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Housing Crisis Truth – How We Got Here and Why It Won’t Be Over For At Least Two More Years

August 25th 2008

Economy - Home Foreclosure

The last thing that anyone thought would result, while watching the Twin Towers collapse on September 11, 2001, was the greatest housing boom in the history of the world. But this terrible event spurred a sequence of events that ultimately led to a tremendous rise in home prices. It arose from a positive feedback.

First, the federal government cut taxes and sent rebates to all Americans. Then the Federal Reserve, led by Alan Greenspan, cut the discount rate to 1 percent. Government officials urged Americans to spend in order to defeat terrorism. Alan Greenspan told everyone that adjustable rate mortgages were a good thing. Congress and President Bush believed that everyone should own a home and pressured lenders to provide mortgages to low income people.

Cut to Wall Street which created new investment vehicles that allowed mortgages to be packaged and sold to investors throughout the world with investment grade ratings provided by Moody’s and S&P, for a price. Mortgage companies and lenders developed ARMs, Option ARMs, teaser rate loans, no-doc loans, negative amortization loans and 100% financing loans. Low income people started buying homes, with these exotic mortgage products, from middle income people. Middle income people started to buy larger houses from rich people, boosting demand for new homes. Rich people bought mansions and second homes. Bidding wars for houses were commonplace. The demand caused by this influx of new home buyers drove prices skyward, with home prices doubling in five years. This price rise brought in the speculators/flippers. They began to buy multiple houses with nothing down, pre-construction, with plans to sell them for a profit without ever moving into them.

Average Americans who saw their paper wealth growing rapidly as their home value increased took advantage of the new housing realities by refinancing their mortgages. They systematically extracted the equity from their homes and spent it. Americans sucked $800 billion from their homes in 2004 and by a similar number in 2005. This immense sum was spent on such things as fancy upgrades, new cars, flat screen TVs, and vacations.

Homebuilders throughout the U.S., but particularly in California, Arizona, Florida and Nevada, went on the biggest building binge in the history of the U.S. These builders deceived themselves regarding positive demographics, or just decided to ride the wave as far as it would take them. This binge led to 8.5 million total home sales in 2005, about 3.5 million more than what would have been expected based on historical rates.

Because the originators of virtually all loans to consumers were immediately selling the loans off, they had no incentive to follow any guidelines or due diligence when issuing the loans. Anyone with a pulse could get a mortgage. Unscrupulous mortgage brokers popped up everywhere, luring uneducated and willing people to join the party. Greedy appraisers went along with the scam by overvaluing houses to whatever the banks desired.

The debt-induced spending that occurred from 2001 until 2007 accounted for virtually all the GDP growth during those years. Without the mortgage equity withdrawal, the U.S. would have had less than 1 percent average GDP growth for the entire period.

The tremendous prosperity that began during the Reagan years of the early 1980’s has been a false prosperity built upon easy credit. Household debt reached $13.8 trillion in 2007, with $10.5 trillion of that mortgage debt. The leading edge of the baby boomers turned 30 years of age in the late 1970’s, just as the usage of debt began to accelerate. Debt took off like a rocket ship after 9/11 with the President urging Americans to spend and Alan Greenspan lowering interest rates to 1 percent.

The authors of the book Why Middle Class Mothers and Fathers Are Going Broke contend that the costs of housing and a good education for their children are killing them. It now takes two incomes to provide what one income provided 30 years ago: a middle-class house in a safe neighborhood with a decent public school. Bidding wars erupted for homes in what are thought to be good school districts, making homes in those areas ever more expensive.

A phenomenon called “expenditure cascade” has occurred in the U.S. according to Cornell Professor Robert Frank. When top earners build large multi-million dollar mansions, they shift the frame of reference for those just below them on the income scale. Those people then respond by building bigger houses and so on down the food chain. This has resulted in families living on the edge. If one parent loses their job, it’s an easy slide into bankruptcy.

