Financial Crisis 2000s: Reason number 1

Why did financial crisis of the 2000s occur?

One reason was that people forgot that housing prices do not always go up. Sometimes housing prices go down. Consider a person named Jose, who has a steady job, rents an apartment, but doesn't have any savings.

In the early 2000s, Jose can now get a mortgage that doesn't cost much more each month than his rent. He doesn't have to spend any money buy a house, which is good, because he doesn't have any savings. He just has to pay a small amount each month. He has to pay this amount each month for three years, but after that, he is going to have to pay more each month. At that point he is going to have a problem, because the new amount is more than he can afford.

But Jose doesn't need to worry. His home is probably going to be worth a lot more in three years (since prices for homes will probably keep going up), so he will be able to get a new mortgage with a new low rate that he can continue to afford. No one will have a problem loaning him money as long as his house is worth more than his mortgage.

It is three years later. Jose still makes about the same amount of money, but, home prices stopped rising a year ago. Jose has been making his payments diligently, but he doesn't have much more than he had three years ago because most of the money he gives the bank each month pays the bank. (That part of his payment is called interest.) Very little of the money he pays each month reduces the amount of money loaned to him. (That part of his payment is called the principal).

Now Jose has to pay more, but he can't afford it. So Jose tries to get a new mortgage. When he goes to get a new mortgage, he is told that his house isn't worth as much, so he can only get a mortgage for less money. But, if he gets a new mortgage (for less money), then he has to pay off his old mortgage (for more money), and where is he going to get the money to make up the difference? Jose struggles each month to pay his mortgage, and eventually he can't do it anymore. When he can no longer pay, he has defaulted on his mortgage, and he will lose his house.

In 2005, more than 1.5 million mortgages were created with low rates that were set to have higher rates in 2007 or 2008 according to a paper by the Federal Reserve.

That's why things started to go wrong in 2007 and 2008, but a new way that certain financial services companies tried to make money off of mortgages ended up making things a lot worse. But first, how are financial services companies supposed to work?