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Housing price conundrum (part 3)

Why did lending standards become more and more lax from 2000 to 2006? Created by Sal Khan.

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  • blobby green style avatar for user Gilles Frenette
    I was thinking, we haven't been talking about the changing demographics of North American society on housing demand. The fact is there are more people living alone (single-person households) than ever before. A house that used to house 3 or 4 or more people very often only houses 1 person these days.

    Does this affect housing demand in any significant way ?
    (25 votes)
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    • mr pink red style avatar for user Nathan Muller
      Or is the question: has the increased availability of cheap financing spurred more people (who under other circumstances would have to live with others, due to the increased afford-ability) to chose to enter the housing market? I tend to think that they may have acted together, but I would posit that people, over time, have always had a preference to live on their own, but only until recently has it been economically feasible (maybe not financially prudent, it must be pointed out) to do so.
      (19 votes)
  • spunky sam blue style avatar for user Jason Civalleri
    One basic definition of fraud is an expert knowingly giving false information to others out of personal interest. For example, a surgeon telling a patient that they need surgery without disclosing that there is chance that the patient won't live. If these banks were certified financial experts and giving loans to people who couldn't afford them so they could bundle the sub-prime investments with more enticing ones and expecting a certain level of profit, how is this not clear-cut fraud?
    (8 votes)
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    • old spice man green style avatar for user Chris Sinestro Baggett
      We don't have any real regulation on the shadow market or Derivatives. The Ratings agencies (moodys and the like) were the ones who were supposed to be telling the banks what was good or subprime, but were rating subprime as AAA.

      It's true that we need to enforce our current regulations more, but we also need tighter more complex regulation on the shadow market and derivitives (which the republicans made sure to sideline in Dodd-Frank and in the watering down of the Volker rule).
      (5 votes)
  • blobby green style avatar for user mjberkey88
    So, I get why the mortgage broker gets a cut, but why does the investment banker take a cut as well? Why don't the investors buy straight from the mortgage brokers and cut out the middle man? Are there any videos on this website that explain the investment broker's role in all of this?
    (5 votes)
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    • spunky sam blue style avatar for user Jason Civalleri
      From what I understand, the mortgages were bundled with other stronger loans by Bear Sterns and the like in order to minimize the loss of sub-prime borrowers. The banks themselves probably didn't have the volume of loans at the local to accomplish an enticing bundle, so they all funneled through the investment banker
      (4 votes)
  • mr pants teal style avatar for user vistamsrsanqui
    Who is Franny Mae or Freddie Mac?
    (4 votes)
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    • male robot hal style avatar for user Andrew M
      Fannie Mae is the nickname for the Federal National Mortgage Association (FNMA -> "Fannie Mae"). Freddie Mac is a nickname for a similar company, Federal Home Loan Mortgage Corp. These companies were sponsored by the government in order to make home ownership more affordable. Fannie and Freddie would purchase qualifying mortgages from banks so that the banks could make new loans rather than hold the ones they already had.
      (4 votes)
  • blobby green style avatar for user Diego Armando Romero
    What does "Investors" include?
    (2 votes)
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    • leaf green style avatar for user yashrajatodaria
      All the loans are converted into marketable securities. Also known as "SECURITIZATION". They convert all their loans into tradable securities which promise to give some return on your investment. The instrument is similar to what we call bonds or debentures. The investors can be anyone. Even retail investors are included. In some cases, farmers from Norway were also investing in these securities.
      (4 votes)
  • blobby green style avatar for user Aric Diamond
    Why did the idea of mortgage backed securities ever catch on? Isn't it inefficient for all parties involved to move a loan through that many channels? Wouldn't it have just been more profitable for Countrywide to just hold onto them if they were so profitable?
    (2 votes)
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    • male robot johnny style avatar for user 10brucewaynealti
      The reason why Countrywide and other banks like it sold the loans on was to reduce risk and to free up their balance sheet. If you had millions of loans sitting on your balance sheet that means more risk depending on the rating for the loans. (Keep in mind that a loan rated AAA typically has a lower yield than a more risky loan.) What the banks did was really smart if you think about it. They sold the loans on and in the process eliminated the risk and made a profit. Whenever the bank sold the loans it was able to issue more and the cycle was continuous.
      (2 votes)
  • mr pink red style avatar for user Bobby Smith
    Did something like this ever happen before? Will it ever happen again, or will people learn from their mistakes and be less trusting and more vigilant?
    (1 vote)
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    • leaf blue style avatar for user Lee Lebensbaum
      With the increasing power of banks and some very wealthy individuals when combined with the Citizens United Supreme Court case and the total unwillingness of the Congressional republicans to sponsor both legislation and oversight, the likelihood of market manipulation increases every year. The stop gap measures which had any chance to protect the consumer are being increasingly undermined by special interests, especially in the financial community, including major banks. These are the folks which use their power to funnel money to candidates and legislatures to protect their interests at the expense of consumer interests. The progressive and moderate republicans who created the social safety nets are all but gone. In their place, as better stated by others, are vulture capitalists. This is the present and this is the future.

