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Housing price conundrum (part 2)

How lower lending standards led to housing price inflation. Created by Sal Khan.

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  • piceratops tree style avatar for user Rafael Zamora
    What is Fanny May and Fanny Mac? Sorry, but I'm only twelve.
    (18 votes)
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    • leaf blue style avatar for user Tomislav
      They are government sponsored financial institutions that increase flexibility and liquidity in the credit market. They buy loans from commercial banks and give them money so banks can make even more loans. They also issue the mortgage-backed securities.
      Basically, they are putting more fresh money in the banks, while taking risky loans from banks.
      (12 votes)
  • blobby green style avatar for user Eli Farmer
    Given that all this is true, how about now? Why would banks want to not refinance/remodify loans and allow homes to fall into foreclosure?
    (4 votes)
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    • blobby green style avatar for user matthew.ebersviller
      It depends on the banks' perception on the likelihood of a given individual defaulting or not. For instance, say the bank loses $25k per $100k foreclosed home on average. Also say that a given demographic will only actually default on the loan 10% of the time. The cost of foreclosures over this pool is $2500/house.

      Now let's see what happens if they lower the payments: If the same bank were to renegotiate the same house/loan instead of heading to foreclosure, what price do the renegotiate to? If it's the market value of the house, well, that's the same $25k loss they took by foreclosing and reselling the house. So now, they've guaranteed their loss of $25k on the house. Since the bank has an open remodify policy, more than 10% of homeowners (indeed any rational homeowner) will attempt to remodify a loan. 11% or more of loans remodified is a greater loss than the "let them foreclose" scenario. Add onto this scenario that some people will still foreclose even after a remodify, and it becomes a bigger loser.

      There are some additional costs involved in foreclosures, and the debt appears on the balance sheet as toxic, which in itself potentially affects how much an institution can legally lend, so this is only a simple model. Still, you can bump those numbers around all you want, but assuming the lenders have a policy of remodification that's a higher percentage than foreclosures, it's a guaranteed losing proposition for the bank. If the percentage of remods are lower than the foreclosure percentage, then it only saves money if they remodify for an amount still above the home's value AND they can effectively decrease the amount of foreclosures enough to overcome the guaranteed losses from remodification.

      If you look at it from the banks' point of view, it boils down to this: If I remodify loans, there's a decent chance I'll lose more money than I am now, and the amount of uncertainty (banks hate uncertainty) increases. If I allow people to foreclose, I can calculate my losses with reasonable accuracy (and thus certainty). With a small chance for limited upside, and a good chance for reasonable downside, remodification often isn't the right decision.
      (11 votes)
  • male robot johnny style avatar for user Godzilla007
    What caused the banks to decimate their lending standards?
    (2 votes)
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    • blobby green style avatar for user brandon.n.atkinson
      The secondary mortgage market. The primary mortgage market is where the lender and borrower come to agree on terms of a loan. The secondary market is where lenders can sell approved mortgages (usually in bundles) to investors. Because the banks no longer risked suffering direct losses if loans defaulted, there was less incentive to determine the real risk of a borrowing not being able to pay back the loan.
      (9 votes)
  • blobby green style avatar for user ajc3388
    For the initial mortgage of 45,000 @ 9% = $4050/yr or $340/mo, the video compares this at to rent at $900 stating that the interest "plus a little principal couldn't be more than $400 a month." But how does that work? even with a 30 year mortgage, you need to repay $1500 a year = $125/month. So adding the interest, $340, with the principal payment, $125, you're roughly paying $465 a month. With a 15 year mortgage clearly number would be a lot higher.
    (4 votes)
    Default Khan Academy avatar avatar for user
    • Over time, as you make payments on your mortgage (paying down the principal), you owe less and less interest in every year. If you keep your mortgage payments steady at about $400 a month for the entire 30 year period, then you will only pay back about $720 of the principal in year 1 (as you suggest). However, by year 30, when the remaining principal is close to $0, it will accumulate almost no interest, and nearly all of your $400 monthly payments will be used to pay down the principal.

