Anatomy of a Financial Crisis: Part I

December 27, 2007 | by | Topic: Economics & Political SystemsPrint Print

The U.S. housing market is hurting, as you undoubtedly know. Home foreclosures are the highest since record-keeping began 35 years ago. 1.69 percent of all outstanding mortgage loans have entered the foreclosure process. The median price of an American house in October 2007 has fallen more than $20,000 this year.

This is the unpleasant aftermath of the housing bubble of the early 2000s. After the stock market bubble burst in 2000 and further weakness caused by 9/11, official Washington’s fear of a 1930s-style deflation prompted the Federal Reserve to flood the markets with cheap credit. It should be noted in passing that the stock market boom-bust cycle that ended in 2000 was caused by the Fed’s inflationary expansion of money and credit, so it should not inspire our confidence that the Fed’s remedy for its own inflationary policies was more inflationary policies.

The artificially low interest rates engineered by the Fed—abetted by a compliant financial industry that cranked out reams of irresistible mortgages (e.g., no money down, no- or low-documentation, minuscule introductory interest rates on adjustable rate mortgages—ARMS)—had their desired effect: they stimulated a housing boom that spearheaded an economic recovery.

Unfortunately, the housing boom had undesirable consequences, too. The artificially low cost of borrowing brought buyers out of the proverbial woodwork. The resulting demand pushed housing prices higher. In addition, the low interest rates were quickly capitalized into higher asking prices for houses. Buyers, conditioned by a decades-long trend of rising home prices, figured that as long as they could “tote the note” (that is, afford the monthly payments) then they didn’t have to worry about the actual price of the house, because they assumed that there would always be someone willing to pay an even higher price for their house. This is the “greater fool” theory that recurs in every financial bubble.

The rise in housing prices was accelerated by enterprising individuals, called “flippers,” who bought houses, then resold them within months for thousands of dollars more. When the history of this boom-bust cycle in housing is written, apologists for government intervention may use the flippers as scapegoats, much as earlier generations of scoundrels blamed private speculators for the stock market crash of 1929. Why should the flippers (some of whom undoubtedly have been burned by the recent downturn) be blamed for trying to take advantage of low interest rates and easy mortgage terms when it was the Federal Reserve and their accomplices in the financial industry who created those conditions?

The Fed-induced boom resulted in house prices rising by 10 percent, 20 percent, 30 percent per year in many regions—far faster than Americans’ income was rising. Obviously, such an imbalance was unsustainable. In less than five years, the median price of an American home increased from 2.8 times to 4 times the median family income.

When interest rates, hence the cost of borrowing, started to rise, demand for homes slowed. Concurrently, defaults—many triggered when ARMs reset to higher rates—rose, increasing the supply of houses on the market. When supply exceeded demand (at different times in different communities), housing prices began to fall, and the boom turned to bust. The trend has accelerated recently.

With record inventories of unsold houses on the market today, the end of this trend is not in sight. In fact, many homeowners now find themselves with negative equity—that is, they owe more on their mortgage loan than their house is worth. Many of these loans will be defaulted upon. Other borrowers can’t afford the higher monthly payments that are starting to become due under the terms of their ARMs. Both of these factors will cause more foreclosures. Consequently, the glut of unsold homes will increase, thereby exerting even more downward pressure on prices in a vicious, potentially self-reinforcing downward spiral.

To break out of this grim spiral, President Bush and Democratic presidential candidates are trying to outdo each other with legislative proposals. One tack is to go after “predatory lenders.” Undoubtedly some unscrupulous lenders cared more about earning fees than ascertaining what borrowers could afford, and misled them. At the same time, as many as half of those who obtained no- or low-documentation loans appear to have lied about their income. And Uncle Sam is partly to blame, too, since it is the law of the land that lending institutions cannot deny credit to poorer Americans. Clearly, though, the mortgage industry needs to resume fulfilling its primary fiduciary responsibility, which is to assess and control risk.

Another legislative proposal is to bail out borrowers in danger of defaulting on their ARMs. This suggestion has elicited angry reactions and raised profound issues of equity. Why should those in danger of defaulting receive aid, but not those who have already defaulted? Why should those who borrowed more than they could afford be subsidized by money taxed from responsible individuals who curbed their other spending so that they could honor their mortgages? How can ordering lenders to freeze ARM rates be fair to those who opted for fixed-rate mortgages to avoid the risk of their interest rate being adjusted upward?

Meanwhile, our friends at the one-trick-pony Fed are giving us all a case of déjà vu. Once again they are lowering interest rates and “injecting liquidity” (Fedspeak for “pumping money”) into the financial markets to reflate the economy. It turns out that the housing bust isn’t the biggest economic threat we are facing. To learn what that is, read Part II.

Mark W. Hendrickson

Mark W. Hendrickson

Dr. Mark W. Hendrickson is an adjunct faculty member, economist, and fellow for economic and social policy with The Center for Vision & Values at Grove City College.

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