      These corporations and individuals create tax loopholes for themselves and hold the consumers hostage. They seek the benefits of our society, but use various schemes to avoid sharing in its responsibilities. As evidenced since 2008, earnings and wealth ascended to a few while the rest struggle. The middle class since Ronald Reagan, followed by Clinton's NAFTA has deteriorated. Work place protections have been evaporated. The frontal and indirect attack on unions has been successful. Republicans have tried every trick to make it harder for the average citizen to vote.

      Given these factors and others, even if there is no blatant market crash, the quiet impact on the average consumer grows. Their capacity to participate is eroding. And as far as I can see into the future, the pattern will continue unabated. Home ownership will recede while rentals will increase. The wealth will buy the homes and rent them to the rest of us.
      (2 votes)
  • aqualine tree style avatar for user Héctor Díaz
    What does it mean when Sal says more people BID on homes?
    (1 vote)
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  • leafers ultimate style avatar for user saiteja Thota
    Who are investors
    ????? What gives the money to all there banks like IB?
    (2 votes)
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  • male robot hal style avatar for user Tyrone Sutton
    Ask a question... Was it illegal for banks and financial institutions to package those types of securities? Did the federal government change the laws for securitization to take place?
    (2 votes)
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Video transcript

So just a bit of review. What happened from 2000 to 2004? Actually I should really say, from 2000 to 2006, because that really was when the housing bubble happened. Well financing got easier. Or essentially they lowered their standards. And it got progressively easier and easier and easier, every year we went. So then that allowed more people to bid on homes. So it increased the demand artificially in certain ways. Because we saw from that New York Times article that people's incomes weren't increasing, and the population wasn't increasing anywhere near as fast to soak up the supply. So all it did is allow people who were renting before, and who couldn't save the money for the down payment, now to participate. So now you had more people bidding for the same house, to bid up houses. But that led to the obvious question. Why did financing get easier and easier? So let's go back to the good old days, like the early '90s. Or actually, let's go even before that. Let's go to the classic, what happens to get a housing loan? Well traditionally, if I want to get a loan I would go to my bank. And that loan officer at the bank, he's going to be giving the bank's money for your house, right? He gives you money. And you're going to pay him interest. Right? This is me. And so that loan officer at the bank, he really cares that they're not going to lose money on the transaction. If he's going to give you $1 million, he wants to make sure that no matter what happens, if you lose your job, if you get arrested, if you skip town, that he's still going to be able to get his $1 million back. And if you go back to our equity and balance sheet presentations, that's why, back in the day, they made sure that you put 20%, 25% down payment on your house, that you had a good credit rating, that you had a good steady income. Because that banker, that loan officer, was going to be in trouble. And his bonus was based on how good the loans he gave held up. So that was the traditional model. What happened-- started to happen the mid-90s, especially in California, and then nationwide in about 2001, 2002-- is you had what we call a securitization of the mortgage market. And this, in all fairness, this actually happened a while before, with things like Fannie Mae and Freddie Mac. And I'll do a completely separate video on those. But Fannie Mae and Freddie Mac essentially had the same standards. They had the standards of, we call them, conforming loans. I think the numbers -- you have to have 20% down. You have to have a certain credit score, certain steady income. So Fannie Mae and Freddie Mac were these entities that might buy the loan from your local banker. But their standards were just as high as the local banker's. And they were based -- I think they were actually, they had oversight by Congress. So they weren't giving away loans for free. But I'll do a whole other presentation on Fannie Mae and Freddie Mac. What you had happen in the late '90s, and especially in the early part of this decade, is you had a whole industry outside of the government-sponsored entities. The government-sponsored entities are Fannie Mae and Freddie Mac. And this is essentially -- instead of you going to your local bank for a loan -- this is me again -- I would go to my local mortgage broker. Countrywide is the most famous of them. I think they're CFC. That's their stock ticker. They're not bankrupt yet. So I would go to Countrywide. And essentially I would get $1 million from them, a home loan. I would get $1 million from them. And I'd agree to pay interest to Countrywide. But then Countrywide would do this like, a million times. So times a million, right? They'll give home loans to a million people, put them all together. And then they'll sell the loans. They'll sell the loans to like, let's say, Bear Stearns. So that's an investment bank. Let's call it Bear Stearns. Hope none of these people sue me. I guess they have bigger troubles now, then wondering about my YouTube videos. They sell it to Bear Stearns. And then Bear Stearns will package a bunch of these