THE ORIGINS OF THE U.S. FINANCIAL AND ECONOMIC CRISESUpdated October 2010 The U.S. economy has clearly been in terrible shape since 2008. What is less clear is how it got that way. Opinions vary on when and where to begin the story, but many experts trace the origins of the current economic situation to the housing bubble that began earlier this decade.The Housing Bubble Housing prices jumped at a rate above 6 percent in 1999 and increased rapidly and steadily as the decade turned, according to a recent study by the Brookings Institution. "After the mid-1990s… real house prices went on a sustained surge through 2005, making residential real estate not only a great investment, but it was also widely perceived as a very safe investment," the study said. The prices eventually moved "out of line with fundamentals like household income," creating the so-called bubble, the study said. There were two trends developing at that time that contributed to the housing bubble, according to experts. First, the Federal Reserve Board, to combat the recession of 2000-01 and the economic effects of the September 11 terrorist attacks, began drastically slashing interest rates through highly expansionary monetary policy. Consequently, it was very easy to borrow money, especially if you wanted to buy a home. Meanwhile, global investors - flush with cash from the worldwide economic booms of the 1990s and early 2000s - were looking to the U.S. economy to make even more money. ''You have a group of people growing richer by leaps and bounds," said Peter Rodriguez, an economist at the University of Virginia. "And they liked the idea of parking some cash in the biggest, safest economy in the world." Enter the second trend, mortgage-backed securities. Wall Street firms sought to connect therich investors with the rapidly expanding housing market by means of complicated financial instruments. These instruments - such as the mortgage-backed securities we have heard so muchabout - made it easier to move the investors' funds into the housing market, which fed the extraordinary price spiral, Rodriguez said. “It really began to take on a life of its own when people saw how much money they could make in housing,” he said. “Before long, everybody was pushingalong the momentum of this train.” So how do these mortgage-backed securities work and what role did they play? Let’s say there are three prospective homebuyers in a neighborhood. A local bank, Bank B, makes mortgage loans to all three, then bundles up the mortgages and sells the bundle to a big Wall Street firm, like the now-bankrupt Lehman Brothers. The Wall Street firm takes its bundles of mortgages and sells “shares” in them to savers. The savers make money off the interest paymentsfrom the original borrowers. This process is summarized in Figure 1.These instruments helped minimize risk for the local bank. If the borrower subsequently defaulted on the loan, the local bank that originally made the loan would not be affected. “You didn’t even have to worry about a loan once you made it. You didn’t have to keep it on your books,” Rodriguez said. “The only limitation was how fast you could turn the loans.” It was an intoxicating era when you could make a lot of money quickly through the housing market, and you did it through the "basic idea of leverage," Rodriguez said. He provided an example: You take out a mortgage loan for $100,000 and make a 20 percent down payment, which would equal $20,000. If the price of the house goes up to $120,000, you've effectively doubled your money. If you sell at that price - assuming there are no transaction costs - you walk away with an extra $20,000. Leverage works the same way for banks. They borrow from other banks or other institutions so that they can hand out more loans and make more money. ''This encourages all sorts of risky behavior by individuals looking to buy homes, and it encourages banks to lend because, in an environment where prices rise, they're making lots of money, too," Rodriguez said.Economists say not everyone can - or should - buy a home, but that did not stop many homebuyers, banks or Wall Street firms during the housing bubble, when it looked like the only wayfor prices and profits to go was up.2Interest paid by homebuyers Interest paid by financial firm Sell shares borrow from Sell loans toFIGURE 1How Mortgage-Backed Securities WorkLocal BankA(Mortgagelender)Local BankB(Mortgagelender)Wall StreetFinancial Firm“Creates”Mortgage-BackedSecuritiesHolds mortgageloans “on itsbooks” Homebuyer 1Homebuyer 2Homebuyer 3Local BankC(Mortgagelender)Saver 1holdssharesSaver 2holdssharesSaver 3holdssharesInstitutional Savers: Mutual Funds, Hedge Funds, Pension Funds, Banks sell Sell shares borrow from Sell loans toFIGURE 1How Mortgage-Backed Securities WorkSome banks and other institutions were even eager to lend money to prospective homebuyers with poor credit and a spotty financial history who would not typically qualify for loans. These transactions are known as "subprime" mortgage loans and they usually charge interest ratesthat are above the "prime" interest rates available to borrowers with good credit. On its face, there is nothing devious or illegal about a high interest "subprime" loan. It is simply a case of a lender taking on a higher risk and receiving a higher interest rate in return.However, during the housing boom, lenders were so anxious to make new loans to anybody that they offered “teaser” rates to attract borrowers: subprime lenders offered relatively low interest rates for the first couple of years, after which the rates would increase. Another enticement was the “interest only loan.” Under this deal, borrowers paid no principle for the first few years which kept the monthly payments down for a while. Many borrowers also did not have tocome up with a down payment to get a mortgage loan. Consider a typical family from southern California.In 2005, Mario and Leticia Montes found a home they loved, a gray stucco bungalow with a hot tubin the backyard in a middle-class neighborhood of Orange County. The price was a major stretch at $567,000. But the couple, who had sold a home a few years earlier to move to a better area, was tired of renting. Like many people who jumped into the rising