08S7C's Economics Blog

Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do.
In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing,
But it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.

For many years, Cleveland was the sub-prime capital of America.
It was a poor, working class city, hit hard by the decline of manufacturing and sharply divided along racial lines.
Mortgage brokers focused their efforts by selling sub-prime mortgages in working class black areas where many people had achieved home ownership.
They told them that they could get cash by refinancing their homes, but often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate.
The result was a wave of repossessions that blighted neighbourhoods across the city and the inner suburbs.
By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting on behalf of bondholders, was the largest property owner in the city.

Sub-prime lending had spread from inner-city areas right across America by 2005.
By then, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time in the "hot" housing markets of Southern California, Arizona, Nevada, and the suburbs of Washington, DC and New York City.
House prices were high, and it was difficult to become an owner-occupier without moving to the very edge of the metropolitan area.

But these mortgages had a much higher rate of repossession than conventional mortgages because they were adjustable rate mortgages (ARMs).
The payments were fixed for two years, and then became both higher and dependent on the level of Fed intereset rates, which also rose substantially.
Consequently, a wave of repossessions is sweeping America as many of these mortgages reset to higher rates in the next two years.
And it is likely that as many as two million families will be evicted from their homes as their cases make their way through the courts.

One reason the economic slowdown could get worse is that banks and other lenders are cutting back on how much credit they will make available.
They are rejecting more people who apply for credit cards, insisting on bigger deposits for house purchase, and looking more closely at applications for personal loans.
The mortgage market has been particularly badly affected, with individuals finding it very difficult to get non-traditional mortgages, both sub-prime and "jumbo" (over the limit guaranteed by government-sponsored agencies).
The banks have been forced to do this by the drying up of the wholesale bond markets and by the effect of the crisis on their own balance sheets.

Banks lose money! In turn, due to the lowered confidence in banks by consumers, they have even lesser capital as the consumers(people with money to put into the banks) choose not to put their money in for fear of the bank collapsing and their money disappearin.