Jun 21, 2008
The subprime meltdown
21 Jun 2008
Posted by VAR
This post is a more extensive version of an article by the same name that ran in the May/June issue of Commonwealth Magazine. This entry is also available as a 325k PDF download.
In a wonderful scene in The Godfather, Don Corleone has convened a meeting to negotiate a peace among the warring crime families. He begins his address to the assembled mob bosses by asking: “How did things ever get so far? I don’t know. It was so – unfortunate – so unnecessary.”
It’s hard not to think of that sentiment when we examine the housing crisis we now face in so much of the country, and in so many parts of Virginia.
How did things ever get so far?
The question invites a history lesson, one that informs so much of what we must do – and must not do – to see our way through.
As we try to make sense of our predicament, it is useful to understand the principal ingredients to economic policy, especially fiscal policy (established primarily by Congress and the president in formulating tax, regulatory and other economic policy) and monetary policy (established by the Federal Reserve through its control of money supply and interest rates). It is the interplay of policy decisions in these areas that provided the fertile ground for the highly questionable decisions of lenders, borrowers and investors that led to the current unpleasantness. So join me in an interesting stroll through recent economic history for the context that we need to understand how REALTORS® should act both individually and as an association in the light of current events.
The power of the Fed
First, however, a brief explanation about how the Fed affects interest rates and money supply. Interest rates are set mainly through the Fed’s mechanism of making funds available to member banks and other financial institutions. The main rate we hear about is the Federal Reserve Board discount rate, the rate at which member banks in need of liquidity can borrow from the Fed. This rate in turn affects everything from credit card rates to fixed and adjustable mortgage rates.
Money supply is manipulated in part by printing money or buying financial instruments (thereby increasing the supply of money in circulation) or selling assets from its balance sheet such as government notes and bills (thereby decreasing the supply of money in circulation).
The Fed’s purchase and sale of interest-bearing instruments such as T-bills and notes also affects interest rates, because rates move directly opposite the price paid for the instruments. Aggressive buying of t-bills, for example, pushes up their price, and thus drives interest rates lower, and the opposite is the case. (To see why this is true, consider that you own a bond yielding 5 percent. If interest rates go up to 10 percent, your 5 percent bond becomes less valuable, and if interest rates drop to 2 percent, your 5 bond yielding 5 percent becomes more valuable. Prices of bonds and their yields – interest rates – thus go in opposite directions.)
One other piece of table setting. In 1944, as the war was winding down, the major economic powers met in the small New Hampshire town of Bretton Woods to establish an economic accord that took its name from that rustic New England hamlet. Because the United States was certain to emerge from the war as the world’s economic powerhouse, the dollar was established as the reserve currency for the world’s economic system, with all other currencies pegged to the value of the dollar. To assure its value, the dollar, in turn, was pegged to the historic store of value – gold. Dollars would be redeemable at the U.S. Treasury at the rate of $35 per ounce of gold. (The U.S. at this time owned about 65 percent of the world’s supply of gold).
throughout the 1950s, economic prosperity returned after the long years of depression and global war. the years of the Eisenhower administration saw average increases in the Consumer Price Index of around 1 percent. But an economic slowdown at the end of the decade prompted President Kennedy to propose a fiscal stimulus in the form of massive tax cuts, and President Johnson secured their adoption. the economy revived, still with low inflation. But the perfect storm was brewing. The U.S. was waging the Vietnam War, the Cold War and the War on Poverty, and the federal budget exploded. the Fed monetized the debt created by this massive increase in federal spending, and supplied huge amounts of new money into the economy. Predictably, inflationary pressures grew, and pressure on the dollar increased. With the world supply of dollars rapidly increasing, and with global confidence in the American economy further eroded by large tax increases pushed through by President Johnson, other countries doubted the dollar would maintain its value, and began to redeem these excess dollars for gold at the low, fixed price established by Bretton Woods. American gold reserves dropped rapidly, and inflation, which had been at less than 1 percent in 1961, reached almost 6 percent by 1970.
Nixon’s responses were historic, and fateful. He slapped on wage and price controls (bringing about all
sorts of distortions in the economy), and, more importantly, abrogated the Bretton Woods agreement. He decoupled the dollar from the gold peg and let it float. Gold prices doubled by 1973, as the dollar slumped against other currencies.
During the remainder the 1970’s, inflation accelerated and the economy, in response to constrictive fiscal policies, began to stagnate. at the same time, commodity prices around the world began to soar. Oil, which had been trading at $12 a barrel in 1970, reached $22 a barrel in 1973. Gold reached $100 an ounce in 1973, and was near $200 an ounce by the time Nixon left office in 1974.
