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Understanding the U.S. housing meltdown

By Karen Abrams

More than 700,000 Americans lost their homes to foreclosure in 2006, around 1,300,000 in 2007 and a projection of 2,000,000 in 2008 as 400,000 adjustable rate mortgages are scheduled to rise to higher interest rates each quarter in 2008.

Trying to determine the initial cause of this national emergency in the United States is like trying to solve the “chicken or the egg riddle”. Many say, it all began on June 15th 2002, when President Bush laid out a plan to increase minority home ownership by offering mortgage loan education, down-payment assistance and a housing tax credit to new home owners. At that time, President Bush also challenged the private sector with these words, “government action isn’t enough. We need to energize and engage the private sector, as well. That is why I have challenged the real estate industry leaders to join with the government, with non-profit organizations, and with private sector financial institutions in a major nationwide effort to increase minority homeownership”. This challenge led to the roll out of many loan instruments which many have come to revile and to perceive as the single largest contributor to the “mortgage meltdown” in the United States.

Responding to that challenge, many financial institutions seized the opportunity to create or expand revenue opportunities for themselves with instruments like interest only loans, no doc (uments) loans, expansion of ARM loans (adjustable rate mortgages) and high interest, high risk loans targeted to home owners with poor credit ratings. What these new instruments did was to exponentially drive up demand for home ownership, not just by minorities but by those looking to purchase huge luxury homes, by home investors (“buying and selling homes”) or by those who purchased and held many properties to gain financial benefit from the accumulation of equity in their homes. Equity or cash which allowed them to make down-payments on additional properties take expensive vacations and unwisely purchase consumption items. The housing market became almost a housing fever as many renters purchased homes, many middle class families acquired additional homes, house flippers (or investors who bought low, fixed and sold high) and the US economy thrived from the many purchases by the new cash rich middle class.

Caution was “thrown to the wind” because after all, property prices would rise indefinitely right?
Wrong!

Many middle class citizens (not wealthy) could now afford large dream homes which cost anywhere from $250k to as much as $600k. Many financed these purchases through the acquisition of interest only loans which allowed home owners to repay only the interest on the loan for an initial period of around 10 years, at which time, the entire principal of the loan would come due. The homeowners thought process was that property value would appreciate because of strong demand in the market place; this would allow them to sell their homes for a big profit or refinance to a lower interest rate before the loan came due.

Many small business owners, overseas investors, self employed, or sporadically employed citizens took advantage of “no doc” loans. These loans did not require documentation on employment, income or credit history from applicants. The catch was of course that they would be charged a higher interest rate, sometimes as high as 12%. Home owner logic was the same for these loans. For those with poor credit, the plan was to hold these loans for a year or two until credit was improved and the applicant became eligible for a fixed rate mortgage loan at a lower interest rate. Many investors looked forward to aggressive appreciation in home values, which made higher payments due to higher interest rates a temporary situation, and many with lower incomes just wanted a chance to own a home and planned for multiple home occupants to share the mortgage payment or for multiple jobs to earn the income required to make the higher home payments.

ARMs or adjustable rate mortgages allowed home owners to benefit from a bet that mortgage rates would remain the same or fall thereby benefiting the home owner who would not be stuck with a higher interest on a fixed rate mortgage. ARMs come in many forms, some allow a fixed number of years at a lower rate at which time the mortgage would revert to a higher rate. The logic for taking these loans were mostly always the same, a chance at home ownership, a bet that interest rates would remain low, a view that property values would continue to appreciate and an optimism in the housing market leading to a view that if nothing else, the home could always be sold for a profit thereby providing a “profitable out” for home owners.

From the financial institution point of view, the new instruments allowed them to aggressively increase their markets, and to make massive profits from trading and underwriting these loans. With no consideration of the risks associated with the expanded home owner pool, these instruments were given a AAA rating by credit agencies like Moody’s, Standard and Poors and Fitch; while many top executives reaped multiple million dollar incomes for themselves and multi-billion dollar returns for their companies.

Many financial institutions attracted by excessive returns invested an increasingly large percentage of their portfolios in these risky instruments which provided great returns…for a while. Like any good “Ponzi ” scheme, the key to ongoing success in this sector was a strong economy implying strong employment driving increasing demand and thus increasing property values; the prevailing thought was that even if the owner could no longer make the mortgage payment and the property was foreclosed, the banks would still be able to sell the property for more than the outstanding balance on the mortgage, leaving investors in the “black” or with a financial gain. Sadly, such a scenario would not continue indefinitely.