      In fac
      (2 votes)
  • leaf green style avatar for user Yehyeon Cho
    what is credit rating?
    how do you measure it?
    (3 votes)
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    • purple pi purple style avatar for user Ujjwal Vaish
      Credit Rating basically decides your ability to repay a loan , the higher the credit rating , the more reliable you are , the more easily you can get loan ( as you are reliable ) and also at a lesser interest . If a company has low credit rating , it finds difficult to take loans , and if it finds one , the interests are high . There are various credit rating agencies like Moody's or Standard & Poor that measures the credit rating based upon past records , and brand value etc.
      (3 votes)
  • blobby green style avatar for user Arbaaz Ibrahim
    What does Sal mean by Good Credit?
    (1 vote)
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  • spunky sam blue style avatar for user Laird Simmons
    why couldn't the houses retain there value?
    (1 vote)
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  • orange juice squid orange style avatar for user Madeline
    what about fanny may and freddie mac?
    (1 vote)
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  • blobby green style avatar for user Robert.Powerplant
    This video assumes a conventional mortgage. FHA & VA loans were available in the 80's and had a low 3-5% down payment. So in general I agree with the premises but there would be more to the story. How many loans were FHA & VA over time vs. conventional.
    (0 votes)
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  • blobby green style avatar for user uMarmUneer
    Does the 400 dollar monthly payments account for the payment made to pay off the principal?
    (0 votes)
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Video transcript

