Understanding the Housing Crisis

The financial crisis sparked by the subprime mortgage collapse has shaken Wall Street to its core. The crisis underscores the fact that a relatively small number of bad investments can hammer our economy. Indeed, 95 percent of Americans continue to pay their mortgages on time, while only 5 percent of American homeowners have either defaulted or are in danger of defaulting on their high-risk loans.

While the American economy is strong enough and resilient enough to overcome this challenge, the “subprime mess” also underscores the dangers posed by the “bubbles” that cyclically enrich Americans
and then become a blight on our economy.

The Dot.Com Bust Legacy

The burgeoning of the internet in the 1990s generated unprecedented wealth for many Americans. Unfortunately, much of that wealth was created by an irrationally optimistic technology. In 2001, the dot.com bubble finally burst, which was a primary factor for the subsequent American recession. In an attempt to prevent long-term financial damage, the Federal Reserve Board under the leadership of Alan Greenspan predictably reduced short-term interest rates in rapid fashion, making funds easily available to lending institutions. This is a common measure the Fed can take to mitigate the effects of a recession and to insure, if possible, that its duration is short and its impact is limited.

Thanks to his rate cuts, Greenspan was able to isolate the damage from the 2001 dot.com bust, and kept the economic fallout to a minimum. However, the rate cuts had side effects. The Fed’s cheap and easy money policy, combined with the increasing creation of innovative mortgage instruments, set the stage for a seven year boom in housing sales and real estate construction. A new bubble emerged.

The Housing Boom

The home market has two components. One is the demand for a larger home by those who already own a home. The other is the demand for a home by those entering the market as first-time buyers. After the dot.com bust, the federal government significantly increased the pool of first-time buyers who could qualify for a home mortgage. The government did this by keeping interest rates low, which made borrowing money cheap and easy. But this was only half of the problem. The government’s mistake was not properly monitoring the questionable lending practices of a number of banks that issued mortgages allowing borrowers to make less expensive mortgage payments in the short term, but with much larger payments due later in the term.

Eager first-time homebuyers essentially ignored the fact that painful balloon payments loomed, or that adjustable rate mortgages (ARMS) would soon jack up the monthly cost of staying in their homes. The popular perception was that housing prices would go up indefinitely, so that when higher payments came due, homebuyers could safely refinance their mortgages, keeping payments low, and even taking cash out of existing home equity. The perception that the real estate market would continue to rise also encouraged speculators or “flipper” buyers, who bought homes, refurbished them, and then sold them for a quick profit.

A dangerous cycle developed. New homebuyers, who would likely not have met credit qualification standards in decades past, flooded into the market. The prices on existing homes skyrocketed, enabling existing homeowners to sell at a handsome profit, and then buy more expensive houses that they, too, would not likely have been able to afford if historic credit qualification standards and appraisal criteria had been applied. This fueled the biggest housing boom in U.S. history.

The Housing Slide

The years 2006 and 2007 marked the beginning of the end for the housing boom. Confronted with rising inflation, the Fed began to raise interest rates. This, in turn, upped the mortgage payments for many new homeowners whose loans were “subprime.” As lending rates continued to rise, so did the cost of many monthly mortgage payments, which increased the number of Americans who were unable to pay for the homes they could never afford in the first place.

Raised interest rates also had the effect of reducing the overall demand for new and existing houses. Indeed, when mortgages become more expensive, they become less attractive. This essentially put a cap on the prices of homes that had been surging for half a decade.

Americans were soon faced with the realization that the price of homes would not keep going up indefinitely. Worse yet, prices could actually come down. The speculators or “flippers” were the first to exit the market. Some even refused to settle on purchase contracts for new homes and condominiums when they were completed. In some areas, especially in Florida, Las Vegas, and other boom markets, these speculators comprised as much as 40 percent of the market. As these buyers fled the market, it became increasingly apparent that there was a significant glut of condos and houses. With less demand and more supply, prices dropped precipitously. In some markets, this downward spiral is still taking place.

Bad Bets

While homeowners were hit hard, banks were hit even harder. Seeking to derive benefit from the housing boom, financial institutions realized that they could increase their earnings significantly if they sold mortgages as securities. The securitization of mortgages, however, lacked proper oversight. A great majority of these mortgage-backed securities received an “AAA” rating by the various rating agencies. This rating enabled financial institutions to sell their new mortgage-backed products to countless banks, insurance companies, hedge funds, and individual investors. Until the housing bubble burst, these institutions and investors believed they were getting a higher rate of return from the mortgage-backed securities, as compared to other “AAA” instruments.

The challenge now facing the financial industry and the housing industry is one and the same. Both industries must now deal with the fallout of the Federal Reserve’s easy money policies, and the failure of the Fed’s regulators to police the actions of banks and other financial institutions that should have been more closely regulated.

Learning From History

While the inclination is to actively fix the problem by drastically lowering interest rates again, this would be simply throwing more money at a problem that was created by cheap and easy money. Another popular proposal is increased legislation. But the danger here is to over-regulate. America’s financial system always works best when free market forces are allowed to correct problems on their own.

This was made abundantly clear during the previous housing crisis. Indeed, we can learn much from the housing slump of 1974.

The American economy had been hit hard by the first oil crisis of 1973. When Middle East nations curtailed the supply of oil to America, the resulting price hikes and shortages accelerated an economic downturn. By February 1974, it was evident that the sale of homes, which had been strong over the prior years, was grinding to an almost complete halt.

The housing crisis became full blown as buyers cancelled purchase agreements in large numbers, and the traffic through builders’ model homes dried up. This marked the beginning of a three-year slump in the sales of both existing homes and new homes. Americans simply rode out the bad housing market. It lasted a mere three years. Housing soon returned to historic sales numbers.

Of course, many of the factors present in our current housing crisis were not present in 1974. Flipping and home speculation were not factors; homebuyers were largely buyers who intended to live in the house they were buying. Moreover, there was no such thing as a condominium, so there were no condominiums under construction. Finally, there was no banking crisis; lenders did not sell mortgages to people who intended to hold the mortgages in their investment portfolios. Indeed, the securitization of home mortgages had not been invented.

An End In Sight?

To extrapolate from the past, we must factor in the negative pressures on our current housing market by assessing the damage created by the collapse of the securitized mortgage instrument markets, and the speculation that inflated sales and new housing construction. On the positive side, we might also factor in the potentially exaggerated deflation of housing prices now occurring. Indeed, fear may have pushed prices lower than their fair market values.

In the aggregate, while predictions are always challenging, it can be argued that the period of recovery from our current housing crisis may be further away than those previously experienced. Indeed, if this housing crisis is more acute than that of 1974-1977, it is certainly possible that the current downturn could extend into the coming decade before we see a return to historic normal sales levels of new houses.

This drag on the economy notwithstanding, it is important to keep sight of the fact that home sales now have tremendous upside potential. Additionally, the current housing crisis has taught America an important lesson about the dangers of bubbles. Secretary of the Treasury Henry Paulson is now reviewing new ways to prevent similar crises in the future.

Finally, it cannot be stressed enough that the U.S. economy is the strongest, most resilient economy in the world. While the housing crisis has been (and will continue to be) a headache, the dream of home ownership for most Americans is still an achievable reality. And the free market capitalist system upon which this country was founded will continue to provide the best opportunity for real economic growth in the future.