I received and read a copy of this article from DC Downsizers early this month but have only today been given a go ahead for republication. I think you will find it an interesting and refreshing account of just who is responsible for the whole subprime mortgage problem.
You can watch hours and hours of news, or read columns of print in most newspapers, and come away no wiser about the causes and prospects for the current financial turmoil.
Most journalists and TV talking heads do not really understand the subject, and those that do speak and write using so much jargon that the average person must feel he or she is trying to follow a conversation in ancient Hebrew.
We are going to try to cut through the jargon, and explain the situation as best we can, in plain English. If you find our explanation of value, please forward it to others.
The current housing crisis, and all that flows from it, comes from two main sources, both deriving from Washington. First, Congress passed something called the “Community Reinvestment Act” in 1977, resulting in the creation of bureaucratic regulations designed to encourage, or even compel, financial institutions to make loans to people with lower incomes. These regulations were then amended in 1995 and 2005 to create different rules for institutions of different sizes, so that various kinds of institutions would be better able to meet the government’s goals for fostering home ownership in lower income communities.
Second, the Federal Reserve starting making loans available to the banking system at extremely low interest rates.
Third, steps one and two combined to make cheap housing loans available to people who could not have afforded or qualified for them before. This caused an increased demand for housing that sent home prices spiraling upward.
Fourth, mortgage lenders managed the risk involved in making these loans by selling their mortgages to other companies, which in turn thought that they were managing their own risk because they had a wide variety of mortgages, from many different types of borrowers, in their portfolio.
Fifth, these decisions about how to manage the increased risk created by the “Community Reinvestment Act” were all in error, because the Fed’s policy of easy money had falsely inflated the value of ALL homes. This meant that good mortgages could not be used to manage the risk involved in questionable mortgages, because the value of ALL homes was falsely inflated.
Sixth, as with all inflationary booms, increases in home prices finally absorbed the increased purchasing power provided by the Fed, leading to a slow-down in home purchases. When this moment arrived everyone realized that the homes they had purchased weren’t really worth what they had paid for them. The defaults and foreclosures then began, along with the collapse of the financial institutions that owned these unsound mortgages.
Now, the complicated, multi-part scenario described above has been simplified in popular reporting to just two words: sub-prime loans. These two words, combined with the idea that lenders took advantage of poor unsuspecting customers, are supposed to explain everything. But this explanation is both simple and simply insufficient.
A study by the Mortgage Bankers Association tells the true story. In the third quarter of last year fixed rate mortgages accounted for 45% of foreclosures, while sub-prime ARMs accounted for only 43%. (See Cato)
It’s not hard to understand why. Who wants to be on the hook for a mortgage that is tens or hundreds of thousands of dollars higher than the property is really worth? Rather than bear this burden, many borrowers are choosing to default, and walk away from their properties. This is especially happening with speculators who bought houses in order to “flip” them. To cope with these foreclosures . . .
Banks have offered their bad mortgages as collateral to borrow money from the Federal Reserve. The money the Fed lends through this process is created out of thin air. This has two shocking consequences. First, the Fed is coming to effectively own an increasing portion of America’s stock of housing, and two, these Federal Reserve loans are inflating the money supply, causing prices to rise all through the economy.
As the Fed creates more and more new dollars, the value of all the previously existing dollars declines. This forces people to seek ways to protect their accumulated wealth against the devaluing effects of monetary inflation. Thus . . .
People buy other currencies, causing the exchange value of the dollar to fall They buy gold, pushing the price up above $1,000 an ounce And they buy oil futures, driving up those prices too
But it gets worse . . .
Monetary inflation is making foreign investors reluctant to buy U.S. Treasury bonds. Who wants to hold bonds denominated in dollars when the Federal Reserve is reducing the value of the dollar?
The “London Telegraph” reports that foreign participation at a recent auction of U.S. Treasury bonds fell from 25% to less than 6%. (See Telegraph)
Sadly, there is every reason to expect this phenomenon to continue. This will leave the Federal government with only two options for funding its ever growing deficits. The government must either pay much more interest on its bonds, to compensate lenders for the monetary inflation, or it must sell its bonds to the Federal Reserve System, which will buy the bonds with yet more money created out of thin air, adding still more fuel to the inflationary fire.
