The Economics Of The Housing Crisis
Currently, the United States is in the middle of an economic conundrum which has become the focal point of the presidential election. The mainstream media has dubbed this the “sub-prime mortgage crisis,” but people are calling it the “housing crisis.”
Both John McCain and Barack Obama have geared their talking points around the “greed of Wall Street” and how their recklessness has effected ordinary Americans on “main street.” They both have plans on how to fix this economic crisis – both of which have to do with spending more money and increasing inflation.
In this respect, it is obvious that neither Barack Obama, John McCain, or most of the Congress or Senate have any idea how to actually fix this issue. In fact, their plans for bailouts will only make things worse in the long run.
Because this issue is so important to the health of the economy, it is important for the public to understand the cause of this mess, what really happened that caused the economic downturn, and what should be done to fix it.
The Start Of The Crisis
Whenever some crisis takes place, the politicians are quick to play the blame game. It started with the Democrats blaming President George W. Bush and his “failed economic policies.”
Then the Republicans shot back by saying it was the incompetent leadership of the Democratic Congress that really got us into this mess.
Then, it was President Jimmy Carter’s economic policies which forced financial institutions to loosen up lending standards for high-risk low-income individuals to buy affordable housing, a policy that President Bill Clinton took to the next level.
But tracing it back even further, we could lay the blame at the foot of President Richard Nixon, who took our currency off the Gold Standard. Or perhaps it was President Lyndon Johnson’s fault, since he was the one to cheat the world’s economic system by funding the Vietnam War and aggressive social programs entirely through deficit spending.
But the true cause of this crisis goes to the very heart of how the U.S. economy works, with the creation of the Federal Reserve in 1914.
Remember that the Federal Reserve Bank is not a part of the U.S. government. Unlike the CIA, FBI, Department of Defense, and other government agencies which are accountable to a Congressional committee which supervises their operations and controls their budgets and supervises their activities – the Federal Reserve is a private corporation.
That means the Fed is accountable to no one. It has no budget. It is subject to no audit. And no Congressional committee knows of, or can truly supervise, its operations. The Federal Reserve is virtually in control of the nation’s monetary system and is accountable to nobody.
The Birth Of The Fed, And The Start Of A Crisis
In 1907 there was a banking and stock market panic in the U.S., aptly called the Panic of 1907. It was widely believed that the big New York banks known as the Money Trust had been causing crashes on Wall Street, and then capitalizing on them by buying up stocks from rattled investors and selling them for tremendous profit just days or weeks later.
The Panic of 1907 was a particularly devastating one for the U.S. economy, and there was an outcry by the general public for the government to do something.
In 1908, Congress created the National Monetary Commission to research the situation, and to recommend banking reforms that would prevent such panics, as well as to investigate the Money Trust.
Senator Nelson Aldrich was appointed chairman, and immediately set out for Europe, spending two years and $300,000 (that’s $6 million adjusted for inflation) to consult with the private central bankers of England, France, and Germany.
Upon his return, Senator Aldrich decided to take some time off and organized a duck hunt with some friends. The friends he invited on vacation with him were the who’s who of U.S. economic power – the very New York bankers he was supposed to be investigating.
It’s estimated that the men on this duck hunt represented one-quarter of the world’s wealth. But during this getaway, there wasn’t much duck hunting. Instead, Aldrich and his guests spent 9 days around a table hatching a plan that eventually created the Federal Reserve.
Secrecy was important to the attendees of this summit because Aldrich, as the chairman of the National Monetary Commission, was charged with investigating banking practices and recommending reforms after the Panic of 1907, not to conspire with bankers on a remote island.
So the bankers who were under investigation for needed reforms got together with the chairman of the congressional investigating committee (the guy that was supposed to investigate the suspects) at a secret meeting on an isolated island and concocted a bill – the Aldrich Plan – for a private central bank that they (the suspects) would own.
When the bill was presented to Congress, heated debates ensued. But the Aldrich plan never came to a vote in Congress, because it was a Republican-backed bill, and the Republicans lost control of the House in 1910, and the Senate in 1912.
