The Housing Bubble
I am constantly amazed at our elected officials, media analysts and citizens demands that we bail out the housing industry and individual borrowers.
But few people seem to understand what really caused the current crisis. Many blame it on greedy lenders, lack of adequate regulation or evil Wall Street financiers. Each of those parties have played a part, but the root causes have nothing to do with these players.
Sowing the Seeds of Disaster
The first cause of the crisis is abnormally low interest rates. But wait you say, low interest rates are a good thing. They can be, but they can also lead to serious trouble. Allow me to explain.
When someone lends money, they expect to be paid a fair rate of return in the form of interest or appreciation. The amount of interest received should exceed the rate of inflation and reflect the risk the person is taking by lending the money. For example, if you deposit money with an FDIC insured bank, you expect that your money is safe and cannot be lost. So a fair rate of return should be a little more than the rate of inflation. If you lend your shiftless brother in law money and have reason to believe he won't pay it back, you would want a higher rate of interest since you may lose your investment completely. That extra interest or return is what's called a risk premium - you get more income in exchange for the amount of risk you take.
Traditionally, savings accounts or CDs at banks paid a rate of interest just about the inflation rate.
The Prime Rate - the rate charged to the best, most credit worthy customers, tended to be one or two points above the rate paid for savings accounts. Prime used to be the basis for most loan interest rates. A customer who was not quite a prime risk paid 1% more, another 2% and so one based on the risk the lender thought they were taking in making the loan.
Mortgage loans for most borrowers were usually 2 or 3 points above prime. Traditionally, borrowers needed good credit, a stable income, made a significant down payment (so that they stood to lose money if they lost the home) and could only borrow 2 or 2.5 times their annual income. And they had to prove their income by submitting several years of pay stubs and tax returns. Underwritten this way, defaults on mortgages usually ran less than 1-2%.
Auto loans carried a higher interest rate than mortgages for several reasons. Cars decline in value as they age, so the value of the collateral declines over the life of the loan. If times get bad for the borrower, they would normally let the car go before losing their home, so the risk of the lender not getting paid was higher than on a mortgage, so the lender wanted more interest to help reward them for that risk.
Credit cards carried even higher interest rates since they were unsecured loans - there was no specific collateral that the lender could take if the borrower did not pay.
You get the picture. The greater the risk, the greater the reward. So far, so good.
Where do banks get the money they lend?
Quite simply, banks borrow money from individual and businesses. The banks pay these customers interest for the loan they make to the bank. The bank in turn lends the money to others at a higher rate of interest. If the bank is not attracting enough money from their depositors, they need to pay more interest to bring in more capital.
Savers and investors look at it another way. If the interest rate paid by a bank for a savings account or CD is not enough to cover the cost of inflation, they will usually either invest the money elsewhere or they will spend it instead. After all, if inflation is 4% and the bank if paying 2%, you are losing 2% per year by putting it in the bank.
The interest rates banks pay are driven by a variety of factors including the Fed Funds rate, the rate on Treasury Bills and money market rates. With the advent of low interest rate policies by the Federal Reserve - and those policies were largely driven by Congress. The chairman of the Federal Reserve is hauled before Congress on a regular basis and was often pressed for more accomodating interest rate policies. Meanwhile, the Treasury participated in quantitative easing. Without boring you with the technical details, this is a fancy term for printing money. By increasing the money supply, interest rates go down. In addition to political gain, the federal government NEEDS low interest rates. Our astonishing national debt makes it difficult and then impossible to make payment as interest rates rise, so there is a significant motivation to keep the interest Uncle Sam pays as low as possible.
So by flooding the system with cash, banks no longer needed to pay a fair interest rate to their depositors. Rather than accept below inflation returns, depositors stopped saving or sought higher returns in other investments. This led directly to a dilution of the risk premium, an irrational increase in risk appetite and in many cases, a failure to understand risk overall. At the same time, investors were willing to buy bonds from companies with poor financial prospects. Take a look at the yields on junk bonds over the last twenty years and you will see that risky companies that once would have had to pay 10 or 15% interest were borrowing money for 6 and 7% as those investors desperate to get an above-inflation return assumed more and more risk.
And on the lending side, banks were facing a similar problem. Because the system was flooded with cheap capital, the interest rates the banks could charge their customers was dropping too. They in turn started making more and more questionable loans and taking greater risks.