The more the Federal government has to pay in interest, the larger the deficits will grow, or, the more it borrows from the Federal Reserve, the more it will have to pay in interest to private lenders. It’s a vicious bind.
There is one thing the Federal government could do immediately to lessen this bind. It could cut spending to balance its budget, thereby reducing inflationary pressures. Please use our “Unfunded Liabilities” campaign to ask Congress to do exactly that.
Use your personal comments to tell Congress that you know foreign participation in U.S. bond auctions is declining. Tell them you do not want them to sell their bonds to the Federal Reserve, thereby driving up the money supply. CONGRESS MUST BALANCE THE BUDGET NOW. You can send your message here, at DownsizeDC.org.
Then, do one thing more. Send Congress a second message asking them to pass Ron Paul’s “Honest Money” bills. Use your personal comments to tell Congress that you’re aware that the current crisis was caused by a combination of the “Community Reinvestment Act” and the Federal Reserve’s easy credit policy. Tell them you want Ron Paul’s “Honest Money” bills to curb the ability of the Fed to inflate the money supply. You can send that message here, at DownsizeDC.org.
What a long-winded way to say one sentence:
“The Government tinkered with the price system; the price system won.”
Don’t worry, tax rebate checks are coming, that’ll fix it, won’t it?
First, Congress passed something called the “Community Reinvestment Act” in 1977, resulting in the creation of bureaucratic regulations designed to encourage, or even compel, financial institutions to make loans to people with lower incomes.
This is, as Frederick Davies points out, a pricing issue, and therefore a misallocation of resources issue. And when “pricing” wins, the correction is painful. And this is just over hundreds of billions. What is going to happen when the gross misallocation of resources due to unfunded entitlements hits when that misallocation is 100 times bigger?
Dale, how can I get a permission to translate and publish it on an Israeli blog?
I don’t know but when you do, you should probably change that line about ancient Hebrew. 🙂
Olde Anglisch might be an appropriate transform 🙂
Btw Alisa, I sent them a note saying you were going to do so.
Having been a participant (in one way or another) in the subprime mortgage industry for over 20 years, this is a topic in which I possess a fairly substantial degree of expertise. This article is reasonably accurate as far as it goes, but there is a lot more to the story. (I could probably write a book on this, but I’ll try to keep this post as brief as I can.)
The CRA only applies to banks, and while banks are the originators of a large number of mortgage loans, non-bank lenders have come to comprise a substantial portion of the mortgage industry. This is especially true in the subprime sector. Thus while the CRA was a typically bad Washington idea, propounded by “poverty lobby” zealots with no conception of how the market works, it isn’t really the principal source of the problem. That honor goes to Wall Street.
Subprime loans are not “agency-eligible”, which means that they can’t be sold to Fannie Mae or Freddie Mac, the two huge quasi-governmental agencies that dominate the mortgage world. For this reason subprime lending remained a fairly small segment of the market (much like “payday lenders” are in a different market) until Wall Street figured out how to securitize the loans. Securitization is an extremely valuable financial tool, as it allows loans (which in essence are nothing more than streams of cash flows) to be combined into giant pools and carved up into separate “tranches” having different characteristics as to timing, default risk, etc. By separating these cash flow streams the tranches can be sold to different investors with different investment criteria (insurance companies, for example, have clear actuarially-determined timing needs for cash), which results in better pricing. Overall, securitization created a more efficient market for mortgages, which benefitted everybody. Unfortunately, it got out of hand, primarily because of the rating agencies and, to a lesser extent, the monoline bond insurers.
Mortgage-backed securities are rated by Moody’s, Standard & Poors, and Fitch, to determine their investment grade. This affects both price and the appropriate universe of investors. As more and more subprime mortgages (and especially unusual ones like “pay-option ARM” loans) began to be placed into securitization pools, the rating agencies failed miserably in analyzing them and forecasting their performance characteristics. Monoline insureres, who provide bond insurance for the highest-grade bonds, similarly failed to adequately model these loans’ performance, and thus imposed inadequate credit enhancements (loss reserves, subordination levels, etc.) on the deals. Lenders found that they could sell all the loans they booked, with no meaningful penalty for weak credit quality, so of course they expanded their guidelines. They were merely reacting rationally to signals the market was sending, and don’t deserve all the blame for the ultimate melt-down.