Not accepting defeat, the bankers essentially took the Aldrich Plan and changed a few details. In 1913, a nearly identical bill, called the Federal Reserve Act, was presented to Congress.
Again the debates raged. Many saw this bill for what it was: a prettied-up version of the Aldrich Plan. But on December 22, 1913 – after what was no doubt a long period of lobbying and payoffs – the Democratically controlled Congress gave up its right to coin money and regulate the value of that money, which was a right granted to it by the Constitution, and passed that right to a private corporation – the Federal Reserve.
Why is this such a bad thing? How could this have created our current economic crisis? Because it has to do with the way the Federal Reserve allows money to be created.
The Federal Reserve employs the use of what is called fractional reserve banking. This states that for every dollar deposited in a bank, that bank can lend out 90% of that dollar, as long as they keep 10% in reserve. This means that any bank can magically create money to be loaned out to people in the form of credit.
So for every $1,000 the bank has, it can create $900 to loan to people. But the truth is, the bank doesn’t really give away actual money, it loans out money via entries created in its book-keeping, essentially creating money from nothing. This is where credit comes from.
The Greatest Pyramid Scheme Ever
After World War I, the United States had most of the world’s gold, due to the free trade that allowed Europe to buy goods from the U.S. industrial base. However, while the U.S. was rich with gold, many European countries had large supplies of U.S. dollars (and depleted gold reserves) because of the many war loans the U.S. had made to the Allies.
Thus was decided that under the gold exchange standard, the dollar and the British pound, along with gold, would be used as currency reserves by the world’s central banks and that the U.S. dollar and pound would be redeemable in gold.
In the meantime, the U.S. had created a central bank – The Federal Reserve – and given it the power to create currency out of thin air. How can you create currency out of thin air and still back it with gold? Simple – you impose a reserve requirement on the central bank, limiting the amount of currency it creates to a certain multiple of units of gold it has in the vaults.
In the Federal Reserve Act of 1913, it specified that the Fed was to keep a 40% reserve of “lawful money” (gold, or currency that could be redeemed for gold) at the U.S. Treasury.
Fractional reserve banking is like an inverted pyramid. Under a 10% reserve, $1 at the bottom of the pyramid can be expanded, by layer upon layer of book entries, until it becomes $10 at the top of the pyramid.
Adding a fractional reserve central bank, underneath fractional reserve commercial banks, is like placing an inverted pyramid on top of an inverted pyramid.
Before the Federal Reserve, commercial banks, under a 10% reserve ratio, could hold a $20 gold piece in reserve and create another $180 of loans, for a total of $200.
But with the Federal Reserve as the foundation under the banking pyramid and having a reserve requirement of 40%, the Fed could put $50 in circulation for each $20 gold coin it had in its vaults.
Then the banks, as the second layer of the pyramid, could create loans of $450 for a total of $500.
With the new gold exchange standard, foreign central banks could use dollars instead of gold. This meant that if the Federal Reserve has a $20 gold piece in the vault, and issued $50, then a foreign central bank could hold that $50 in reserve and, at a reserve ratio of 40%, issue the equivalent of $125 of their currency. Then, when that $125 hit the banks, the banks could expand that to $1,250 worth of claim checks, all backed by a single, solitary $20 gold piece.
That means that the real reserve ratio (the ratio of real money that could be paid out against their currency) was now only 1.6% instead of 40%.
Now there was an inverted pyramid, on top of an inverted pyramid, on top of another inverted pyramid.
As you can imagine, this is a highly unstable financial structure. And once the Federal Reserve moved away from the Gold Standard, the situation just got more dangerous.
The Creation Of Credit Bubbles
Every pyramid scheme flourishes in its early days, and so did the gold exchange standard. With all the new currency available from the central banks, the commercial banks could now generate many more new loans than it could before.
This abundance of currency led to the greatest consumer credit expansion thus far in American history, which in turn lead to the biggest economic boom America had ever experienced.
