Back in the good old days, if you needed a mortgage, you went to a local bank. The bank loaned you money and the mortgage loan was an asset that was put on the bank’s books. The banks couldn’t loan out more money than they had, so they were prudent in their lending practices. They wanted to be repaid, so they didn’t willingly make risky loans.
But eventually, that all changed. The demand for mortgage loans exceeded the supply of money available for mortgages. Banks simply did not have enough money to lend to everyone who desired a mortgage. What the banks DID have was mortgage loans which were sitting on their books as assets. And just like any other asset, mortgages have value. The banks (and the government) figured out that if banks could SELL their mortgages, they would have more money and could make more loans.
As a result of this situation, a complex and convoluted system was developed, in which banks packaged mortgages and sold them. In reality, a mortgage is nothing more than a pile of paper. These piles of paper were bundled into neat little packages and sold. Small packages were bundled into larger packages. Many were sliced up and regrouped into new packages, some riskier than others. It became a giant game of paper shuffling.
So who bought these packages? Well, they were sold to Fannie Mae and Freddie Mac, to investment banks and to investors around the world. These packages were turned into mortgage backed securities and became part of investment portfolios. The mortgage backed securities were cut into slices (called tranches). The tranches were repackaged and resold as collateralized debt obligations (CDOs). And the system chugged along. The banks lent money for mortgages. The mortgages got packaged and sold everywhere – on Wall Street and on Main Street. It is highly possible that people even unwittingly bought slices of their own mortgage.
So what was wrong with this system? Well, back in the days when the banks held onto their mortgages, they had to be careful about who they loaned money to. They knew that if a borrower defaulted, they were stuck holding the bag. But once the practice of selling mortgages became commonplace, the banks got careless – and greedy. They became less concerned about what would happen if borrowers defaulted, since they weren’t keeping the mortgages anyway. They created risky mortgage products – things like Option ARMs, Stated Income Loans and Sub-Prime mortgages. And then they sold them.
It was reckless lending practices and risky mortgage loans that ultimately drove up real estate prices. Eventually borrowers began defaulting on their mortgages and the entire house of cards came crashing down. Banks began foreclosing on homeowners and home prices plummeted. It became clear that many mortgage backed securities weren’t neat little packages after all. They were giant cans of worms.
Many people argue that the Great Recession was caused by too many people taking out mortgage loans that they couldn’t pay back. And, in fact, it is true that many people DID overextend themselves on mortgages and other forms of debt. But the people who blame the Great Recession on the people who took on the debt completely miss the big picture.
If the banks had simply made bad loans and kept them, well, that would have simply proved that the banks were stupid. But they didn’t KEEP the bad loans, they sold them – and they passed them off as having far more value (and less risk) than they actually did. If a company like Boeing made and sold an airplane that they KNEW would crash, who would be to blame when the plane ultimately crashed? Would anyone argue that it was the fault of the passengers for getting on the plane? Would anyone argue that it was the fault of the airline for purchasing the plane? Of course not.
The situation with the banks is not very different. The banks created and sold bad products. The people who are angry with the banks are justified in their anger. What the banks did was wrong – and we are all paying the price for their greed.
