So I've been trying to understand the complex mess we're in. One way to do that is to separate the mess into its parts. At one end we have the housing market. At the other end, we have the Wall Street equity houses. In between, we have the mortgage companies, banks, and other institutions that write the mortgages, collect them together and package them for the equity houses to buy and/or to provide 'insurance' for. Domestic and international investors and funds provide the money for the equity houses
Okay, so there was a bubble in housing construction. Before the bubble burst, many individuals and groups were convinced this hot market was a good place to invest money. They used house mortgages to increase their buying power. And if one house was good, wouldn't two be better? And families, pushed by ever increasing house prices, decided they should upgrade to that bigger house now rather than wait until it was easily affordable. After all, wouldn't it be a good investment? A number of first time buyers, worried that the price increases would forever put houses out of their reach, decided to buy.
There was a lot of money to be made by the companies who constructed these houses. Why worry? The more you build, the more you sell. Oh, and more money is made from a large house than a dinky one. It's also easier to sell.
The in-between banks and mortgage companies were flush with investors (equity companies) wanting to underwrite loans, Where better to invest it than in the booming housing market? In competition to write mortgages, the in-between companies started offering to write loans first at 100 percent and then at greater than 100 percent to cover closing costs and the down payment. Traditional down payments were twenty percent on an old house, ten percent on a new one. Some loans were written for an even higher percentage of the original house cost to finance house payments for the first few years. People who couldn't qualify for an ordinary loan were offered a 'sub-prime' one. The idea with sub-prime was the buyer would pay only the interest on the principal for several years, then, because house prices are always increasing, the buyer could refinance with a standard loan before the sub prime loan converted to the higher payments, dramatically higher because of the first few year's grace.The idea was to let several years of inflation pay the down payment. But by then, the house was worth less than the loan. A lot of money was made by the loan writers, Bonuses were paid to the top performers.
All these mortgages fed into the Wall Street equity houses who eagerly competed to suck them up. The volume of loans soon surpassed available equity. Not to worry. These were smart, capable, high-paid financial experts. A few years before, some of the rules about the allowable debt to equity ratios were changed. Add that to almost-zero oversight by the government, an artifact of the Bush administration. Derivatives, leverages, houses-of-cards, smoke and mirrors, call it what you want. Basically, the equity houses underwrote orders of magnitude more loans than they and their associated investors actually had money to cover. They made a lot of money handling these loans. Bonuses were paid to the top performers. Sounds a bit like Enron, doesn't it.
One has to understand the housing construction industry has never proceeded on an even keel. There are always great highs and great lows. That's investing 101. Every investor knows or should know that. The other thing to understand is that it always recovers to provide long term gain. Sometimes it takes twenty or thirty years; usually it's three or four. Sometime in the future, well before the loans are paid off, those houses will recover their value. That is, barring a drastic decrease in the population.
I've seen this happen several times in my life. When we bought our second home, I remember it as being in 1974, maybe 1975, new houses so glutted the market that we received a $2000 tax credit just to buy one. Five years later, we had no trouble finding a buyer and sold that house for twice what we paid for it. I would have thought George W. would have learned from his father's mistakes. I can remember the savings and loan debacle of 1989. It took three or four years for the housing markets to recover from that.
My point is: given time, what seems to be a bad loan today can be a good one in the future. Right now, trim 20 percent off (the deferred down payment for many) the loan, drop the interest rate a bit if it's too high, and let those willing stay in the house pay off the loan. Give a tax credit to the mortgage company for doing the trimming. Recap the money by collecting the amount from the owner when the house is sold so it doesn't become part of their profit. To those unwilling or unable to take this deal, say goodbye and allow them an easy trip through bankruptcy court. Trim another 10 percent off and sell the house and loan to someone else. Again, let the mortgage company do it and get a tax credit.
That takes care of the mortgage companies and the house owners. For the Wall Street equity houses, I'd have a special bankruptcy category for them. Don't allow 'golden parachutes' or severance for anyone who leaves, Review salaries. Loan the company only enough to pay bills and meet commitments so they can continue as an equity company, but with new rules concerning the debt-equity ratio. They lose the special bankruptcy status when they pay off the government loan.
I think GWB is rushing to get this problem handled before the election. I think his approach is flawed, costly, and rewards the equity companies. I also think increasing the national debt is a serious mistake. The right-wing talk show pundits are blaming all this on subprime loans. I think this is an over-simplification, and it's mainly an attempt to direct the blame away from the real culprits, the equity companies, who took on so much debt they crumpled when the loans started defaulting. In hindsight, which is always easier, if the government had done more six months ago to solve the loan default problems...
Remember, I'm always right...except when I wrong!