In a real sense, cheap credit put the roar in the roaring twenties. Whenever credit becomes easily available, you see an increase in the currency supply. This is because whenever someone signs a mortgage paper, a car loan, or a credit card slip, new currency springs into existence. The Federal Reserve tries to control the creation of this new currency by manipulating interest rates. When the currency is being depressed and contracting, it lowers rates to bring more money into existence. When inflation starts to rear its ugly head, it ups interest rates to try and keep the money supply from expanding.
When a currency supply is increased, it has to go somewhere, and people start buying things left and right. This is what happens in a credit bubble – when money becomes easy to get, people start buying, the bubble expands.
The bubble pops when the currency supply contracts – due to defaults on loans, mortgages, and bankruptcy. When this happens, the currency gets depressed, and people stop spending.
Thus, these bubbles start with the creation of credit and loans. This is important, because its at the crux of the current housing crisis.
The Start Of The Subprime Mortgage Crisis
What is a subprime mortgage, you may be wondering?
Subprime lending is a financial term that involves financial institutions providing credit to borrowers deemed “subprime” (sometimes referred to as “under-banked”). Subprime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. Although there is no standardized definition, in the U.S. subprime loans are usually classified as those where the borrower has a credit score below a certain level, e.g. a FICO score below 660. Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards.
So subprime mortgages are mortgages awarded to people who are less likely to pay back those loans.
Now, you may ask yourself - if these subprime people are so high risk, why would any bank be willing to give those loans to people with such bad credit?
The answer is because they have to.
This issue is traced back to President Jimmy Carter in 1977 with the “Community Reinvestment Act.” This is a United States federal law designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, including low and moderate-income neighborhoods. The Act was intended to reduce discriminatory credit practices against such neighborhoods, a practice known as ‘redlining‘.
The Act requires the appropriate federal financial supervisory agencies to encourage regulated financial institutions to meet the credit needs of the local communities in which they are chartered, consistent with safe and sound operation. To enforce the statute, federal regulatory agencies examine banking institutions for CRA compliance, and take this information into consideration when approving applications for new bank branches or for mergers or acquisitions.
In short: If the banks did not loosen up their lending practices, they would be punished by the government.
In July 1993, President Clinton asked regulators to reform the CRA in order to make examinations more consistent, clarify performance standards, and reduce cost and compliance burden. Robert Rubin, the Assistant to the President for Economic Policy, under President Clinton, explained that this was in line with President Clinton’s strategy to “deal with the problems of the inner city and distressed rural communities”.
Discussing the reasons for the Clinton administration’s proposal to strengthen the CRA and further reduce red-lining, Lloyd Bentsen, Secretary of the Treasury at that time, affirmed his belief that availability of credit should not depend on where a person lives, “The only thing that ought to matter on a loan application is whether or not you can pay it back, not where you live.”
Bentsen said that the proposed changes would “make it easier for lenders to show how they’re complying with the Community Reinvestment Act”, and “cut back a lot of the paperwork and the cost on small business loans”.
In 1995, the CRA regulations were substantially revised to address criticisms that the regulations, and the agencies’ implementation of them through the examination process, were too process-oriented, burdensome, and not sufficiently focused on actual results.
The agencies also changed the CRA examination process to incorporate these revisions. Information about banking institutions CRA ratings were made available via web page for public comment. The Office of the Comptroller of the Currency (OCC) also revised its regulations, allowing lenders subject to the CRA to claim community development loan credits for loans made to help finance the environmental cleanup or redevelopment of industrial sites when it was part of an effort to revitalize the low- and moderate-income community where the site was located.
During March 1995 congressional hearings William A. Niskanen, chair of the Cato Institute, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal the Act.
Responding to concerns that the CRA would lower bank profitability, a 1997 research paper by economists at the Federal Reserve found that “[CRA] lenders active in lower-income neighborhoods and with lower-income borrowers appear to be as profitable as other mortgage-oriented commercial banks“.
Speaking in 2007, Federal Reserve Chair Ben Bernanke noted that, “managers of financial institutions found that these loan portfolios, if properly underwritten and managed, could be profitable” and that the loans “usually did not involve disproportionately higher levels of default”.
