-com crash in 2000
The 1990s were the longest period of economic growth in American history up to that point. In 1993, after Mosaic was invented, people had access to the internet for the first time. Between 1990 and 1997, US households that owned computers increased from 15% to 35%, marking the beginning of the Information Age.
At the same time, interest rates were low so people had capital available to invest. Moreover, the Taxpayer Relief Act of 1997 lowered the top marginal capital gains tax in the United States. This made it even more appealing for the public to invest in stocks. On top of all that, the Telecommunications Act of 1996 was passed, and people expected the telecom industry to then blow up. Telecom companies invested more than $500 billion, mostly financed with debt, into laying fiber optic cable, adding new switches, and building wireless networks.
As a result of cheap capital and a lot of optimism about the internet and telecom, people were eager to invest. There was a lot of irrational behavior and speculative investments being made without much grounding in reality.
But by the end of the millennium, the optimism waned as people started to fear Y2K . You might recall, everyone was scared that computers would have trouble changing their clock and calendar systems from 1999 to 2000. As a result, investments in technology started to get more volatile.
In February 2000, once people realized that Y2K didn’t lead to world apocalypse, the Fed announced plans to aggressively raise interest rates, which made capital more expensive thereby disincentivizing people from investing). Then on March 13, 2000, Japan once again entered a recession, triggering a global sell-off.
Unfortunately, technology stocks took the hit because people were trying to move their assets from speculative stocks to safer stocks. On March 10, 2000, the NASDAQ Composite stock market index peaked at 5,048.62. What came next was a bloodbath.
News of tech companies collapsing started to scare people. For example, Yahoo! and eBay ended merger talks. Microsoft was found guilty of monopolization and violation of the Sherman Antitrust Act. Pets.com failed; Geocities was acquired by Yahoo but then shut down; Webvan and eToys.com went bankrupt…and the list goes on.
The speculative tech bubble had burst. By the end of 2002, stocks lost $5 trillion in market capitalization. The NASDAQ-100 dropped to 1,114, down 78% from its peak.
The dot-com bubble was yet another shock to the US economy. However, the recession was brief and shallow. It lasted eight months; GDP declined by only 0.3%; and unemployment peaked at 6.3%.
Even though the bubble was pretty bad, the economy was able to sustain the shock without a major recession.
Clearly, there were a lot of shocks in the US economy during the Great Moderation period. However, the economy was resilient and bounced back a lot faster than it did during the Great Depression.
Think about what could have been the cause for this resilience. Is it because the Fed was able to serve as the safety net whenever bad things happened in the economy? Or is it that we just got lucky and the shocks were not as severe as previous shocks? Or was the economy really that much more resilient?
Think about it and let me know in the comments, or feel free to share on the weekly review call, if you’re currently in one of our crypto literacy educational cohorts! #DazzlingDecathlon
Next, we’ll talk about the series of events that did finally cause the economy to collapse in 2007. You knew it was coming: What goes up must come down.
After discussing the chaos of the Great Depression and its economic fallout, in the last post we talked about the series of shocks to the economy that America occurred during the Great Moderation. Despite these shocks, the US economy remained resilient and avoided a major recession. Good times, right? Great news!
But…the good times always seem to end, and they finally did when the ’90s housing bubble grew so large (and fragile) that it eventually popped, leading to economic free fall.
The housing bubble
From the late 1990s until early 2006, house prices in the US soared.
During this surge, mortgage lending standards deteriorated significantly and alarmingly. For example, in early 2000, the average subprime borrower had a FICO score of 660 or less. By 2005, the required FICO score dropped to 620. You can already see how this is heading for trouble.
Other examples of dangerous lending practices included:
Interest-only adjustable-rate mortgages (ARM): An “ARM” is when the interest rate varies throughout the life of the loan. An interest-only adjustable-rate loan is when a borrower is only required to pay the interest portion for a certain period of time, before the payments balloon at the end to pay off the actual loan. During the housing bubble, lenders offered “negative amortization ARMs,” where the initial payments did not even cover interest costs.
Long amortization: Lenders offered loans where the payment period was greater than 30 years.
No-documentation loans: Prior to the early 2000s, home buyers typically made a significant down payment (e.g., 10%, 15%, 20%) and had to document their finances in detail. This was a wise strategy on the part of lenders and prevented catastrophe. But as house prices rose, many lenders began offering mortgages to less-qualified borrowers and required little or no down payment and little or no documentation. Bad idea. Abysmal, in fact.
NINJA: No income, no job, no asset verification required (NINJA) mortgage products
This is just the tip of the iceberg in terms of the sloppy lending practices that persisted during the ’90s. As house prices continued to rise, the equity value on homes increased, which allowed borrowers to refinance into more-standard mortgages after a few years.
SOURCE: FEDERAL RESERVE BERNANKE LECTURE SERIES
Rising house prices and weakening mortgage standards fed off each other and created a vicious cycle. As house prices rose, people had a sense of optimism, and so they poured all their money into buying homes.
