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Housing conundrum (part 4)

The virtuous circle of housing price appreciation making defaults go down making lending lax making housing appreciate even more. Created by Sal Khan.

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  • blobby green style avatar for user John Butler
    How does financing becoming easier cause house prices to go up?
    (7 votes)
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    • male robot donald style avatar for user drew.storey01
      If housing prices routinely go up, a homeowner won't have to default on their loan if they can't pay it. Instead, they can simply sell their home (since the price of their home went up) and pay the bank its due in full.

      Since the housing market became a surreal environment where everyone's homes were increasing in value at shockingly fast rates, the banks had little reason to deny providing a loan. If banks have good reason to assume that all their debtors will be able to repay what they were loaned, they will lower their standards for who they will loan to. Thus, financing becomes easier.
      (14 votes)
  • blobby green style avatar for user newtoparkcity
    Sal, you explain WHAT happened, but not WHY it happened
    The Chinese want their currency to be cheap so that their exports are cheap. In order to make the yuan cheap they sell yuan and buy dollars. When they buy dollars they buy US Treasuries. This artificial buying of Treasuries drives interest rates down in the US and creates excess liquidity. The Fed could have counted this buying of Treasuries with their own selling of Treasuries to sop up the excess liquidity, but they did not.
    (3 votes)
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    • blobby green style avatar for user alexanderstudivz
      They didn't do it, because if I can get money on low interest rates, I can sell the money for high interest rates. Why should I give the money back? And the Fed is the institution where US Banks get their money from. And low interest rates are good for driving investements in the economy.

      In short: China buys for 0.5% interest to Fed, Fed sells for 1% interest to banks, banks sell for 1.5% to companies. --> Cheap money for the US economy --> This is/was driving the economical growth.

      It's your choice to believe this is working^^

      Plus: Buying up your treasuries could create deflation which is bad for export, but this goes to far for now^^
      (4 votes)
  • piceratops ultimate style avatar for user Dicky Wira Senjaya
    what did Sal means with "Default rates go down" at ? what is Default Rates mean??
    and what is "Perceived lending risk go down" at ? what is perceived lending risk mean??
    (2 votes)
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  • mr pink red style avatar for user limfxoo
    When would this cycle start to collapse?
    (2 votes)
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    • piceratops tree style avatar for user rumankhurshid
      basically , from what i'm able to understand that the start of collapse was when in 2005 a no. of adjustable mortgages were maturing and the subprime borrowers inability to refinance their loan, was the actual time when it began to reverse and as andrew stated it reversed very quickly leading to a crisis no one could stop.
      (1 vote)
  • blobby green style avatar for user Bank Investor
    what about people who did pay off the mortgage? were they packaged in the MBS and CDOs too?
    (2 votes)
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  • blobby green style avatar for user Brian Kelley
    I'm not sure I understand why the housing prices went up. I understand that if you were selling your house, you would want to sell it for more than you bought it for. I guess I'm curious about who was building all of the new houses. Why didn't competition keep the prices of those houses down?
    (1 vote)
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  • male robot donald style avatar for user Varu Singhal
    What does it mean when Sal says Default Loans.
    (2 votes)
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  • leaf green style avatar for user Yoni Friedman
    I understand that the trick of grouping loans together was essential for this cycle to occur, but I don't understand what was the catalyst that allowed the cycle to begin. Actually, I would've thought that in the year 2000, when the dot-com bubble burst, default rates would go up (because of lost jobs) and we'd have a negative cycle in which housing prices drastically fall.
    Obviously, something must have happened to kick-start the cycle. What was it?
    (1 vote)
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  • blobby green style avatar for user kenny.leshner
    How can a person with no job or a very low paying job even pay the the interest on the mortgage?
    (1 vote)
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  • blobby green style avatar for user metallicarulez1983
    Didn't Bob Dall and Lewie Ranieri pioneer mortgage securitization at Salamon Brothers?
    (1 vote)
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Video transcript