So the mortgage pools got riskier and riskier, but no one really appreciated that fact until delinquency levels began to surge last summer (there is a fairly long lag time between mortgage origination and delinquency). Once investors realized how bad the pools had gotten they stopped buying the bonds. The market for mortgage-backed securities ground to a halt almost overnight; pricing for existing securities went into free-fall, and new deals simply couldn’t be completed. And since banks and other financial institutions which own most of those securities are required to write them down to current market values, their paper (unrealized) losses ballooned. This is the reason for such events as the Bear Stearns failure; it had pledged those securities for its borrowings, and when the bond values plummeted and the loans were called they couldn’t come up with the cash.
It is a typical Wall Street “bi-polar” overreaction, but the pain is very real. Property values, which had been driven up by speculative excesses and cheap money (as noted in the article), are falling rapidly, especially in the areas where they had risen the most (Florida, southern California, Arizona, etc.), and until they bottom out the liquidity crunch will continue. Eventually that will happen, though, and when it does things will return more or less to normal. Hopefully the participants in this market will have learned something from the experience, but I’m not sanguine about long-term wisdom; Wall Street has a short memory, and the next generation of traders will probably repeat at least some of these mistakes.
So there is blame to go around: foolish laws and regulations; inadequate understanding of the effects of weakened credit standards; a few (but very few) truly predatory lenders taking advantage of unsophisticated borrowers; and greedy borrowers who were speculating in real estate values or who simply wanted to extract all of the equity in their homes for current consumption. (In my opinion this last group is getting far too little of the blame.) It was a market failure of monumental proportions, but as long as the politicians will stay out of the way the market will correct itself; it always does. Unfortunately, it now appears that politicians (who always want to be seen as “doing something”, whether it makes sense or not) will muck around in matters which they don’t understand and make things worse.
The Law of Unintended Consequences will come back to bite us. It always does.
Sorry for the length of that post (I hate long posts!), but I couldn’t figure out any way to make it shorter.
Laird has done a great job of summarizing the plot; I’ll just add one point he does not discuss much.
While these pools of mortgages are indeed of inferior quality, they are by no means horrible. Default rates in them may have yet to go up, depending on how much further house prices have to drop, but are for now not horrible. What’s eating Wall Street is not the bonds per se, but the fact that Bear Sterns and the likes of it hold them with high leverage. If you have a $100 bond, and it goes down in price to $95, you lost 5%. If you control the same bond in a 20:1 leveraged position with $5, the same $5 drop in price has wiped out all your equity. That’s the reason financial institutions have little money to loan out, and even have to go to Helicopter Ben hat in hand. Deleveraging is going on at full speed.
And yet, the hue and cry is still raised about the need for affordable prices (or costs) for all sorts of things, housing, insurance, child care…
There are even definitions (usually based on relationships to median income levels) of “Affordable”
The continuing acceptance of AFFORDABLE as social and economic criteria will lay foundations for still more sandcastles to be washed away in the tides of reality
Laird:
I used to think that the fact that there was no bubble in commercial real estate was an indication that the CRA was the principle source of the problem. What am I missing? Did the CRA include commercial real estate?
It sounds (not necessarily from you, but from the media) that everyone was duped and taken completely by surprise, while I remember knowing as early as 5 years ago that the housing prices are seriously inflated, and even remember a NYT article saying this.
Laird. Excellent post. Would you mind if I moved your comment to the front page as I think it belongs on the same level as this post in terms of explaining what has been going on.
Alisa, I won’t dispute that there were voices crying in the wilderness some years ago about a “housing bubble.” There were also those who early on forecast the bursting of the “dot-com bubble.” Unfortunately, there weren’t enough of either, and no one paid any attention; business went on as usual.