On the flip side, lax lending standards drove the soaring demand for housing. Banks were too confident about house price increases and didn’t foresee a scenario where hundreds of people would default at once. If they ran into problems, banks assumed they could just sell their loans to riskier buyers. It was a vicious cycle, rapidly leading toward a devastating economic end.
SOURCE: FEDERAL RESERVE BERNANKE LECTURE SERIES
When house prices stopped rising, borrowers could neither refinance nor meet the (typically increasing) payments on their exotic loans.
In addition to deteriorating lending practices, there were many other things happening in the economy that were leading indicators of the housing crisis, each of which we will briefly discuss below.
1) Securitized products
Another big factor that played into the housing bubble was a large international demand for US assets. Banks took advantage of this by creating securities that packaged exotic and subprime mortgages with better loan products and selling them to meet international demand and other investors (e.g., pension funds, accredited investors, etc). This process of bundling a bunch of assets into a new type of asset is known as “securitization.”
Some of these securities were very complex and opaque derivatives — for example, collateralized debt obligations, or CDOs.
Rating agencies gave AAA ratings to many of these securities.
SOURCE: FEDERAL RESERVE BERNANKE LECTURE SERIES
And companies like AIG sold “insurance” to protect investors or financial firms that held these securities. These ratings masked the truth about the real risk underlying these securities.
2) Predatory lending
Predatory lending, which came to define the ’90s American economy, is when lenders entice borrowers to enter into unsafe loans for inappropriate purposes. Banks failed to adequately monitor and manage risks they were taking. If you were human, they gave you a loan.
Countrywide Financial, for example, was sued for using false advertising and deceptive tactics to push homeowners into complicated, risky, and expensive loans so that the company could sell as many loans as possible.
3) Community Reinvestment Act
The Community Reinvestment Act was established in 1977 to help low-income Americans get mortgage loans so they could own homes. This encouraged banks to relax their lending standards and lend to higher-risk families.
While the Act may has been well intentioned, its downstream effects were a recipe for disaster.
4) Low interest rates
Yet another trigger was low interest rates.
In 2001, Federal Reserve chairman Alan Greenspan dropped interest rates to 1% to help jumpstart the economy after the dot com bubble. Why does this matter? Because a lowered Fed Funds rate impacts mortgage rates as well. Mortgage rates are set in relation to 10-year treasury bond yields, which, in turn, are affected by Federal Funds rates.
A drop in interest rates reduces the cost of borrowing, which then increases demand. Hence, house prices increased significantly, with inflation-adjusted US home prices increasing 5% during this period.
Former Federal Reserve Board Chairman Alan Greenspan later admitted that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates.”
5) Lack of regulation and deregulation
Another key trigger was the lack of proper regulation and supervision. Despite the fact that financial institutions were recklessly taking on too much risk, the Federal Reserve failed to regulate them.
For example, starting in the 1980s, there was a lot of deregulation in the banking industry. The Depository Institutions Deregulation and Monetary Control Act of 1980 allowed similar banks to merge and set any interest rate. The Garn–St. Germain Depository Institutions Act of 1982 allowed adjustable-rate mortgages. The Gramm–Leach–Bliley Act of 1999 allowed commercial and investment banks to merge. In essence, the deregulation allowed banks to get really big without also increasing Fed supervision in tandem.
To add to the trouble, in 1997, Greenspan fought to keep the derivatives market unregulated. Eventually, the U.S. Congress under President Bill Clinton allowed the derivatives market to be self-regulated. This led to a huge surge in the derivatives market (explained below).
The CDS and CDO damage
A popular derivative product sold during this time was credit default swaps (CDS). A credit default swap is when a seller and buyer hedge their bets based on an underlying reference asset (e.g., a mortgage). The seller of the CDS insures the buyer against the asset defaulting. The buyer of the CDS makes a series of payments to the seller. If the reference asset defaults, the buyer receives a payoff from the seller. Otherwise, the buyer ends up paying the seller the payments until the maturity date.
So as an investor, instead of lending directly to the borrower, you now could sell credit default swaps and insurance against those same borrowers defaulting. In both cases, you got monthly payments — if you lent directly to the borrower, you earn interest payments, whereas if you sell a CDS, you receive an insurance payment.
In both cases, you lost money if the borrower defaulted. But the key difference between lending directly to the borrower versus selling CDS is that an unlimited number of CDS could be sold against a single mortgage, and a lot more money could be made.
The logical conclusion, then, is that the CDS market exploded. The volume of CDS increased a hundredfold from 1998 to 2008. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number grew to $62 trillion. Yes, trillion.
Even worse (yes, it keeps getting more awful!), rating agencies used the Copula formula to assign risk to these assets. The formula, created by David Li, was thought of as a breakthrough for assigning risk to underlying assets. As you might know, analyzing the underlying risk of an asset is an incredibly complex process. If it were as easy as a plug-and-play formula, we’d all be billionaires.
