By late October 2007, U.S. credit markets for most real estate lending became almost frozen because of uncertainty among both lenders and borrowers about how to value specific types of property. This confusion arose from problems among subprime residential loans.

In subprime markets, many operators made loans on flimsy credit terms to low-income buyers, securitized those loans, put them in collateralized debt obligations (CDOs) or special investment vehicles (SIVs), and tried to sell those instruments to investors.

At first this tactic appeared attractive because of the high yields on subprime loans. But subprime defaults began to rise beyond what packagers and investors expected. Some investors were not being paid off as scheduled. These investors included many foreigners unfamiliar with U.S. home lending practices. They relied on AAA ratings made by U.S. credit rating agencies to support their decision to buy such paper.

Investors flinch

As subprime defaults made headlines, other originators of subprime loans were still trying to sell securities that included similar loans. But potential investors refused to buy this paper at the same rates that the originators had expected. Consequently, the originators could not sell the paper they were putting into CDOs or other SIVs at the prices they needed to cover the home loans they had made.

Therefore, firms owning those originators, or banks who had lent the originators money, found themselves having to advance large sums to keep the originators from going broke. This chain reaction exposed the problems that Bear Sterns had with two of its hedge funds, and affected a lot of other hedge funds and originators.

Although subprime loans were less than 15% of all residential mortgages outstanding, many CDOs contained a significant amount of subprime paper. Therefore, uncertainty had a much broader impact than the total amount of subprime loans would imply. Such broadening was provoked by the frequent lack of transparency in CDOs. Many investors had bought them for high yields without knowing all they contained.

Once widespread uncertainty arose about the value of CDOs, many investors who had been making real estate loans without doing traditional due diligence began to reconsider. They recognized their own loans could also default, even if those loans were not subprime. So uncertainty about values of real estate debt securities became rampant.

Rating agencies stumble badly

The basic cause of poor real estate underwriting was immense competition among investors with lots of capital seeking good yields in markets where property prices had soared and cap rates had fallen. After stocks crashed in 2000, a huge amount of global capital was looking for someplace to go in real estate. Pressure to make loans that ostensibly had good yields became intense. Eager investors were often given no time to complete normal due diligence before having to commit funds.

As a result, credit terms deteriorated into covenant-light loans unsupported by much due diligence. But once most lenders realized that they might become vulnerable, they started demanding more covenants, more time, and higher interest rates to cover their actual risks.

The resulting unwillingness of investors to buy commercial paper backing various types of high-risk instruments was reinforced by skepticism about the major rating agencies. Those agencies had apparently closed their eyes to the poor-quality underwriting supporting not just subprime lending, but other lending as well.

Suddenly, AAA ratings were almost meaningless. This frightened even more investors who had relied on such ratings, and the credit freeze became endemic. The rating agencies should be ashamed of themselves.

The stakes grow higher

The subprime contagion then spread to the private equity market. There, a few major banks had made huge loans to enable private equity firms to buy large publicly traded corporations. The banks committed these big loans to private equity buyers at fixed prices over the London Interbank Offered Rate (LIBOR).

But when banks securitized those big loans and tried to sell the pieces in investment markets, investors began demanding higher yields than the banks' initial spreads over LIBOR. Investors were seeking to protect themselves from increased uncertainty. Some banks were left with huge commitments they could not cover without large losses.

Banks affected by the credit crunch faced two alternatives. They could sell their securitized paper immediately and take major losses. That would give them back enough money to continue in the lending business. Or they could hold the big loans without selling parts to others, in hopes that investor uncertainty would soon dissipate and they could then sell their paper at smaller losses.

But if investors held out long enough, the banks would be out of the lending business for quite a while because the loans they had made had consumed so much of their capital. Big banks need to keep lending because the interest generated from their big loans does not provide high enough yields to meet their earnings targets. To hit those targets, they need to charge a lot of activity fees in addition to interest. Thus, they have to stay in the lending business.

On the other hand, bond investors had three alternatives. They could stop making loans unless they obtained better covenants and higher interest rates to offset the greater risks they perceived. But this would slash their own yields on capital, since they would have to park that capital in low-paying money-market funds or U.S. Treasuries until bank behavior changed. After all, investors were paid to get good returns on the capital entrusted to them, which often came from pension funds or other contributors.

The second option was that investors could accept banks' lower yields if the banks could offer more proof that the paper the banks were selling was properly underwritten. Thirdly, investors could simply accept the banks' lower yields and therefore accept higher risks without getting any higher returns. But most investors by then perceived a large increase in uncertainty that raised their risks, for which they believed they deserved more compensation.

Don't bank on a January thaw

This overall situation amounted to a standoff between banks and loan originators on one side, and investors loaded with capital on the other. Who would blink first? Neither side wanted to yield. Both sides therefore decided to stand pat for a while. Both were betting on a gradual reduction of willingness to stay out of the game by people on the other side. Each side initially thought that only the highest quality deals would be underwritten.

The conventional wisdom was that as confidence gradually returned among investors, more and more average deals would get through the process, and eventually the market would return to normal — though probably with higher underwriting standards and somewhat higher interest rates.

At least that is where the real estate lending game stood as of late October. How long it will stay frozen or semi-frozen is difficult to predict. But both sides hope it will not remain frozen long enough to severely damage either side. Don't bet too heavily on the outcome.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.