mortgages together, essentially IOU's from people. And then they would sell those to investors. Right? So essentially, instead of Countrywide being responsible for my loan, my payments now go to these investors. And you could watch the-- that says investors. I know my penmanship is horrible. But you should watch the videos on mortgage-backed securities and collateralized debt obligations, if you want to get a better understanding of exactly how the money flows go. But the bottom line is, because of this process, what's happening? Countrywide is just being a transactional. They're just doing the paperwork for my loan. They're temporarily holding the loan. And they're doing a little bit of due diligence. And in return for that, that Countrywide mortgage broker will just get a fixed fee for doing that transaction. Maybe they'll get like $5,000 for just doing the paperwork for my mortgage. Right? And then Bear Stearns will package a bunch of these mortgages up-- and now it's going to be in the billions-- and then repackage them and sell them to investors. In the process, Bear Stearns gets a cut. And Bear Stearns is doing this for millions of mortgages at a time. It's in the billions of dollars, and Bear Stearns gets a cut. So Bear Stearns essentially just gets a fee, like the mortgage broker. Of course it's a huge fee. And then the investors are going to get my interest payments. Right? And let's say if the interest rates, if I'm paying 7%, and the other million people are paying 7%, the investors are going to get 7% on their money. And that seems like a pretty reasonable proposition. And of course the investors would care that the money that they're essentially giving -- because they're giving money to the investment bankers who are giving money to Countrywide. And that's where my $1 million is essentially coming from. The only reason why the investors would give their money, is if they have a lot of confidence that these are really really good loans. Well the investors, they don't know who I am. They don't know what my job is, how likely I am to pay the loan. So the investors have to rely on someone to tell them that these are good loans. And that's where the rating agencies come in. And these are Standard & Poor's and Moody's. And they rate these assets, these mortgage-backed securities. And what they say is, well, they'll look at this big package of mortgages, these million mortgages that Bear Stearns has packaged together. And they'll look at the historical default rate. And they'll say, wow, these mortgages really haven't been defaulting. And you can think about why they haven't. Because housing prices been going up. So these mortgages really haven't been defaulting. There's a very high chance you're going to be able to get all your money back. So we're going to give these what they call, let's say they say AAA rating. So this investor, who knows, it could be the Central Bank of China. It could be a hedge fund. It could be a whole set of people. It might be the investment banks themselves. Sometimes they actually bought these just to make some extra money. These investors, they don't know who actually borrowed the money, or what kind of credit rating they had, or anything. But they just took a leap of faith. They said well, Standard & Poor's or Moody's did the work. They're telling me that this is AAA, which means the highest level of debt. Or you know, whatever they told them. Maybe it was A. I forget all the different qualities of debt. But they just took their word for it. And they got their 7% interest on their money-- whatever it was, 6% money. And that worked out pretty well. And so these guys, they liked the fact that they were getting the 7%. They said, this is a good asset class. So then they funneled even more money. So then there were even more investors that wanted do this. They're like, this is great, with very little risk I'm getting a pretty good return on my money. That's better than putting it in the bank. That's better than buying Treasury Bills, right? So then even more money flowed in. Well, more money wanted to invest in people's mortgages. But Countrywide would say, well, we're already giving mortgages to all the people who qualify. So in order to actually find more people who want mortgages from us, we'll just have to lower the standards a little bit. Right? And we can lower the standards, because we find even when we do lower the standards, no one's defaulting on their mortgages. And in the next video, I'll maybe give a little bit more [? color ?] why. So Countrywide will issue even more mortgages, and give them to these investors with even lower standards. Of course, the mortgage brokers at Countrywide, they love it. Because every time they do a transaction, they just get some money. And then they give the mortgage to the investment banker, which packages them up and then sells them to investors. So they get it off their hands. And they just got the fee. So they just collect the big cash. The investment banks love it, right? They just love doing the transactions, because they get more and more money every time they do the transactions. And for the moment, the investors seem pretty happy, because they keep giving money into this system, so to speak. Even though they might be reading the newspaper and seeing that the standards are going down. But they're consistently getting their return. And because the defaults were very low over this time period -- and I'll explain in the next video why the defaults were very low -- they felt that they were getting a good return, maybe 6% or 7%, on investments that had very, very low risk. So in the next video, I'll explain why the defaults were very low in that time period. See you soon.