Meanwhile, our esteemed leaders in Congress (and Presidents from BOTH parties) wanted to increase 'affordable housing'. Did this mean they wanted to lower house prices? No, what they wanted was to lower the payments and the down payments to purchase homes. They also wanted more and more people to be able to buy homes. Home ownership can be a positive thing economically and socially. The Community Reinvestment Act of 1977 sowed the seeds. Sucessive administrations and Congressional action spurred more and more aggressive lending. FHA no down payment loans added fuel to the fire. But an even greater disaster was to come - Fannie Mae and Freddie Mac. The Federal National Mortgage Association and the Federal Home Loan Corporation as they are formally known, are PRIVATE companies owned by shareholders but are federally chartered. While under the law, the debts of these two behemoths are not gauranteed by the federal government, there was an 'implied' guarantee that the feds would not allow them to fail. Fannie and Freddie buy mortgages from lenders. The idea was that lenders could only make so many mortgages as the amount of capital was finite. The concept was that if someone bought the mortgages from the lenders, the lenders could make more loans. As a concept, it could be quite successful assuming that the loans were properly underwritten and that the interest rate being paid on the loans made up the risk of default. For an excellent explanation of the current crisis, I highly recommend The Housing Boom and Bust by Thomas Sowell.
But that's not what happened.
By continuing to buy even the most poorly underwritten loans, our government wunderkinds have led us to the brink of an abyss. Let me explain the concept of moral hazard.
Moral Hazard is defined as the lack of any incentive to protect against a hazard when you are protected against it. Would you take $5,000 out of your savings account and bet it on one number on the roulette wheel? After all, if you won, you would win $175,000. Your odds of winning are 38 to 1 on a US roulette wheel. But what if the casino guaranteed they would give you back all the money you lost in their casino? You could make that risky bet knowing that if you won, you could keep the money but that if your number did not win, you still did not lose any money since they are giving it back to you anyway.
Traditionally, lenders made money on mortgages by making loans to people who had the ability to pay it back plus interest. If the lender made a bad decision - loaned to a person with a poor credit record, loaned them more money than they could afford to repay, etc., the lender repossessed the home and usually lost money selling it since foreclosed homes almost always sell for less than comprable homes. The lender also is out the costs of repossessing and owning the home until it is sold. Because of the risk of these losses, the lenders were careful who they lent money to. They also made sure that the borrower put down a significant down payment so that if the borrower lost the home, their investment went with it. And if the borrowers credit record was less than perfect, the lender charged a higher rate of interest and/or required a larger downpayment to help offset the risk of lending to that person. That higher interest rate is what we call a risk premium. Remember that word, because you will see it again. The important point here is that if the lender failed to manage their risks, the lender lost money of the transaction.
Enter Fannie and Freddie.
They were (and are) willing to buy that loan and assume the risk of loss. (And thanks to the government bailout of Fannie and Freddie, we taxpayers have assumed that risk). So the mortgage lender makes a loan to someone who may not be able to pay it back. But the lender does not care, they collect their fees, get paid off by Fannie or Freddie and go make another loan. The more loans they make, the more profit they earn. So what motivation did they have to make good loans?
None.
Mortgage Backed Securities: With the destruction of any fair rate of return for savers, some financial wizards created the concept of mortgage backed securities. These complex instruments can best be explained as another way for lenders to unload their loans to someone else so they can in turn make more loans. Instead of selling one loan to an investor, hundred or even thousands of loans are packaged together and then 'slices' of the package are sold to investors - mostly banks, insurance companies, and investment funds including some money market funds. The theory behind these 'slices' was that while the risk of one loan going into default was X, the risk of many loans going into default made that risk more manageable. Traditionally, the default rate for mortgages was less than 2% (under the "old" underwriting rules...). Rating agencies like Fitch and Standard & Poors rated the securities A and above, making them eligible for purchase by institutions that are restricted from buying certain risky investments. And while home prices were trapped in a semmingly unending upward spiral, the performance of even the risky mortgages did OK. After all, if the home price increased 10 or 20% each year and the borrower got into trouble, the borrower could sell the home for a profit and pay off the mortgage. Or the lender could foreclose and actually MAKE money in the process. That phenomenon helped increase so called predatory lending - there were many lenders that WANTED the borrower to fail to make payments since the lender could make money by siezing and selling the property.
So who are the real villains? See my next post.