But at the time, the collective delusion was too high for any rationality to matter. Ratings agencies assumed they could rely on this simplistic formula, regardless of how complex the underlying assets were. For example, rating agencies at the time were giving triple-A ratings to collateralized debt obligations (CDOs). A CDO is an incredibly complex financial product that pools together corporate bonds, bank loans, mortgage-backed securities, etc. and then is sold to institutional investors. Financial institutions used the Copula formula to price the risk of CDOs, which was in essence a false guarantee to the buyers of the CDOs. As a direct result, the CDO market ballooned from $275 billion in 2000 to $4.7 trillion by 2006.
Calculating the risk of these complex derivatives cannot be narrowed down to a simple formula, and yet it was. The financial gurus were making too much money for anyone to convince them otherwise. Plus, house prices were still going up, so there was no reason to be pessimistic.
This was fine when things were going “well,” but the good times eventually came to an end. It’s no wonder Warren Buffett famously referred to derivatives as “financial weapons of mass destruction” in early 2003.
6) Fannie Mae and Freddie Mac
At the time, there were federal mandates in place to promote affordable housing. Fannie Mae and Freddie Mac are private corporations established by the Congress to help create affordable housing for Americans. The two entities are referred to as government-sponsored enterprises (GSEs). They don’t issue mortgages; rather, they’re the largest “packagers” of individual mortgages into mortgage-backed securities (MBS), which they guarantee against loss (hint: the government sponsors them).
The Housing and Urban Development Act of 1992 mandated Fannie Mae and Freddie Mac to have at least 30% of their total loan purchases be related to affordable housing. By 2005, 52% of the loans Freddie and Fannie issued were to borrowers with income that was less than the median in their area. To meet these mandates, they loosened their lending standards and loaned money to people who couldn’t, in actuality, afford to buy homes. Fannie Mae and Freddie Mac bought $200 billion in subprime mortgages from banks and engaged in massively risky loan purchases. To compound an already bad situation, they were operating with inadequate capital to back their guarantees. This is not looking good…
7) Housing tax policy
In 1997, the Taxpayer Relief Act of 1997 created a $500,000 exclusion of capital gains on the sale of a home for married taxpayers (and $250,000 exclusion for single taxpayers), which could be used every two years. All other capital gains exclusions were removed, and housing became the only investment that escaped capital gains tax. This encouraged people to buy homes instead of other assets like stocks and bonds.
This built on the unequivocally American belief that owning a home is the ultimate dream and that renting is a waste of money. Further sweetening the poisoned financial pie, the media did a spectacular job promoting home ownership and real estate as great investments. Combined with cheap capital and tax advantages, this led Americans to buy homes and investors to speculate on the mortgage market at an unprecedented rate.
8) Dot-com bubble collapse
Remember the dot com crash in the last post? When the stock market crashed, many people started to move their money out of speculative stocks and into speculative real estate. Humans do so love to speculate 😉
In summary, as a result of all of the reasons above (and more that I did not list, such as over-leveraging, huge growth in shadow banking, etc.), Americans started buying homes left and right. From 1990 to 1995, an average of 609,000 new single-family houses were sold. By 2005, that number went up to 1,283,000. And during this period, house prices appreciated a lot.
The bubble pops
Yep. You knew it was headed in this direction. The financial party couldn’t last forever (by now you know they never do). Eventually, rising costs of homeownership began to dampen housing demand, and house prices began to drop in early 2006.
As house prices fell, people owed more on their mortgages than what their houses were worth, and people were suddenly underwater (also known as “negative equity”).
Homes became less affordable. Mortgage payments as a share of income rose sharply.
The banks that serviced these toxic mortgages and mortgage-backed securities started to face massive losses.
“The great housing bubble has finally started to deflate … In many once-sizzling markets around the country, accounts of dropping list prices have replaced tales of waiting lists for unbuilt condos and bidding wars over humdrum three-bedroom colonials.”
— Fortune magazine, May 2006
Given how big the housing market had gotten during this period, any signs of collapse were seen as a massive risk to the overall economy. The US economy had been resilient for the last couple of decades, but the collapsing housing bubble would be too big to contain.
By March 2007, more than 25 subprime lenders declared bankruptcy. The biggest one was IndyMac Bank. IndyMac had given out really risky loans to borrowers and even went as far as to fabricate the volume of credulous loans that it gave out to make the situation seem better than it was. But when home prices declined, they couldn’t hide from their bullshit much longer. What came next was a catastrophic bank run and eventual bankruptcy. IndyMac was one of the largest bank failures of the ’90s…and it was just one of many.
Things got really ugly, really quickly. In the next article, we’ll learn more about the “pop” and the collapse that followed. (I’ll give you a hint — it’s not nearly as pretty as an imploding soap bubble.)