In response to budget deficits he considered too high, and blaming them for the economic troubles of the previous decade, President Carter pushed through the largest tax increase in American history, with disastrous effects for the economy. The Fed, doing what it could to ease the economic pain caused by the fiscal tightening, opened the monetary spigots, and massively increased money supply. The results are almost too painful to recall. By the end of the Carter administration, gold was near $700 an ounce, as the dollar’s value plummeted. Oil, which had cost $22 a barrel when Carter took office, reached $62 a barrel by the end of his term. Inflation hit nearly 14 percent, and interest rates reached 20 percent. We learned a new term: “stagflation.”
Adding to the misery was the fact that the music of the 1970s was really, really lousy. Remember disco? Remember “Disco Duck”?
The Reagan administration and the new Federal Reserve chairman, Paul Volker, promptly reversed course. Sweeping tax cuts were enacted to give the stagnant economy a fiscal stimulus, and the Fed clamped down on money supply to wring the inflation out of the economy. A brief but sharp recession began in 1982, but starting with the tax cuts in 1983, the economy began a generation-long expansion that has continued largely unabated – with the exception of two mild and short recessions – until recently. By the end of the decade of the 1980s, inflation was under 5 percent, interest rates were around 8 percent, oil was $28 a barrel, and an ounce of gold fetched about $350 an ounce, or about half its price in 1981.
The 1990s saw this economic growth continue, with stable prices and low interest rates. Mortgages rates slid to the 6 percent range, inflation averaged a bit over 2 percent, oil traded at an average price of about $20 a barrel, and gold remained in a narrow trading range between $300 and $400 an ounce. With generally responsible fiscal policies from Washington, prices remained stable, interest rates hit new lows, and the economy grew briskly through the 1990s.
A one-two punch
In the last years of the 1990’s, the Fed, under Allen Greenspan, became increasingly concerned about the possibility of a global financial crisis threatened by – do you remember? – Y2K. Policy makers believed that our technology would not be up to the change from 1999 to 2000, and wanted to assure adequate liquidity in case of a financial meltdown as the clock struck midnight on January 1.
At the same time, the technology sector was roaring, and technology stocks were selling at prices that defied reason, in part because of monetary policy adopted to counter the expected effects of Y2K. At one point the tech-heavy NASDAQ hit 5000. When the Y2K crisis failed to materialize, the Fed reined in the money supply, and the tech sector collapsed. Within less than 2 years, the NASDAQ had lost half its value. The collapse of the tech sector sent the economy into recession in the last year of the Clinton administration, and in part to counter this slowdown, President Bush pushed through large tax cuts during his first year.
Then came 9/11 and a real global financial crisis. Stock markets around the world tumbled in response
both to the terrorist attacks and fear of the repercussions. To stem the panic and the global financial crisis, and to assure financial markets that adequate liquidity would be available, the Fed opened the spigots aggressively. The Fed not only kept interest rates low, but continued to pump money into the world economy.
This was necessary, prudent and effective – to a point. Beginning in 2005, however, many observers began to wonder whether the Fed had not overshot its targets. The Wall Street Journal, for example, began to caution that leading indicators of inflation were beginning to signal trouble brewing. The dollar had begun a steep slide against foreign currencies, gold burst through its long trading range between $300 and $400 an ounce, and oil prices hit levels not seen since the Carter years. The signals were clear, and, in retrospect, ominous.
We can now confidently say that the Fed’s decision to keep money supply increasing rapidly throughout the first years of the decade was a historic mistake. It contributed mightily to rapid increases in the price of commodities (including oil), to rocketing gold prices, and to a precipitous decline in the dollar’s value.
A few facts illustrate this. The euro, trading at $.75 in the first years of the decade, now trades at over $1.50. For the first time in living memory, the U.S. dollar is below parity with the Canadian dollar. Gold has recently traded at more than $1000 an ounce, and as of this writing oil is trading at $123 a barrel.
Most importantly, however, Fed policy contributed greatly to a housing bubble that began in 2001 as Fed monetary policy kicked into high gear. Interest rates were at historic lows, as the Fed discount rate hit less that 1 percent. Mortgage rates tumbled, adding to the demand for housing and accelerating price increases already under way.
Beginning in 2004, the Fed began to reverse course by raising interest rates once again, well after the housing bubble had appeared. The discount rate peaked at 5.25 percent in mid-2006 and remained near these levels until the fall of 2007. A byproduct of this effort was the popping of the housing bubble. Since 2007, home prices nationwide have declined by approximately 20 percent from their highs in 2006.
Monetary policy alone is not the cause of our current problems. But most analysts now believe that Fed policy during this time was the sine qua non of the housing implosion we are now dealing with.
The Fed has, during the last 20 months or so, begun a rapid reduction of interest rates to the current 2 percent level, and has throttled open the money supply once again to try to support home values.
The effect? Gold, oil, and commodities are skyrocketing, inflation is hitting very disturbing levels not seen in many, many years, and the dollar is sinking further. Echoes of the 1970s.
Worse, the Fed is probably just pushing on a string. You can make the money available to lenders, but you can’t make buyers buy or lenders lend when they expect the value of the home or the collateral to sink further. This is just what buyers and lenders think, and they are almost certainly right.
