10.01.2008 0

Anatomy of a Train Wreck

  • On: 10/23/2008 16:48:04
  • In: Economy
  • ALG Editor’s Note: As proven by the following featured report, printed here in full (29 pages), government has systemically wrecked America’s credit standards throughout the nation:

    Anatomy of a Train Wreck

    By Stan J. Liebowitz

    The mortgage meltdown has been the largest economic story, perhaps the largest story of any kind, since mid 2007. In the coming years, many books will be written about how and why the mortgage mess came to pass.

    The basic outlines of the event are uncontroversial and fairly easy to state. Through the early years of the twenty-first century, the housing market experienced a pricing boom—with prices soaring—of almost unprecedented scale. That came to an abrupt end in the second quarter of 2006, at which time a steep decline in home prices began. Not coincidentally, in the third quarter of 2006, mortgage defaults began to rise to what would be, in modern times, unprecedented levels, although it was not until mid 2007 that the mortgage stories began to make frontpage news because the financial system, which had invested heavily in securitized mortgages, began to experience signs of possible collapse. The stock market swooned, GDP (gross domestic product) growth groaned to a halt, and politicians stepped in to propose various “fixes” to the problem.

    The financial difficulties are continuing through the summer of 2008 as this report is being written. Drastic actions taken by the Federal Reserve in the spring of 2008—including its bartered fire sale of Bear Stearns, a global investment bank, to JPMorgan Chase, a financial services firm; its willingness to open its discount window to investment banks; and its acceptance of new types of securities as collateral—are all indicative of a massive effort to preempt a possible financial calamity. More recently, the political classes, led by the Treasury Department, have agreed that they would, if necessary, bail out Fannie Mae (the Federal National Mortgage Association, or FNMA) and Freddie Mac (the Federal Home Loan Mortgage Corporation), which guaranteed about half of the country’s mortgages. Finally, Congress and the president have enacted legislation to put a potential bailout of those two organizations in statutory language, allowing the now-saved Fannie Mae and Freddie Mac to act as “saviors,” a strange position for two essentially bankrupt organizations that wholeheartedly helped engineer the financial calamity they are now supposed to fix.

    As we will see, a record-breaking level of mortgage foreclosures occurred when the economy was still robust and before housing prices had fallen very far. These increased foreclosures occurred at the same time and with virtually the same intensity for both the prime and the subprime mortgage markets, although this has not been commonly understood. The very steep home-price decline that followed has greatly exacerbated the foreclosure problems.

    The increase in foreclosures caught the banking and finance industries by surprise and greatly lowered the value of securities based on these mortgages. The declining value of these securities, in turn, decimated the mortgage specialists such as Countrywide Financial and IndyMac Federal Bank, badly damaged major finance and banking firms such as Citicorp and Merrill Lynch, and brought the behemoth government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to the brink of bankruptcy.

    The point of this report is to help provide some understanding of how it is that the mortgage market melted down so badly. A seismic economic fracture, such as this one, does not have but a single cause. Nevertheless, a precondition for the market to self-destruct due to a record level of mortgage foreclosures is that a great many mortgage recipients must have been unable or unwilling to continue to pay their mortgages.

    How did this come about? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?

    It is the thesis of this report that this large increase in defaults had been a potential problem waiting to happen for some time. The reason is that mortgage underwriting standards had been undermined by virtually every branch of the government since the early 1990s. The government had been attempting to increase home ownership in the U.S., which had been stagnant for several decades. In particular, the government had tried to increase home ownership among poor and minority Americans. Although a seemingly noble goal, the tool chosen to achieve this goal was one that endangered the entire mortgage enterprise: intentional weakening of the traditional mortgage-lending standards.

    After the government succeeded in weakening underwriting standards, mortgages seemed to require virtually no down payment, which is the main key to the problem, but few restrictions on the size of monthly payments relative to income, little examination of credit scores, little examination of employment history, and so forth also contributed. This was exactly the government’s goal.

    The weakening of mortgage-lending standards did succeed in increasing home ownership (discussed in more detail later). As home ownership rates increased there was self-congratulation all around. The community of regulators, academic specialists, and housing activists all reveled in the increase in home ownership and the increase in wealth brought about by home ownership. The decline in mortgage underwriting standards was universally praised as an “innovation” in mortgage lending.

    The increase in home ownership increased the price of housing, helping to create a housing “bubble.” The bubble brought in a large number of speculators in the form of individuals owning one or two houses who hoped to quickly resell them at a profit. Estimates are that one quarter of all home sales were speculative sales of this nature.

    Speculators wanted mortgages with the smallest down payment and the lowest interest rate. These would be adjustable-rate mortgages (ARMs), option ARMs, and so forth. Once housing prices stopped rising, these speculators tried to get out from under their investments made largely with other peoples’ money, which is why foreclosures increased mainly for adjustable-rate mortgages and not for fixed-rate mortgages, regardless of whether mortgages were prime or subprime. The rest, as they say, is history.

    In good times, strict underwriting standards seem unnecessary. But like levees against a flood, they serve a useful purpose. When markets turn sour, these standards help ensure that homeowners will not bail out of homes at the first sign of price declines, that they will have the financial wherewithal to survive economic downturns, and that even if homeowners can’t make their payments, mortgage owners will be covered by the equity remaining in the home. Removing these protections greatly increased the risk in this market when a storm did approach.

    Unfortunately, it seems likely that our governing bodies have learned little or nothing from this series of events. If the proper lessons are not learned, we are likely to have a reprise sometime in the future.


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