According to a 2000 United States Department of the Treasury study of lending trends in 305 U.S. cities between 1993 and 1998, $467 billion in mortgage credit flowed from CRA-covered lenders to low- and medium-income borrowers and areas.
In that period, the total number of loans to poorer Americans by CRA-eligible institutions rose by 39% while loans to wealthier individuals by CRA-covered institutions rose by 17%. The share of total US lending to low and medium income borrowers rose from 25% in 1993 to 28% in 1998 as a consequence.
Because banks were now being forced to loan money to high-risk borrowers, this lead to practices of predatory lending. This meant that companies that sold mortgages could participate in predatory lending practices - getting gullible borrowers to sign up for exploitative high-cost loans - because they knew the banks would be open to granting the loans because of the Community Reinvestment Act.
Many companies which aggressively marketed these predatory loans would come up with packages the required no proof of income or assets to get the borrows to sign up for the loan. However, many of these loans were structured to enact payments that were significantly higher than the borrower could afford to pay once it came time to start repaying the loan.
The people who sold these mortgages worked on commission, which meant that the more loans they got people to agree to, the more money they made. This means the mortgage brokers did not care who was signing for loans, as long as they got them to sign.
These mortgage companies would then bundle their mortgages together and sell them to banks, which would then turn around and sell them to Wall Street, who would then sell them to foreign investors.
It was this practice of selling high-risk mortgages which lead to the crisis.
How The Crisis Happened
The government circulates the currency by paying people and buying stuff.
People deposit currency into banks, so the banks and other entities end up with lots of currency. When a person wants to buy a house, they go to the bank and take out a loan by signing a mortgage.
The mortgage basically says: “IOU x-amount of currency, plus X-amount of interest.”
The bank creates a book entry for the amount of currency you borrowed and at the same time, a book entry is made as a debt that you owe on your loan account.
On the bank’s balance sheet, liabilities are netted out against assets, the books stay balanced, and the bank is happy. But the bank didn’t loan you any of the currency it had on hand. It just created book entries.
When you signed that mortgage, the currency the bank loaned you sprang into existence the second your pen hit the paper. The bank just expanded the world’s currency supply.
The bank then takes a bunch of mortgages and packages them all into a bond (i.e. an IOU) called a “Mortgage-Backed Security.” These Mortgage-Backed Securities are a way to limit a financial institution’s risk when it comes to debt.
Look at a Mortgage-Backed Security this way – you’re at a bar, and your friend asks if he can borrow $20 for a drink. Your friend writes on a napkin “I owe you $20.” You give your friend the $20 to get his drinks, but you get hungry and now want $10 to buy food. You then turn to another friend, and offer to give him the IOU in exchange for $10. Your friend sees it as a good deal because he’ll make $10 by buying the IOU from you, so he gives you the money. You lose out on $20, but you have $10 in your hand, which you can use to buy the food you want at the bar. So you’ve eliminated your risk that your buddy won’t pay you back.
A Mortgage-Backed Security is basically the same as that IOU napkin your friend gave you for drinks, only the napkin is backed by the idea that a person is going to pay off their mortgage. The bank then packages the Mortgage-Backed securities together and sells them to Wall Street, who then packages it and other loans together and sells them to investors world-wide.
Think of it like this: People are basically buying and selling your debt.
The current housing crisis stems from the fact that the Federal Reserve kept interest rates so low for so long, that it caused an immense wave of currency and credit creation, which devalued the dollar and caused housing prices to rise at record levels.
With credit so cheap, and currency so plentiful, soon banks were loaning money to anyone who wanted it – whether they could afford it or not. Not only that, they were being encouraged by the government to loan money to high risk borrowers under the Community Reinvestment Act.
The banks then sold these mortgages to Wall Street, who repackaged those loans and sold them off to investors.
Why would investors buy these Mortgage Backed Securities? Because owning debt can actually be good business. When you buy debt, you also buy the interest that debt generates. So a $500 debt with a 10% monthly interest rate means you get $50 per month until the $500 debt is paid off. Depending on how long it takes, you could essentially double your investment.
