The financial crisis which led to the Great Recession was caused by the combination of misguided good intentions and "honest" greed. It had all of the elements of a classic Greek Tragedy. A Hero who is brought low by Hubris and Flaws, aided and abetted both by Villains and Allies.
The misguided good intentions was the imperative for everyone to own a home. The American Dream -(HERO). Home ownership is viewed as a worthy goal which gives people a sense of pride, stability and opportunity to build wealth for the future.
Why shouldn't all Americans have that opportunity? Since home prices only went up (HUBRIS), once a person started on the home ownership path their futures were assured; their kids went to better schools, they lived in more stable neighborhoods and they were a able to build equity for their future and perhaps for the their children. Essentially it was a way out of lower income status; that's why it was called the American Dream.
The problem was that buying a house is such a large expenditure that almost no one is able to do it with all cash.(FLAW) Therefore borrowing through conventional mortgage financing (ALLY) was usually the only way, and in all events the best way, to go. The Government (ALLY) long encouraged mortgage financing by among other things, allowing tax deductions for home loan interest payments, even after dropping tax deductions for all other non- business interest payments. Yes, older readers will remember a time when all interest was deductible; however that was eliminated for everything other than home loans when tax rates were reduced in the 70s.
Also, as I have told my law school finance class, buying a home using mortgage financing was the most common way ,and usually only way, for the average person to utilize the benefit (along with risks) from the customary business technique of leveraging. (FLAW)
A simple example of the benefits of leverage is as follows:
1. If you bought a house for $100,000 with all cash and sold it for $120,000, your return on investment was 20% - not bad, but not great.
2. However,if you bought the same house, but only put down $20,000 in cash (the prudent "old fashion " way), and got an $80,000 mortgage, when you sold it for $120,000, you just paid the bank back it's $80,000 loan ( which likely was less due to monthly amortization payments), and your return on your $20,0000 investment was 100%-- that's great. You then used that profit to trade up for a more expensive house. And so it goes - or I should say "went". (HUBRIS)
The "dark side" of leverage surfaced when home values dropped giving rise to the notion of "being under water" (the value of the home being worth less than what is owed under the mortgage).
The problem of course is many low income people didn't qualify for most of the mortgages they were seeking. (FLAW) That became a serious problem when a disproportionate number of low income mortgage seekers were minorities. The Banks (ALLIES/VILLAINS), rightly or wrongly, were accused of discrimination, either outright or through use of techniques called red-lining. The result was the Government (THIS TIME A VILLAIN) put pressure on the Banks to make loans which they normally would be reluctant to make from a pure credit perspective. The Banks continued to resist making what they viewed as risky loans, except for a relatively small number of Community Reinvestment Act loans
Enter the subprime lenders (VILLAINS),along with their friends and abettors the mortgage brokers.(VILLAINS) For the most part subprime lenders were not conventional commercial banks. As such they were not as highly regulated as Banks, and with the help of mortgage brokers, were willing to make riskier loan for a higher return. They quickly dropped the conventional underwriting criteria of a substantial down payment, good credit history and sustainable income to service the debt.(HUGH FLAW) Many, if not most, low income borrowers could meet few or none of these customary underwriting requirements.
Nevertheless the Government, urged on by community activists (APPARENT ALLIES, BUT REALLY VILLAINS) were willing to allow these subprime lenders to operate with impunity and little or no supervision. Essentially the Government looked the other way or as Barney Frank so famously said , "let's roll the dice". Because, once again, they believed home prices never go down. And no, I'm not pinning the blame on Fannie and Freddie; they were more of big enablers who came relatively late to the game; no matter what some Republicans say.
I'll never forgot a New York Times article I read where community leaders were criticizing a belated crack down on subprime lending. In the article a civil rights leader in supporting subprime lending said, "you may think a 30% default rate is high ( it's actually astronomical and got even higher), but I see the 70% as my constituents who now own a home".
Subprime lenders funding sources were not so much from depositors or federal reserve borrowings like banks, but rather from Wall St. securitization houses (VILLAINS) who were in the business of taking high return risks. (HUBRIS) They knew there was risk in making these loans, but thought that home prices only go up, and that through the technique of tranching (AAA,AA,A,B etc.) the priority of debt repayment, each tranche sold in the securitization would be priced according to its risk. (HUBRIS/FLAW)
The theory was securitization would diversify the risk over many investors with different risk appetites, and therefore was safe, or at least priced for the risk taken. (ULTIMATE HUBRIS AND FLAW). Of course Wall St would make big fees and profits in the securitization process.