Riding the bubble
So where does this leave us? To get the answer to this question, look at the graph, “Home prices and household income”.
The bottom line shows the trajectory of average household incomes since 1999. It shows a fairly steady increase that’s in line with the good economy of the last 25 years. The top line shows average U.S. home prices. You are looking at a classic asset bubble. This graph tells us what we already should know: a situation in which home prices increase faster than the ability of households to pay them cannot – cannot – last.
But this graph tells us much more. Let’s look at it closely. The first thing to note is that home prices have not yet returned to their historic relationship with household incomes; in short, home prices still have a way to go on the downside. Estimates put this number at anywhere from 10 to 20 percent, and that should also inform the decisions of policy makers. We have a choice: we can take steps to reacquire equilibrium as quickly as possible, in a manner consistent with political reality and the need not to send the economy tumbling, or we can delay reaching that necessary equilibrium by taking actions that keep prices artificially high.
One thing is strongly suggested by the graph: in many markets, buyers who are skeptical about buying now are probably more right than wrong. So are lenders who are hesitant to lend to borrowers who don’t have pretty good credit and who are not making a reasonable down payment. It just might be fair to say that anything we do to delay getting back to equilibrium will, per force, keep buyers out of the market. Why? Because in so many places, prices are unaffordable for average households.
The evidence that buyers understand this is compelling. A recent poll conducted for the Associated Press-AOL Money and Finance by Abt SRBI Inc. found that a growing majority say they will not buy a home anytime soon. Sixty percent of those interviewed said they definitely will not buy a home in the next two years, up sharply from the number who said the same thing 18 months ago, at the start of the downturn.
The poll notes that the growing reluctance is at least partly the result of the worry that housing prices will continue to fall. Half of all those interviewed say that homes are still overpriced, a fact borne out by the graph. Not surprisingly, the number of those saying houses are about right has fallen to about a third of those sampled. The poll found that the biggest worriers are those expecting to buy soon. of that group, almost half believe that value will drop in the next two years.
Another thing you’ll notice while looking at the graph is that there are a lot of people on the inside of the bubble. These are people who are nameless and faceless to reporters, who, for understandable reasons, focus on the sympathetic and identifiable families being forced out of their homes. But these people are nonetheless real. They want a home, but they can’t afford one. They were unwilling to gamble during the recent frenzy. And they will not have a home to buy unless someone is willing to sell at a price in line with their income.
One way to think about the “nothing down,” subprime borrower is as a renter. For him, finding another rental is, financially, a reasonable demand if he can’t afford the “rent” on this house. Somehow, subsidizing his payments means to deny the other guy a house he can afford.
Instead, we can ask the current owner to leave, and let the lender put the house on the market at a reasonable price. This, in effect, is what the foreclosure does. As we will also see, it is what the short sale, as a proxy for the foreclosure and sale of the REO, does even more efficiently.
Another thing should also be clear in looking at the graph. Anything that keeps the income line from continuing an upward trajectory will exacerbate the problem we now face. If anything, we should do everything possible to increase the slope of the line, by increasing average household incomes.
So here’s how we might order our thinking, if we understand our history and can believe the evidence
- Housing is still overpriced, and needs to return to the levels that history says are sustainable and affordable. In fact, they must logically return to those levels, unless we take action to prevent it. But if we take such action, it will only delay a recovery.
- Until the equilibrium is reached, many buyers will be locked out of the homes they could otherwise afford. Buyers who have the option to do so will stay out of the market, unwilling to buy an asset they believe is likely to decline in value.
- Lenders can read economic tea leaves as well, and will be hesitant to return to normal lending practices while they expect the asset they lend on to decline in value.
- Policy makers should acknowledge the realities we face and do everything possible to permit the orderly correction of the market. Most of all, they should not make it their priority to keep prices artificially high as viewed from the vantage point of family incomes.
If that means the current owners should be allowed to lose the house so it can find its proper level for the benefit of another buyer, that should happen, as truly sad as that might be for the current owner. If that means the lender has to take a haircut, well, the lender made the imprudent loan.
The most maddening policy decision of all would be to rescue reckless lenders from the consequences of their actions.
- Nothing that will cause average family incomes to decline should even be contemplated in Washington or state capitals. In fact, policy should focus of giving the economy a fiscal push, as leaders of both parties have done successfully in recent history.
- Until these things happen, the Fed is unlikely to rein in the money supply and stop viewing its loose monetary policy as the sole bulwark against economic catastrophe. But until that happens every gain we make in one way will be eaten up by the escalating costs of fuel, food and other commodities, as confidence in our currency erodes. Right now the biggest source of damage being done to family incomes comes at the gas pump, the grocery store, and wherever else necessities are bought.
Finally, REALTORS® must do everything within their power – both politically and professionally – to
move policy in the right direction. We must also learn how to deal with the difficulties we face in a