I'll now explain to you why, from 2000 to 2005, we had very low defaults on mortgages. Let's say that I buy a house for $1 million. I buy a $1 million house. So let's say the bank gives me $1 million. And then I'm willing to pay a percentage on it. So this is from the bank. This is me. And I use that to buy a house. I don't know if these diagrams help you. But you get the general idea. And the bank does that. And let's say, I don't know, a year later I lose my job. I just can't pay this mortgage anymore. So I have a couple of options. I can either sell the house and pay off the debt, or I guess I could just tell the bank, well I can't do anything, and I'm going to foreclose. And that would ruin my credit. It would hurt my credit. And I would lose all my down payment. So what are the circumstances that I can sell the house? Well, if I borrowed $1 million, as long as-- and let's say I didn't put any money down, just for simplicity. If I can sell the house for $1.1 million, well I would do it, right? Let me sell for $1.1 million. If I sell for $1.1 million, I pay the bank-- let me switch colors. I pay the bank $1 million, and I net $100,000. And everyone's happy. The bank got their money back, so they didn't lose any money on the transaction. I made $100,000. And so the whole reason why this worked out, even though maybe I was a credit risk, is because the housing prices went up. So when you have rising housing prices, the banks will not lose money lending you. Because if you can't pay, you just give back the house, the bank can sell it. Or, you won't even give back the house. You'll sell the house and you'll pay it off, even though you can't pay the mortgage anymore. The only situation where I would foreclose is if the market price of the house goes less than my loan. And that's actually the situation that we're facing now. So if, let's say that I can only sell this house for $900,000. Well, then I'm just going to give the keys back to the bank. That's actually called jingle mail, because you just mail the keys back. And then the bank sells the house for $900,000. And then they would take a loss. So when housing prices go down, that's the only situation where really you should have foreclosure. When housing prices soon. go up, the person who borrowed it is just going to sell the house and pay off the loan. And they are actually probably going to make some money. So there was every incentive to buy a house. So let's think about this whole dynamic over the last several videos that we've been building. So we said, from 2000 to 2004 housing prices went up. Let me do it like this. Let me change it a little bit. We can even say, from 2000 to 2006. So we know that housing prices went up. And why did why did housing prices go up? Well, we saw the data. It wasn't because people were earning more. It wasn't because the unemployment rate went down. It wasn't because the population increased. It wasn't because the supply of houses were limited. We disproved all that. We realize it was just because financing got easier. The standards for getting a loan went lower and lower. Financing got easier and easier. And because housing prices went up, what did that cause? We just said when housing prices go up, default rates go down. You could give a loan to someone who's a complete deadbeat. But as long as housing prices go up, if they lose their job, they can still sell that house and pay you back the loan. So housing prices going up makes sure there's no foreclosure, so defaults go down. So then the perceived risk goes down, of lending. Perceived lending risk goes down. So that makes more people willing to lend. And the corollary of more people willing to lend, is you that the actual standards go down. That's financing easier. We could actually write that. Standards go down. So you had this whole-- I guess you could argue whether this is a negative or a positive cycle. But you had this whole cycle occurring from the late '90s, but especially, it really got a lot of momentum at around 2001, 2002, 2003. That financing got easier, despite the fact that people were earning less, population wasn't increasing that fast, that there were all of these new houses. And that caused housing prices to go up. Housing prices went up, then we had a lot fewer people defaulting on their loans. No one would default on their loans if they could sell it for more than the loan. Then a lot more people said, well these are super safe. And so the ratings agencies, Standard and Poor's and Moody's, were willing to give AAA ratings to more and more, what I would argue, are risky loans. So the perceived lending risk went down. Then more and more people liked this asset class. They said, wow, this is great. I can get a better return than I can get in a bank, or in Treasuries, or in a whole set of securities, even though these are very low-risk or perceived low-risk. So I want to funnel more and more money in here. And so the mortgage brokers and the investment banks said great, the only way we can get more volume to satisfy all these people who want to lend money-- the only way we can find more people to lend money to, is by lowering the standards. And this cycle went round and round and round. And it really started because this whole process of being able to take a bunch of people's mortgages together, package them up, and then turn them into securities and then sell them to a bunch of investors-- this was a quote-unquote innovation in the mid-'90s, or early '90s. I forgot exactly when. And it really started to take steam in the early part of this decade. So that's essentially why housing prices went up. And why kind of all of this silliness happened. And in the next video, I'll talk a little bit more about maybe who some of these investors were. And I'll tell you what a common hedge fund technique. And I think it's very important not to group all hedge funds together. There are some good ones. But what a common hedge fund technique was, to take advantage of this virtual cycle, to make the hedge fund founders very wealthy. I'll see