The irony is that securitization rather than spreading and diversifying the risk, and by that I mean reducing its impact after loan defaults, actually spread the contagion and amplified the fall out when loans started to go into default. Investors panicked and the downward spiral began, leading to the Great Recession, the impact from which is still being acutely felt.
Remember, however, that those same Wall St. houses and Banks actually bought those now toxic AAA and AA rated mortgage backed securities. They thought they were safe, but they became toxic when defaults on the underlying subprime mortgage began. As the chairman of Morgan Stanley so inelegantly put it, "we ate our own cooking and it choked us".
Recall as well that the Government strongly encouraged the Banks to buy those securities by given them bonus capital credits under the Basel I Accords. (VILLAIN) They were super safe because of the AAA ratings given by the rating agencies (VILLAINS) and the fact that home prices never go down. It's easy to say now "what were they thinking",but there were not many who sounded the alarm.
Were those who operated these securitization greedy? Of course they were. Were they dishonest in a criminal way; apparently not. Remember greed is not illegal, only dishonest greed is illegal. So far the government (and fortunately it's the Obama administration) hasn't found actual criminal behavior, yet. Our legal system places a very high threshold of proof when it comes to criminal prosecutions. Sadly many erstwhile liberals appear to have forgotten that (did they leave their ACLU cards behind?) in their zeal to attack Wall St and the Banks.
Fortunately we are still a country of laws, and not lynch mobs, witch burners, human sacrifices or McCarthyites. To date the Obama administration, try as I'm sure they might, have not found greedy behavior which rose to the level of dishonesty, and therefore criminality.
If anyone was really at fault it was the Government. Many others were greedy and irresponsible, but it was the Government's policy of pushing home ownership for everyone, including those who were not credit worthy, and its Regulators' failure to rein in subprime lending by requiring (as it was authorized to do) customary underwriting compliance, which were the root causes of the housing mortgage crisis.
The subprime mortgage crisis set off the panic which lead to the broader financial melt down, which ultimately resulted in the Great Recession. Would we have an economic downturn anyway without subprime lending? Probably, but it would have been more of a correction than a collapse in home prices. Take a look at Canada which prohibited subprime lending. They fared pretty well through this crisis.
Subprime lending was a relatively new industry which arose to satisfy an agenda of those who felt that credit was not widely available enough and took advantage of our misguided goal of the American dream of homes for all-- whose prices never go down- alas.
EVERYONE DIES--CURTAIN
Sadly in hindsight it is easy to see the unfolding of the Great (Building) Recession and like all great tragedy is there for the audience to suspect early on. Truthfully, despite the new mechanics (securitization, tax and legislative and social incentives, ratings agencies, etc.) of this horrific cycle, the pattern of overbuilding and depressed real estate values is as old as the US. In fact my grandfather’s business fed off the same consequences during the Twenties and Thirties. He started a small “wrecking company” which ultimately became the largest in the Midwest, but in its early days was based on property owners who could not afford to own developed property and wanted the improvements (i.e. apartment building, commercial or industrial building) demolished. Labor was cheap, and my grandfather would pay for the demolition, and sell the salvage (lumber, windows, plumbing, etc.) for his profit.
ReplyDeleteAs an Economics major at Michigan, I wrote my Honors paper on “building cycles” which interested me because of both our wrecking company which had grown to hundreds of employees, and a building materials/lumber company which had also developed from my grandfather’s business. I would see our developer customers in the lumber business overbuild subdivisions and we would file liens, etc. to make recovery.
Building cycles are long and they are not one cycle, but a combination of various kinds of sub-cycles for various sorts of residential, office, high rise, and so on. I am not an expert any longer, but the peaks and valleys of the various subsets are much different although they also overlap. The overbuilding results largely because of the enormous lag-time between visualization, accretion of land, financing, and development…the years before product comes to market. Conception in need and delivery in glut perhaps six to ten years later. The overall cycles unfortunately are generational being about 20 years in time from valley back to valley. So there will be recoveries in some forms of real estate development much sooner than in others, but now as in other real estate depressions there is no ability to finance or get investors even if a need can be perceived.
One of the great mysteries to me is why the Obama Administration would not have known these things and the solution for the economy was to build governmental infrastructure to employ the entire generation of skilled and semi-skilled tradespeople who were formerly building homes and other buildings. Also to devote attention to remodeling and renovations to keep the housing stock of existing homes in good stead. To tear down excess store capacity. To tear down outdated industrial facilities. So there is plenty of work that can be done, but waiting for a new cycle of development…it will not happen for another dozen years.
Marc