2008 Woodie Awards
Understanding the Credit Crisis
What is at stake?
Geoffrey Berkheimer
Issue date: 10/6/08 Section: Opinions
Chances are good that if you have been alive and awake over the past few weeks, you have heard a little bit about the credit crisis and the problems with the economy. Students refer to it as the Apocalypse or the next Great Depression - and it is not hard to see how they draw those conclusions.
The fact of the matter is that the media has not done an effective job explaining what the problem actually is and what we have at risk. In an effort to clear this all up, I spoke with economics professor Nathan Anderson who was able to make clear the factors that have created the current credit crisis, and what the long-term threats are now.
The credit crisis that we are now seeing is inextricably linked with the housing market bubble that burst in about 2005. Until this time investors, homebuyers and banks lived with a general perception that housing prices would continue to rise.
Since about 2000, housing prices had been rising dramatically, so it made sense for banks to lend money to potential homebuyers who would not otherwise be able to afford their home. The expectation was that the price of housing would increase and the buyer would make money on it, which would allow the mortgage to be paid off.
Mortgages are bundled into securities, like a bond, and sold to investment banks. The banks are basically buying the right to receive mortgage payments.
These investment banks use the securities as collateral to borrow money from other banks. Because the price of housing was expected to keep rising, these securities were seen as low-risk, high-return securities.
Banks therefore were able to borrow a lot of money using those securities as collateral, sometimes with as much as a 30-to-1 ratio on the supposed value of the assets.
Well, surprise, historical evidence shows that there have been very few instances of a sustained increase in real estate prices. Prices leveled off, proving that it had been, in fact, an inflated market.
The fact of the matter is that the media has not done an effective job explaining what the problem actually is and what we have at risk. In an effort to clear this all up, I spoke with economics professor Nathan Anderson who was able to make clear the factors that have created the current credit crisis, and what the long-term threats are now.
The credit crisis that we are now seeing is inextricably linked with the housing market bubble that burst in about 2005. Until this time investors, homebuyers and banks lived with a general perception that housing prices would continue to rise.
Since about 2000, housing prices had been rising dramatically, so it made sense for banks to lend money to potential homebuyers who would not otherwise be able to afford their home. The expectation was that the price of housing would increase and the buyer would make money on it, which would allow the mortgage to be paid off.
Mortgages are bundled into securities, like a bond, and sold to investment banks. The banks are basically buying the right to receive mortgage payments.
These investment banks use the securities as collateral to borrow money from other banks. Because the price of housing was expected to keep rising, these securities were seen as low-risk, high-return securities.
Banks therefore were able to borrow a lot of money using those securities as collateral, sometimes with as much as a 30-to-1 ratio on the supposed value of the assets.
Well, surprise, historical evidence shows that there have been very few instances of a sustained increase in real estate prices. Prices leveled off, proving that it had been, in fact, an inflated market.
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