Home Management Contemporary Urban Planning
THE HOUSING BUBBLE AND THE PROBLEM OF ABANDONMENT
At the end of the 1990s, housing prices in the United States began to rise very rapidly. The most widely quoted housing price index, the Case-Shiller index, showed that from 2000 to the second quarter of 2006, housing prices in the United States rose by 90 percent. After adjusting for inflation, that was a real increase of 61 percent over a six-year period.17 In the second quarter of 2006, housing prices peaked and then headed downhill rapidly. What had looked to some as a trend that might continue indefinitely turned out to be a bubble, one that burst in 2006. Financial bubbles have been with the human race for many centuries. Perhaps some of the cause is inherent in the human psyche and best explained by psychologists and behavioral economists. One factor behind bubbles in housing or other assets is easy money, meaning credit that is readily available at low interest rates, since that facilitates the buying of assets to hold as a speculation for later sale. The U.S. economy at the turn of the twenty-first century was bubble-prone. There was the so-called dot.com crash of 2000, in which the NASDAQ index lost about three-quarters of its value.18 About two years later the U.S. stock market as a whole went over the top, and the major stock indexes lost close to half their value.
The housing bubble was undoubtedly driven by many of the same psychological and monetary forces that had driven the two stock market bubbles. But it also had another driving force, which takes some explaining.
Some decades ago most mortgages were issued by banks, which then held the mortgages to maturity. The bank thus wanted to be reasonably certain that the borrower would be able to repay the mortgage. That meant requiring a substantial down payment and also taking a careful look at the borrower's income and other financial assets and obligations. Mortgage lending was a staid and cautious business.
Several decades ago this began to change, and the ingredients of a financial "perfect storm" started to accumulate. In the late 1970s the Mortgage Backed Security (MBS) was invented. The invention was credited to a former bond trader and executive at Salomon Brothers named Lew Ranieri. A very dynamic individual, Ranieri not only invented the security but he did a great deal to popularize it and also to lobby the federal government to remove various regulatory obstacles to its widespread use. In 2004 Business Week magazine named Ranieri as one of the great financial innovators of the previous 75 years.
In a MBS a large number of mortgages are combined into a single security. The security pays dividends from the interest payments on the mortgages of which it is composed. The collateral that backs the security is the properties for which the mortgages were written, just as the collateral that backs the individual homeowner's mortgage is the house.
For a time all was well with the MBS. In fact, those who wanted to see homeownership in the United States expand could argue that they were useful, since they brought more money into the mortgage market and permitted more mortgages to be written.
Fast forward to the 1990s. Interest rates were going down, partly as a matter of Federal Reserve policy, and low interest rates generally tend to fuel speculative behavior. Fast forward another decade and housing markets were beginning to look a little "frothy." In 2004 the FBI reported increasing evidence of mortgage fraud but did not pursue the matter. This was shortly after 9/11 and much of the bureau's resources had been diverted to national security matters.
The Federal Reserve Bank had considerable power to regulate many kinds of financial transactions and it could have tightened the supply of mortgage financing, but it did not do so. This was a philosophical matter. Its Chairman, Alan Greenspan, sometimes referred to as the Maestro and regarded by many at that time as the greatest Fed Chairman in history, believed that financial markets, if left relatively unregulated, would tend toward equilibrium. He has since modified that view.
Federal policy was also one of the ingredients of the perfect storm. The Community Reinvestment Act (CRA) put pressure on banks to issue mortgages to buyers they might otherwise have turned down. The idea was to make homeownership more available to lower-income people. It is hard to argue with that goal, but it did contribute to the looming problem. The federal government also put pressure on the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") to facilitate lending to homebuyers who did not qualify for conventional mortgages. Fannie and Freddie did not lend directly to such buyers but they did buy up huge numbers of mortgage backed securities, creating a market for such loans.
Bond-rating agencies frequently assigned excessively high ratings to CDOs (in general, such securities cannot be sold without being rated). One reason was clearly the use of models that underestimated risk. It has also been suggested that conflict of interest may also have been part of the problem. The fee for rating is paid by the bond issuer and thus assigning a rating lower than the issuer expected may cause it to take its business elsewhere the next time around.
The above are some of the major elements of the perfect storm. Here is a prototypical transaction. A homebuyer gets a mortgage from a mortgage broker who quickly sells that mortgage to an investment bank. The investment bank combines that mortgage with many others into a mortgage backed security (MBS). A number of these MBSs may be combined into another security referred to as a Collateralized Debt Obligation. (The terminology can be confusing here and not everyone may use it in exactly the same way. For example, a MBS could also be considered to be a CDO in that it is a debt obligation and is collateralized by the mortgaged properties.) The investment bank then sells the CDO to an investor which might be a pension fund, another bank, an individual, etc., and who might be located in the United States or anywhere else in the world. There was no end of financial innovation. CDOs could be combined into a larger security referred to as a CDO squared. A complex house of cards was being constructed.
