When Apple's 8GB iPhone was released for US$599 in 2007, people were waiting in lines to buy it, and not just for themselves - they were clamoring to buy extras as investments. The iPhones were in short supply and high demand. What could go wrong? (To read more about this basic economic theory, see Economics Basics: Demand and Supply.)
It was the hottest technology in the cell phone market at the time. If you could get one, why not two, three or five?
However, just two months later, the price of iPhones dropped US$200. How could these investors have guessed that iPhones would drop 33% so quickly? But then again, many investors were just as shocked about the mortgage market, when real estate values nosedived in 2007 as a result of the subprime mortgage crisis. What would have happened if iPhone investors had been given equivalent loan options as homebuyers were given during the mortgage crisis? Read on to find out.
iPhone Crisis Analogy Assumptions
The iPhone crisis begins something like this:
- The banks recognize the soaring value of iPhones and hand out credit cards with $5,000 limits to iPhone investors as easily as Halloween candy - even if the iPhone investors don't have the income or credit history to prove they can handle the monthly payments if they're unable to unload their investments.
- Buyers are given a low introductory interest rate that will expire at right about the time iPhone prices start to plummet.
- Many buyers will walk away from the debt (similar to home foreclosures) and let the credit card company have the iPhones to sell.
So, how would the investors who bought iPhones pay off their credit card bills? And, if the iPhone buyers didn't pay their bills, how would this affect the investors in the banks that provided the credit cards?
One option is that iPhone buyers could give their iPhones back to the credit card companies (let's call this an iPhone foreclosure). In this case, the credit card company would have to take the hit for the $200 drop in price, which means anyone investing in iPhone credit securities would also lose value in their portfolios.
To further complicate the situation, because of the perceived stability of the iPhone market, it wasn't just investors who assumed they would earn interest from credit cards secured with iPhones as collateral. Fund managers included iPhone credit card securities (ICCS) in pension, retirement and hedge fund portfolios. In one way or another, most Americans would now be affected by the iPhone market crisis.
The Real Mortgage Crisis
This exaggeration of how iPhones could've affected the economy in 2007 shows the same destruction as the subprime mortgage meltdown. When the real estate market was rising, banks and mortgage companies could easily loan money to anyone who wanted it. Borrowers who didn't have good credit or an income high enough to qualify to buy a home were still freely handed mortgages. The home's supposed price stability would allow the owner to sell the home and the bank would regain the money. But even if the owners didn't sell the home on their own, the bank was counting on being able to recoup the loan amount by selling the home after foreclosure - and possibly even make a profit. (For more information on subprime lending read Subprime Lending: Helping Hand Or Underhanded?, The Fuel That Fed The Subprime Meltdown and How Will The Subprime Mess Impact You?)
Mortgages seemed as valid a currency to trade in as gold, silver or iPhones. Retirement, pensions, insurance firms and hedge funds bought mortgage-backed securities (MBS) under the impression that they were safe investments. Although these securities are categorized based on credit ratings, fund managers thought it was still safe to purchase mortgage-backed securities containing subprime loans. Subprime loans are riskier investments because they are generally given to individuals with less-than-perfect ratings and often with little to no money down. However, investors were interested in the subprime market's higher interest rates, because their investors could earn more money on those loans than on a regular mortgage. At this time, there wasn't a perceived risk to investors if the value of homes continued to rise. (Read more about MBS in The Risks Of Mortgage-Backed Securities.)
In this situation though, the homebuyers didn't have any incentive to keep the homes, because most paid little or no down payment. Consequently, as with the analogy of the iPhone, when the buyers couldn't afford their depreciated asset, they simply walked away from it and foreclosed on the purchase.
To complicate matters for the mortgage market, home prices were able to rise because of the less stringent standards banks were applying to lending money. Income wasn't a factor in loan approval, so the banks didn't notice when incomes weren't rising at the same rate as home prices. Thus, even borrowers with very good credit couldn't afford to buy the homes for the original amount of the bank loan.
Banks and investors not only lost out on the interest and profit they hoped to earn, but were losing up to 40% of their original investment because of the new prices in the home market.
Stock prices went down, various banks failed and the value of many mutual funds that had links to banks or mortgage-backed securities plummeted. As a result of banks not having as much money available to lend, less money was available for businesses, which by nature need to borrow money to grow and pay bills. Reduced or no available credit for businesses only added to the spiraling economy as many were forced to lay off employees, who would then be forced to foreclose their houses.
The mortgage market crisis happened because of one main fact: banks were too willing to lend money based on a trend of rising real estate values instead of the tried-and-true principles of whether potential homeowners could afford to purchase homes.
The moral of the story is that there isn't a risk-free investment. Whether you are investing in iPhones, mortgages or your favorite automobile manufacturer, make sure you can afford to and are prepared to handle both losses and profits. Had this logic been applied in the housing market, the mortgage and credit crisis may never have happened.
For all things credit-crisis related, check out our Subprime Mortgage feature.