Before I go a into an explanation of why housing prices skyrocketed from 2000 to 2006, I think it's a good idea to give a little history of what the housing market and the mortgage market used to be like before things got out of control. So let's go back to, say, I don't know. Let's go back to the late '70s-- maybe mid-'70s, actually. I remember my parents, they bought a house. We lived in New Orleans. And the house, if I remember correctly, it cost roughly $60,000. And back then, to buy a house -- and actually, for a while, until more recently -- in order to buy a house you had to put 25% down. So 25% of $60,000 is 1/4 of it. So you have to put $15,000 down. So you have to save up $15,000. And then you're going to get a mortgage on $45,000, right? $45,000, you're going to borrow. And I forgot the exact interest rates then, but I'm just going to throw out a number. This is really just for instructive purposes. Let's say interest rates back then, they were higher. They were like 9%, I think. So 9% on $45,000. How much interest am I going to pay? 45,000 times 0.09. So I'm going to pay a little over $4,000 a year in interest. Or if I divide by 12, about $340 a month in interest. And I remember at the time, we actually moved out of our house and we rented it out, because we needed cash. And we rented out that exact same house -- and I this is in the late '70s or early '80s-- we rented out that exact same house for $900. The rent was $900. So this raises, I guess, a couple of questions. First of all, the big question is, why did those people who rented our house -- I mean, they paid $900 a month. They must have had a good income, for that time. Why were they willing to pay rent, when they could have bought a house, where the mortgage would have been -- interest plus a little principal -- it would have been no more than $400 a month? So why would you just throw away -- this is the classic rent-versus-buy argument -- why would you throw away $900, where you could actually build equity paying $400 a month for the exact same place? And you can think about that a little bit. But there's a bunch of reasons. What was necessary to buy a house then? Well, one, you needed a $15,000 down payment. Maybe these people had really good cash flow every month, but they just never had the circumstances, or maybe even the discipline, to save up $15,000. You also needed a really steady job. So you needed -- this is the down payment, this is one thing. You also needed a steady job. Maybe the people who were renting, they were working odd jobs, or they didn't have a steady income. Although I doubt it. I don't think we would have actually leased the house to them, had that been the case. They probably had that. And then the last thing you needed to get a mortgage, you needed good credit. And maybe these people didn't have that. Maybe they didn't pay some bills in the past. And they just couldn't find a bank that was willing to give them a loan, despite having a steady job and the $15,000 down. If you have to ask me, I think the biggest barrier for this family at that time was probably the $15,000 down payment. And frankly, they probably had trouble saving $15,000 because they were busy paying $900 in rent. So that was the circumstance throughout, actually, most of modern history. That you had this barrier towards buying a house. That it did make sense, that the conventional wisdom that it is better to buy than rent held. It's just, everyone knew that, but a lot of people just couldn't buy, even though they wanted to, because they didn't have the down payment. They didn't have the steady job. Or they didn't have the good credit. That was a circumstance then, and that lasted for some time. What happened in the early 2000s? And it actually happened in California in the mid-'90s. But it got more and more, I guess we could say, flagrant, as we went through the decade-- is that people started lowering these standards. And I'll do a whole other video on possibly why those standards were lowered. But let's say that in 1980 you needed 25% down. Let me just switch colors. That color is kind of ugly. You needed a steady job. And you needed a, I don't know. Let's say you needed a 700 credit score. And that was true from 1980 to, let's say, 2000. I'm exaggerating a bit. But this is just to give you the broad sense of what actually happened. But let's say then, in 2001 -- and I'll explain later why this might have happened -- the standards were lowered. That if you wanted to buy a house, all of a sudden you could actually find someone who was willing to give you a house for 10% down, maybe kind of a steady job, maybe just need a job. And maybe you had a 600 credit rating. So what happens when the standards on the mortgage go from this to this? Let's go back to these people who used to rent that house from us for $900. Maybe they didn't have $15,000, right? That would have been a 25% down payment. But maybe back then, they had 10%. Maybe they had $6,000. They just couldn't get up to $15,000 in savings. Back when they were doing this, back in the '80s, if the standards got a little bit freer, like they did in the early 2000s, those people could have bought a house. They would have said, man, we don't have to rent anymore. We saved up the 10% down payment. It's gotten a little easier. Our job now meets the requirements. Our credit now meets the requirements. We can go buy that house. So that would have increased the aggregate demand for housing. Even though, even if no one's incomes increased, even if the population didn't increase. All of a sudden, there's a new person who could get financing to buy a house. And then if we go to, let's say, 2003. They say, you know what, you don't even need any down payment. No down. No money down. So you can imagine, there's a whole set of people who maybe had a decent income, but they couldn't save any money. Now all of a sudden there was no down payment barrier to buying a house. Maybe you still needed a job. And maybe you just needed a 500 credit. Right? So all of a sudden, without people's incomes going up, without more jobs being available, without the population increase, there were more people who could get financing. Or more people who could bid up homes. And the situation actually got pretty bad. By 2004, 2005 -- and this isn't exact, but it gives you a sense of what happened. By 2004, 2005, you had a situation where they had these stated income -- they had these things called liar loans. Maybe I'll do videos on each of these. But these were essentially no down payment. If you had a job, you could kind of make it up. You just said, I have a job. They wouldn't validate it. These were stated income. You could just say what you made. So even though the mortgage might require an income of $10,000 a month, and your income is only $2,000 a month, you could say your income is $10,000 a month. So stated income, no down, maybe a job. And they didn't even do a credit check. So what happened from 2000 to 2004 is that credit just got easier and easier and easier. And every time credit got easier, there were more people who, despite the fact that they weren't making any more money, they were able to get financing. And so the pool of people who were able to bid on homes, or the demand for homes because now there was this financing, became larger and larger. And that's what increased the prices of homes. And now you know, the obvious question is, well, why did this happen? First of all, why did they get easier in 2001, get easier and easier as we went to 2004? And why did they get to this unbelievably absurd level, where by 2004 and 2005 -- you hear stories, especially in California and Florida, of people who were making maybe $40,000 a year. And they were able to buy houses with no money down. Some of these people were migrant laborers. And they were able to buy houses for $1 million. So in the next video, I will tell you why that happened. Why were people willing to give their cash to people to buy a house that had a very low likelihood of getting paid back, and for a house that had a very low likelihood of being able to retain its value. I'll see you in the next video.