I think that you may be underestimating he amount of sheer speculation involved in a number of the bad loans. As I understand it, quite a few of the foreclosures are people who never bought with the intention to hold-- they bought with the intention to flip. This happened quite a bit with new housing developments-- people put the down payment in place and inflated their income to get the appropriate mortgage to cover the loan (or took subprime) but they never intended to live in the house or even to rent it. They bought with the intention of reselling right before the house went to market against a presumed large increase. This also went for people who were:
1. Buying to tear down the existing house and put up a McMansion/condos for resale.
2. Buying an apartment building which was converting to condominiums.
In quite a few cases, speculators were buying and selling from speculators-- artificially driving the markets to crazy heights. In my poor dim understanding of the world, this is the difference between a boom-n-bust cycle and a bubble. The bubble (think Tulipmania) happens when the primary driver in price increases is traders who are buying and selling for the purpose of future gains. In these cases, the prices really aren't rising in response to scarcity in the market, so the fall doesn't correspondingly happen in response to glut.
By the time normal people tried to get in on the action, it was essentially too late. They were encouraged to buy houses that they couldn't afford under the presumption that they could buy and then in short order refinance in order to consolidate their personal debt and pay down the mortgage. Many of the odd balloon payment constructions exist (in the prime loan market as well, by the way) on the basis of this assumption.
Add into this mix that the economy in the US has not been recently been powered by real job creation. The government stood back and watched while taxpayers increased spending based on house price increases and refinancing. The hope was the increased consumer spending driven by this factor would prime the engine and generate real job growth. The equity houses are to blame for exceeding their allowed asset-to-loan ratio. However, it wasn't a secret what they were doing and for the government to now cry foul when they were benefiting from the practice and actually winking at it strikes me as disingenuous. Business at that level moves in legal grey areas and while I don't believe that the banks should be rewarded for their behaviour, I also don't believe that they should take the blame alone.
I think that it's also difficult to compare the current situation in the US to the past, since the levels of personal debt are so very very high right now. I'm not at all sure that we can have the same assurance of reasonable repayment and bounce back as we did in the 1970s.
I guess that what I'm saying is that your solution rests on the premise that the market can heal itself, and that corruption in the equity banks can be isolated to the banks. I've heard that a lot lately. I don't agree. I think that the rot is very deep and goes a very long way and that the instinct of the government that massive intervention is needed may well be correct. That isn't to say that I agree with the Bush plan in many (most?) ways that it is going to be implemented (I agree with nothing that is done without oversight). But I really fear that we're in for some very heavy weather.
On September 24th, 2008 04:25 pm (UTC), (Anonymous) replied:
I agree with most of what you wrote and your writing was much more eloquent than mine!
Speculation was rampant all along the way from the builder to the equity houses. Mortgages were bought and sold, packaged and re-packaged as well as houses. I was told recently that homeowners were successfully fighting back against foreclosure simply by questioning the ownership of the debt, which in many cases is very complicated.
One of your points was that house prices and mortgage values were seriously inflated by speculators and don't represent true prices. That could be true in many instances, but the data I've found on the Internet indicate US house prices have declined at most twenty-percent over the past several years. That was the basis for my conclusions. The US housing market bubble is localized. For instance, here in the midwest where I live, the housing market is stable and increasing. My wife's family has a custom home-building business and have not experienced a slowdown. I know other places like Miami, FL and in CA are hit very hard.
The idea someone would buy a house so they could consolidate their credit card debt is a new one for me. This morning, my wife and I had a chuckle over the logic of that. I guess it would allow them to reduce the interest and deduct it on their tax return. I think a simple pair of scissors could create a better solution. The amount of unsecured debt in this country is incredible. Add college loans to the pile of credit cards.
I agree that to keep the whole world afloat, a bailout is needed. And that the government, or lack of government, is largely at fault. The US government must agree to stand good on all those mortgages. I don't like buying the debt from the equity companies at face value and no strings. That's not a solution and it rewards bad behavior. Plus, it just sweeps everything under the rug until after the election. Likewise, we can't buy the debt at reduced prices. That won't solve anything either.
I like the idea of keeping the companies solvent by loaning them money with strict oversight to make sure the money goes toward the debt and doesn't leave with the present management. Also, just-in-time loans will spread the cost to the taxpayers over a longer interval and hopefully make less impact on the national debt.
I do agree with you that debt is a serious problem for the US, one that must to be resolved. I think the most serious debt we have right now is the debt we owe outside the country and through the equity companies some of that debt is from the US housing market.
Very heavy weather ahead for sure.
NP, I figured that it was you.
Re: the personal debt consolidation via refinancing. I know several people who have done this. Also people who used student loans to pay down credit cards. It's recommended, since in both cases the interest is much less. The big problem is that most people who do this don't then stay out of debt, but often run the credit cards back up.
The only debt I hold is my mortgage, which is bad enough.
(The mortgage constructions in Europe would probably make you blanch. I'm quite unusual in that I insist on putting some money down and paying off some of my mortgage. :))