The problem with buying debt is the risk involved with that debt being defaulted on. That’s a risk most investors, however, are willing to take.
Wall Street uses expensive software to help them calculate the risk they take on when buying these Mortgage-Backed Securities, to see if the rewards outweigh the risk. Typically, because banks practiced conservative lending standards, worse case scenario was a default rate of 12%.
This meant that according to past data on the defaulting of mortgage loans, the worst the investor could stand to lose in a bundle of Mortgage-Backed Securities was 12%.
So even if 12% of the mortgages went bad, the investor could expect to recoup his loss on 88% of the other mortgages. (And remember, that was worse case scenario.)
The problem was that Wall Street was using numbers that weren’t congruent with the new loans being aggressively sold by the mortgage companies. They were using OLD numbers that did not take into account the higher number of mortgages given to high risk borrowers.
This meant that though Wall Street predicted a worse case scenario of 12%, it was actually more like 60%, because the vast majority of loans were being given to people with no means to pay them back.
In this sense, what the public now mistakes for “Wall Street Greed” was actually nothing more than an accounting error that lead our financial institutions to believe it was getting a good bargain.
So why did so many people begin defaulting on their loans?
Because banks were reckless with their lending standards, they gave loans to people for houses these borrowers really couldn’t afford. Suddenly, feeling rich, those people pulled money out of their houses as if they were ATM machines and spent it, often on depreciating items like TVs or cars.
Then, the expected rate adjustments that were clearly spelled out in the sub-prime loan documents came due, and suddenly people couldn’t make their payments. When these loans began to default, the Mortgage-Backed Securities that were being bought, repackaged, and sold began to fail.
Now, foreclosures on vacation properties in Florida were causing investors in Norway to go bankrupt.
But more than that, investors in Wall Street lost money, and began to panic. They stopped buying the Mortgage-Backed Securities, and banks were suddenly left holding massive amounts of debt they could not sell off to recoup the money they “created.”
Now, financial institutions are panicking, and that means they are not lending as much money as they used to because they can’t manage risk by selling it off to investors as easily as they used to.
Fallout
In the summer of 2007 when problems with the subprime mortgage sector could no longer be concealed by the banking system, and the crisis finally made the news.
In August, the Fed cut interest rates by 0.5%, and the European Central Bank (ECB) started injection liquidity (currency in the form of cheap loans to banks). Later that month, there were some small panic runs on branches of Countrywide Bank of California, the bank that wrote most of the subprime mortgages, as depositors demanded their currency.
In September, the Fed cut rates 0.5% again. Then October saw bank runs across England when word got out that Northern Rock, the eighth largest bank in England, was in a credit crunch because of the Mortgage-Backed Security crisis and had to borrow from the Bank Of England (England’s central bank).
As USA Today recounted:
“The most visible sign of economic jitters were the Depression-era-like lines that formed outside Northern Rock’s bank branches Friday morning after Northern Rock had gone to the Bank of England for an emergency loan to meet its obligations.”
The $80 billion bailout will cost British taxpayers some $1,500 per person.
That same month the Fed cut rates 0.25% and another 0.25% in December, and the Fed, the ECB, the Bank of England, and other central banks created another $40 billion of cheap credit, but it wasn’t enough to halt the meltdown.
So on December 19, 2007, the ECB injected another 350 billion euros into the economy, the equivalent of half a trillion U.S. dollars. In January, the Fed cut rates 0.75% on the 22nd, and 0.5% on the 30th. Once again, the global currency supply was exploding.
Then on March 5th, the Carlyle Capital Fund had a little problem when it found that some Mortgage Backed Securities it bought from Fannie Mae and Freddie Mac were pretty near worthless. That was the little problem. The BIG problem was that, like LTCM, this bet was highly leveraged, $31 of each $32 Carlyle had bet was borrowed.
Now trouble really started brewing. A good portion of that borrowed currency had come from Bear Stearns, which, coincidentally, was one of the major participators in packaging and selling Mortgage Backed Securities and was already in the process of taking huge losses on the Mortgage Backed Securities they owned.