As Alan Greenspan denies causing the housing crisis today, his words from November 2002 come back to haunt him. He himself said, “our extraordinary housing boom…financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” After making this statement, he proceeded to slash the discount rate to 1 percent in June 2003 and left it at that level for a year. Mohamed El-Erian, the number two man at PIMCO, a leading global investment management firm with more than $829.5 billion in assets under management, fears a negative feedback loop consuming the country. The stages are as follows:

Home prices reached an unsustainable level in 2006. Prices had gone parabolic between 2001 and 2006, with the average price reaching above $225,000. In 2001, averaged prices were just above $125,000. As the pundits keep looking for a bottom in housing, the there is a long way to go on the downside. The massive overbuilding, based on false demand, has led to 3.5 million excess homes in the U.S. based upon historical trends. The most shocking fact is that there are now 1.5 million vacant homes. This oversupply can only be corrected by massive price decreases.

With the tremendous price increases in houses over the last decade, one would think that equity would be at all-time highs. But no, owner equity as a percentage of house value has reached an all-time low of 45%. People have sucked the equity out of their homes and spent it faster than the prices were rising. The problem is that house prices can and will fall, debt remains like an anchor around one’s neck until paid off or it drags the person down into bankruptcy.

The millions of exotic mortgages (subprime, alt-A, ARMs, no-doc, and negative amortization), which have started to blow up, has led to a tsunami of foreclosures. In 2005 there were less than 600,000 foreclosures in the U.S. In the 1st two quarters of 2008 there have been more than 1,350,000 foreclosures, with the pace accelerating. Approximately 15 percent of all subprime mortgages and 7 percent of all Alt-A mortgages are in delinquency. According to UBS, 27.2 percent of subprime mortgages originated in 2007 by Washington Mutual are now in delinquency.

The combination of oversupply, over-leverage, and foreclosure tsunami has now taken on a life of its own. Home prices have been spiraling downward for two years to the point where 29 percent of all households that purchased in the last five years owe more than their house is worth according to Zillow, the home valuation company. For those who bought in 2006, 45 percent have negative equity. It is now making economic sense for people to just walk away from their house and send the keys to the lender. This is referred to as ‘jingle mail’.

The bad has affected the good. The ongoing housing price decreases are now affecting prime mortgages, home equity loans, and home equity lines of credit. Prime mortgages for less than $417,000 had a delinquency rate of 2.44 percent in May, up 77 percent from last year. Prime jumbo loans over $417,000 had a 4.03 percent delinquency rate in May, up 263 percent from last year. According to the American Bankers Association, 1.1 percent of all home equity lines are in delinquency, the highest level since 1987.

Banks are doing what they usually do. They are closing the barn door after the pigs have escaped. As their losses have crossed the $500 billion mark, it is getting tougher for them to convince anyone to buy their stock. They have such bad “assets” on and off their books at inflated values that they cannot or will not lend. The Federal Reserve reported that banks have tightened standards for all loans in record numbers. Based on the well qualified assessments of Bridgewater Associates and NYU economist Nouriel Roubini, there is still $1.0 to $1.5 trillion in losses to go. Citigroup has written down $55.1 billion. Wachovia has written down $22.5 billion. Bank of America has written down $21.2 billion. Bank lending to consumers will be subdued for years.

Is Housing Near the Bottom? The one person who has been consistently right regarding the housing market is Yale Professor Robert Shiller. (He also called the top in the stock market in 2000). He has calculated that some prices are so far out of line with historical averages that there is no doubt that further decreases are in store.

Home prices have historically tracked inflation and are likely to revert to the mean. The latest data does not paint a pretty picture. Sale prices of existing single family homes declined by 15.8 percent in the past year, with markets in California declining by 22 percent to 28 percent. Over 10 percent of the U.S. population lives in California. Bank of America, Wells Fargo, Washington Mutual, and Wachovia have a large exposure in California.

Many pundits have been downplaying the resetting of adjustable rate mortgages, saying that the worst is over. But there are $440 billion of adjustable mortgages resetting this year. That means that the majority of foreclosures will not occur until 2009. Banks will still be writing off billions of mortgage debt in 2009. The reversion to the mean for housing prices and the continued avalanche of foreclosures is not a recipe for a banking recovery. Home prices have another 15 percent to go on the downside. A bottom is unlikely to be reached until late 2009 or early 2010. The market will bounce along that bottom for a few years before resuming an upward trend in 2012.

Take that prediction to the bank.

James Quinn is a senior director of strategic planning for a major university. This article reflects the personal views of James Quinn. It does not necessarily represent the views of his employer, and is not sponsored or endorsed by them.

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