Believe it or not, according to Professor Kirby Cochran (University of Utah), this situation goes all the way back to the dot com era of the 1990’s when that bubble burst. Investors bailed out of the stock market in droves and went looking for safer alternatives for their money.
A new investment instrument called “Collateralized Mortgage Obligations” (CMO’s) became the rage. These were securities backed by residential real estate mortgages. At the time, virtually everyone was comfortable with real estate due to its historical stability and steady growth. So, most investors were comfortable putting their money in CMO’s and they did it in droves. The amount of money that flowed into CMO’s was enormous. The dot com money had found a new home in this new investment vehicle.
As a result of this tsunami of dollars flooding the CMO market, to keep up with the demand, lending institutions began loosening their borrower qualifications for mortgages, resulting in a flood of sub-prime loans to under- qualified borrowers. Creative new loan programs were developed including adjustable rate mortgages (ARM’s), interest-only mortgages, etc.
The result was that millions of new people were qualifying for home loans across the country and the demand for homes far outstripped the supply. Builders were working 24/7 to try to meet the tremendous demand and were selling homes before they were even built. Existing homes for sale were selling at ridiculous premiums. It was a feeding frenzy and the price of homes continued to go up each year. So people were buying homes they couldn’t afford, assuming that the prices would continue to go up along with their equity.
Foreseeing a foreclosure train wreck on the horizon, the Federal Reserve began to act. They started raising the Federal Funds Rate at a furious pace in an effort to increase interest rates and slow the rate of borrowing. Well, it worked -- interest rates increased as planned. The downside was that as Adjustable Rate Mortgages matured, mortgage payments increased to a point where many people could no longer afford to make their monthly payments.
Lending institutions with heavy positions in sub-prime mortgages (where the borrower typically had weak or bad credit but qualified for the loan anyway) had no option but to pursue foreclosure proceedings and were left holding title to mortgages with no payments coming in. Wall Street investment banks who had taken huge positions in CMO’s (recall that these are securities backed by mortgages) were in the same boat. And this proved to be more like the Titanic as we began to see major institutions fail.
Meanwhile, millions of homeowners are now caught owing more on their homes than the homes are worth. So, they can’t afford to sell or they will lose money due to negative equity. Worse, because of the maturity of their ARM, they can’t afford to make the monthly payments. The net result is: FORECLOSURE.
And that is what caused today's foreclosure crisis.