I think much of the reason was that while many predicted a correction in the housing market, no one foresaw property values declining by 30-40% (which we’re seeing in parts of Florida and some other areas). That’s why the rating agencies’ models failed: the sensitivity analyses didn’t stress them hard enough. Truthfully, I don’t think anyone (myself included) expected the drop to be as severe or long-lasting as it has been. And the cascade effect throughout the capital markets, while obvious in retrospect, was not at all apparent a year ago simply because at that time no one really understood just how interconnected everything had become. (An early casualty was a small bank in Germany, which failed because one of its subsidiaries was overly dependent upon commercial paper for funding and the liquidity crunch caused by the mortgage-backed securities market spilled over into that one. Who knew?)
The high levels of leverage employed by what were thought to be well-managed investment banks also played a role, as was noted by Plamus. It’s an extremely complicated story, with many branches and turns, and this isn’t the place to explore it in any detail. Suffice to say that there was error aplenty to go around, as well as the usual amounts of stupidity and greed, but (in my opinion) no true villains.
It’s a cautionary tale of market excesses, just as with all other manias. And as long as the market is allowed to correct itself we’ll get through it, as we always have. The problem will come if (or perhaps I should say “when”) politicians (whose reach always exceeds their grasp, especially in matters economic) meddle in market-distorting ways, such as by bailing out failing companies or over-extended individuals. The end result will be just as much total pain, but the agony will be drawn out over a much longer period (as happened during the Great Depression). Not a happy prospect.
Dale, I would be honored if you did so.
Seems to me that in this case getting trough should be easier and faster. The houses are real assets. Their market value might have plunged, if I am not mistaken, by 10% national average, and it may plunge further another 10% or so, but they haven’t been destroyed by fire or flood, so they are there, and are valuable. This is unlike the dotcoms, many of which were vaporware.
It’s a cash crunch, mostly. Liquidating the assets may take some time, but in the end mortgage backed bond holders will get back a sizable percent of their investment.
Laird: that makes sense. Thank you very much for the insight.
Laird,
I hope you are still paying attention to this thread. I am the author of the article to which you are responding. I like your clarity and you clearly have experience and a free market orientation from which I could benefit. I would love to have access to your advice as I try to compose explanations on this subject that lay-persons can understand. If you would be willing to provide such advice please contact me by email. Thank you.
Alisa, I forgot to respond to the first part of your question, concerning commercial real estate.
The CRA is intended to force banks to “meet the credit needs of the entire community.” Thus, although the principal focus has always been on residential lending, a bank will receive CRA “credit” for small business lending, too. As a practical matter, though, that is not a significant factor in commercial real estate, which is generally considered to mean office buildings, retail complexes, large apartment buildings, etc. (not the sort of things small local businesses are usually financing).
Also, I should point out that the liquidity crunch caused by the subprime mortgage “crisis” is now beginning to spill over into commercial real estate lending, too. There is a lot of fear that commercial real estate has become overpriced (cap rates as low as 5%, for instance), and we are already beginning to see banks back away from apparently meritorious commercial transactions because of capital constraints, liquidity concerns, and increased regulatory scrutiny. The contagion is spreading.
I think much of the reason was that while many predicted a correction in the housing market, no one foresaw property values declining by 30-40% (which we’re seeing in parts of Florida and some other areas).
There have been a fair few pundits, at least in the UK, forecasting up to 40% drop for some time, based on the experience in the early-90s. I lost 20% on my first house pretty much the moment I closed. The worst part of the UK I knew of was the newly build “Bradley Stoke” area of Bristol where it became nicknamed “Sadly Broke” in the early Nineties. Houses that had been bought for £115K+ dropped in a few months around £60K.
Those that could stick with it made their money back. I doubled my own money in the end but it took over a decade.
When house prices reach the point where mortgage lenders have to start talking about 5-6 times income loans at low interest rates then you’ve a pressure build up that’s got to be relieved.
However, when a part of that increase has also been stoked with people using equity release schemes to rack up huge amounts of personal debt on the principle that nothing can possibly go wrong; well, as they say, somethings got to give.
Laird: yes, I have noticed. But as you and Jacob point out, that is a direct result of the cash crunch (not to worry, the Fed is “printing” more as we speak). And I see your point about CRA – it figures.