On Wednesday, March 12, 2008, Carlyle announced that it was unable to pay the loans on its bets and that its creditors would be seizing all remaining assets.
Bear Stearns, being a major creditor, didn’t need more Mortgage Backed Securities, and when word got out, the company collapsed. On Friday, March 14, as reported by USA Today:
“Bear Stearns was crippled when market rumors began to swirl about the size of its exposure to mortgage-related securities and whether it had ample reserves to cover potential losses. That led clients and investors to demand their money back, causing a run on the bank.”
Sound familiar? If you’ve read our article on the Great Depression, it should. This is the same thing that happened back then. A financial institution made too many loans thanks to fractional reserve banking, and when those loans were defaulted on and the currency supply contracted, there was a run on the banks that were unable to pay out because they did not have enough actually money on reserve to pay out, thus causing them to fail.
To try and stop the bleeding, the Fed did an emergency rate cut of 0.25% on Sunday, March 16 and another 0.75% cut on March 18. Finally, the Fed has arranged a wedding where J.P. Morgan Chase, which through mergers and acquisitions is probably the largest stockholder of the Federal Reserve, will gain control of Bear Stearns at 95% off its price from the year before.
But the story gets even better! The Fed will buy the worst of Bear Stearns Mortgage Backed Securities before Morgan even takes over. And it’ll cost us, the U.S. taxpayer, another $30 billion.
Bear Stearns is only the beginning. Bailouts like these will get bigger and become more frequent, thus causing the currency supply to expand, and thereby lowering the value of your hard-earned cash.
It is already happening, as seen by the latest failures of Fannie Mae and Freddie Mac.
How Barack Obama’s Policies Will Make The Crisis Worse
Right now, our leaders in Washington have been focusing on saving the banks from failure. Barack Obama has stated that he wants to do two things to keep the crisis from getting worse:
1. Help people who defaulted on their mortgages to keep their homes.
2. Help stimulate the economy to make credit easier to get.
There are two components to this that we need to focus on. Most of the focus on mortgage borrowing is on initial mortgages, but there are also millions of Americans who have borrowed from their home equity - using their homes essentially as piggy banks. These people are at risk of foreclosure if prices plummet and they get into a situation where they have to sell their home, like extended unemployment.
The unemployment picture in many states most affected by the housing bubble is growing dramatically worse.
- California Unemployment 9 months ago 4.8% Today 6.1%
- Nevada 9 months ago 4.3% Today 5.8%
- Arizona 3 months ago 3.3% Today 4.7%
- Florida 9 months ago 3.3% Today 4.7%
Compared to states where the bubble never hit:
- Texas Unemployment 9 months ago 4.3% Today 4.5%
- North Carolina 9 months ago 4.5% Today 5.0%
The big concern for the next few years is that the housing bubble will be solely blamed on reckless mortgage companies, and not on “smart growth urban planning.” If smart growth does not get the blame, this cycle will repeat in just a few years. Excessive urban planning is the main reason why prices have soared and plunged.
Barack Obama not only wants to create another credit bubble, making money cheap and increasing the currency supply again - but he also wants to continue the practices of Jimmy Carter and Bill Clinton of forcing financial institutions to give loans to high-risk borrowers, because a large part of his base is made up of those low-income, high-risk people.
And now that the government controls much of our financial institutions, it will be easy for them to loosen up lending standards whenever they want, which could cause an even bigger crisis in the future.
Much of Obama’s rhetoric is focused on punishing Wall Street - since many Americans see the rich Wall Street investment companies as the bad guys in this mess. However, the REAL bad guys are in the government!
Not only are these the people who inflated the currency supply in the first place, they are the people who forced banks to adopt looser lending standards, which lead to predatory lending, which is what started the subprime lending crisis.
If we want to truly fix this crisis, we need to have leaders in government who understand economics, who will control the creation of our currency, and who will allow our financial institutions to practice sound business without interfering.
It is obvious from Barack Obama’s stated plans, that he is not one of them. In an Obama Administration, the House and Senate wil continue to spend more money, create more currency, and enforce looser lending standards.