Well, for the last 9 years housing prices had rose unreasonably fast. However, starting in 2006 the prices peaked, and then the tide went the other way and it was all down hill from there. In 2007, the drop in housing prices revealed the people that was "swimming naked" (as Buffett calls it): Mortgage (prime and sub prime) lenders, banks, private equity, bond investors, ratings agencies, house/condo speculators, real estate developers, house builders. So to show all these people got tied together, here is a summary of what happened during the years of myopic exuberance:
The Good Times
The economic boom of the 90s brought wealth and optimism to many Americans. With their new found wealth, they brought bigger houses and more expensive cloth/cars. This and the generational boom in population created a lot of demand for housing. Thus, the prices for land to live on started its 9 year upward march. In 2001, as the housing prices were still rising, many Americans lost a lot of money and confidence in the stock market after the Tech bubble crashed. Looking for a new place to put their money, these speculators dived into housing as the new source of wealth. This created the false notion that a house was more than a place to live, it was an investment - "it was a gold mine of wealth, your every own ATM machine".
Many people joined in to become house flippers and real estate speculators in the industry. The booming real estate created excess optimism in the real estate developers. They built and developed more and more land into houses to exploit the demand of the housing speculators. The house builders and construction industries are more than glad to provide plenty of material and labor for the spate of houses being built. The house speculators needed money to finance their purchases, so they turned to mortgage lenders for help. Since most speculators are not willing nor have the cash to put down a downpayment, they invented new innovative loans to cater to these customers - the adjustable rate mortgage, believing the risk was low since the houses will "surely rise" in value and the speculators will have more than enough to pay off these loans with their sales "profits". The lenders, wanting to make as many of these loans as possible to match the seemingly insatiable demand, turned to banks for finance. The Banks welcomed the opportunity to profit and using their vast knowledge of finance, they repackaged these loans and sold them as safe, interest bearing, asset backed securitized bonds to eager investors. With the triple AAA ratings from the credit rating agencies, who gladly taking the fees, the investors (hedge funds, pension funds, muni-bond insurers, private wealth) snatched up these securities as safe high-yield investments.
All this business brought record profits to the Wall Street banks and the stock market staged a rebound from the tech crash. The Bull market brought back the old beast of finance - the corporate raiders of the 80s. Private equity, the new name of the beast, brought companies and flipped them like houses. Awash with cash, the banks didn't mind lending to the private equities to finance their mega corporate acquisitions. This fueled another boom in the stock market as hedge funds and speculators try to pick which companies is going to be brought up next. The feeling in the air was that easy money was every where and the party was on.
The End of the Party
Greed was rampant throughout the whole industry, but this was not to last as long as many people thought. While Wall Street was partying, the housing prices crested. The prices were so exorbitant that normal middle class American can no longer afford it in many of the nation's urban cities. The bubble had reached its limits. The needle that pokes the first hole was sub prime lending. The lenders, in their incessant pursuit to lend as much as possible to as many people as possible, went so far as to lend to people with shady credit and little or no income. They believed that they didn't have anything to fear since all the loans will be sold investors anyway. The banks, in their ingenious financial wisdom, cropped up these less than stellar credit loans and repackaged them with high credit loans so they too can enjoy the necessary triple AAA credit rating for the whole money making scheme to continue as normal. Unwittingly, this careless mistake started the unraveling of the whole system. In 2007, the sub prime loan holders, as expected, started to default and their houses accordingly went into foreclosure.
This phenomenon triggered two things. One, as more and more houses started to foreclose, this exacerbated the down turn on housing prices and in turned caused the house speculators (and all those people that brought houses thinking they were great investments) to lose tremendous amounts of money and a mortgage that now they cannot repay, which caused more foreclosures, creating a cycle of falling housing prices that spread like a virus throughout the nation. Second, the mortgage lenders, who now has these loans that the holders cannot repay, has nothing to deliver to the investors that brought these loans as securities. The investors, seeing that their "high-yield, low-risk" investments are defaulting, refused to buy any new such securities at any price. The banks, seeing these securities are not selling and pilling up in their balance sheets, immediately panicked as they realized that they would have to take the losses of these defaults. As regulation law forced them to write down the devaluation of these securities, the banks immediately started to hoard up capitol in reserves (by refusing to lend to others) to offset the losses of these loans, thus creating the start of the credit crunch. That was what happened in August of 2007.
Cut off by the banks, the mortgage lenders cannot finance any new loans to operate, so most of them started to go bankrupt. The bond investors that hold these defaulting bonds promptly blamed the credit rating agencies for their false and misleading triple AAA ratings on securities that should have been rated below C. The stock values of the affected companies have all dropped tremendously. The broad sell off has spread across to other sectors, creating a climate of fear among the investors. As the music stopped, these troubled industries all turned to their plan of last resort: whining at congress and the Federal Reserve to intervene (a.k.a. bail them out).