The key point is that money was to be made at every step in this chain of financing, and the question for the mortgage brokers and for those who produced the various securities was not "are these mortgages prudent loans?" as bankers a few decades earlier would have asked but rather "can we move this paper?" Once the security had been sold, its ultimate fate was not of direct financial concern to the party that made up the security.
With all of the money to be made in securitization, mortgage lending became looser and looser. Mortgages were made with no down payment. Some mortgages were made without the buyer having to document his or her income. These "no doc" loans were commonly referred to in the business as "liar loans" for evident reasons. Some mortgage brokers spoke of NINJA loans, NINJA being an acronym for "no income, no job or assets." Some mortgages allowed the buyer to make interest-only payments for some months. Some mortgages, called "reverse amortization" mortgages, allowed buyers for some time to make payments of less than the interest, with the difference being added to the principal. Some mortgages carried low interest rates, referred to as "teaser rates," that "reset" to a higher rate after a few years. And so on.
Thus some people who were financially naive or did not understand the contracts they were signing got sucked into purchases they couldn't afford. Others felt that the prices of housing would keep rising and so, if they couldn't make the payments, they could always sell the house, settle the mortgage, and walk away with some profit. In some cases lenders may have had the same view, which caused them to be less careful about to whom they lent. As long as housing prices kept rising, everything seemed fine. In fact, lots of people made quick money "flipping houses"; that is, buying a house, holding it for a short time, and reselling it at a higher price.
As all bubbles must, this bubble burst. When housing prices began to fall, the value of the MBSs, CDOs, and other securities began to fall and the process fed on itself. The particular bankruptcy that many consider to mark the advent of the financial crisis was that of the investment bank Lehman Brothers in September 2008. Lehman was caught holding many billions in mortgage securities whose value was plummeting and which they could not sell. Much of their debt was short term and had to be rolled over. But no one would lend to them. And so they went under. In a financial panic "cash is king" and no one will part with their cash until they are very sure of being repaid. The financial system locked up and the Great Recession was underway. Lehman Brothers was no more or no less to blame than many other institutions.19
The above is not to say that the financial crisis was entirely due to the mortgage situation. Excessive leverage in many financial institutions and the presence of enormous numbers of relatively lightly regulated derivatives, those instruments that the great investor, Warren Buffet, has referred to as "financial weapons of mass destruction," were also involved. But mortgages were a major factor.20
Where do we stand now? Housing prices dropped very far following the financial crisis of 2008 and as of 2014 had made up approximately half of the loss. Banks at the time of writing are extremely cautious about mortgage lending and the majority of mortgages on single-family homes were being written by Fannie, Freddie, and the Federal Housing Administration (FHA). Fannie and Freddie were dragged under by all of the bad mortgage paper they had bought and were rescued by about $165 billion in federal aid. They are now operating profitably and have repaid the federal government for their bailout. In 2009 these once-independent Government Sponsored Enterprises (GSEs) were placed under a federal conservatorship and remain there at the time of writing. In general, most of the financial wreckage has been cleaned up.
Many in Congress, especially conservatives, would like to see Fannie and Freddie abolished. And, indeed, a reasonable case can be made that government backed and guaranteed lenders should not be competing with other lenders. It may be argued that the very fact of government backing can lead to reckless behavior, "moral hazard" in economic jargon. However, at this time, banks are very skittish about lending without some guarantee behind them, and so without Fannie, Freddie, and the Federal Housing Administration (FHA) mortgage lending would collapse.
The most important action of the federal government with regard to housing markets since the financial crisis of 2008 has been the regime of very low interest rates maintained by the Federal Reserve. Mortgage rates for a time dropped to under 3 percent, a historically low level. Two federal programs designed to reduce the rate of home foreclosures had by the end of 2013 assisted somewhat over 4 million homeowners.
HAMP (Home Affordable Modification Program) enabled some homeowners who were behind on their mortgages to make modifications that changed the type of mortgage (for example, from adjustable to fixed rate), extend the mortgage term, lower the interest rate, or roll some previous mortgage-related debt into the principal amount and thus stretch out its payment. The purpose of all of these changes was to reduce the size of the homeowner's monthly payment.
HARP (Home Affordable Refinance Program) was restricted to homeowners who were not currently behind on their mortgages but who could not get conventional refinancing because the amount that they owed was greater than the market value of their house. As with HAMP, the purpose is to reduce the monthly mortgage payment and thus reduce the chance that the homeowner will default and be foreclosed.
Both programs, though supported financially by the federal government, were administered through the banks. Both programs were restricted to homeowners whose mortgages were guaranteed by Fannie Mae or Freddie Mac, or by participating mortgage lenders.
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