No one can say definitively what specific variable caused the meltdown, we do know that it was some combination of a larger pool of high risk borrowers, the energy crises, job losses due to outsourcing and an ailing economy, a higher cost of living and a sense of panic caused by the media’s daily prediction of falling home prices and economic hard times. Many now say that the melt-down was predictable and showed signs as early as 2004 but very few leading economists called it. Even former Fed Chairman Alan Greenspan declared, “I didn’t really get it until very late in 2005 and 2006”. What followed was disastrous for both citizens and the private sector.

As unemployment increased, as adjustable interest rates rose and as cost of living increased, home foreclosure rates soared. In 2007, major metro areas experienced alarming increases in foreclosure rates; 500% increase in Stockton, CA, 100% increase in Detroit, MI, 200% increase in Las Vegas, NV, 400% increase in Sacramento, CA, 179% increase in Cleveland, Oh and on and on. Foreclosures increased across the nation and soon even the optimistic economist began to slowly acknowledge the “train wreck” before them.

Almost overnight financial institutions holding a large percentage of previously AAA rated instruments saw them down-graded to junk status and the devaluation of subprime linked assets causing them to write down huge financial losses. Institutions like Citigroup, Merrill Lynch and Morgan Stanley have sustained massive losses. Many financial institutions have declared bankruptcy, put themselves up for sale or are out of business as unemployment in this sector soars.

On Wednesday of this week, President Bush dropped his veto threat of a $300 billion dollar bill which is planned to help home owners and to improve confidence in the mortgage finance sector. Some experts argue that this is not enough however, and that relief will not come until supply of homes and demand for homes come into equilibrium. They posit that because of higher risk, investors will begin to demand higher yields thereby causing a decrease in home demand and thus home prices. Homeowners will have to invest more equity in their homes and future home owners will have to deposit significant down payment. In short, some people will probably never own a home again.

The US economy continues to fight a battle on many economic fronts, from high food prices, higher unemployment, increased foreclosure, high gas prices and a pessimistic citizenry. Some argue that nothing short of a good dose of nationalism, inward investment, and optimism will return the US to the glory days of reckless consumption spending upon which it heavily relies. Why does this matter to Guyanese? Well because millions of dollars in remittance spending sent by Guyanese in the diaspora is relied upon by local Guyanese citizens each year. If that well dries up, hopefully you’ll have a better understanding of “the why”.

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5 Responses to “Understanding the U.S. housing meltdown”

Joe Coxall
on July 25th, 2008 6:27 am

A very good analysis of the housing meltdown. However the cure will turn out to be worst than the disease. The fereral reserve are now set to bail out the very banks that own the federal reserve. it is hand wash hand economics- good for the banks- bad medicine for the taxpayers.

This week alone, if you had shorted the stocks of Fannie and Freddie, you would have come out with an 85% profit on your investiment. Loopholes are still left open to allow greedy investors to squirrel away their profits off the table. Who cares, the taxpayer will foot the bill of this fiat money system that was bound to collapse sooner or later.

Joe.

[Reply to this]
Joe Coxall
on July 25th, 2008 6:33 am

It is still a great time to short stocks on the market, even Google went down 30%.
My advise is to buy gold. not jewelry, but raw gold. One ounce of gold will give you the same amount of goods as during the time of Christ. It remains recession proof. On the other hand your US dollar will continue to loose value as a result of runaway inflation.

Joe.

[Reply to this]
vatvic
on July 25th, 2008 5:19 pm

buying Raw gold is illegal here. And it would make good reading for the writer ( Karen Abrams) to comment about how a Obama or Mcain presidency will alter the present dynamics.

[Reply to this]
Joe Coxall
In reply to the above comment on July 25th, 2008 5:39 pm:
Vatvic,
I would not, this meltdown is far worst than the politicians and their mouthpiece media is letting out at this time, wait until after the election, it will be a blood bath in the ecomomic sector.

One lady has already commited suicide after faxing a letter to her mortgage company saying that she will be dead by the time they came to foreclose on her the very same day.

Joe.

[Reply to this]
Joe Coxall
In reply to the above comment on July 25th, 2008 8:52 pm:
Vatvic,
What the Guyana government needs to do to allow its citizens to invest in gold is not to actually sell you the gold.

They should allow you to buy an ounce of gold at market price then issue you a certificate to be redeemed at any future date at current market price. that way they get paid for the gold while still keeping it as a reserve. They can then lend your money to investment firms for interest instead of having to sell that gold themselves.

When you are ready to redeem your gold, it is there to back up the higher price that you must be paid. Of course if the price goes down you lose, but the government does not. So it is a safe investment as long as the government keeps the gold reserve to honor your certificate.

Joe.

[Reply to this]