Wall Street History

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Wall Street History

06/17/2011

A Look Back at the Housing Bubble, Part I

I thought I’d look back at the housing crisis and some of what both I, and others, wrote before the bubble burst, and then as housing began to collapse. Yes, some of the following is self-serving, but if you can’t be self-serving on your own website, when can you be?

“Yes, since World War II, nationwide, housing values haven’t declined in any single year, but tell that to California homeowners during the period 1989-1997, or Houston residents during the oil bust of the 1980s. No doubt, many parts of the country have more diversified economies than they once did, as in the above two cases, but the watchword is ‘affordability’ and in large swaths of America, folks are either stretching beyond their means or simply can’t make the move.

“Housing was the prime source of the wealth effect that helped carry the economy through the post-2000 bubble period, as people saw their #1 asset appreciate at 8%+ a year and then borrowed against it. And heck, I know I’m a broken record on this topic and have zero credibility by now, but the big gains are in and now we wait to see if the next move is down or sideways. Either way, many won’t feel as wealthy a few years hence, if not sooner, unless there is a spectacular rally on Wall Street, and consumer spending is bound to suffer.”

“Remember, the bubble isn’t just a U.S. story, it’s global; whether we’re talking Britain, Spain, Australia or China.”

“Ask anyone who’s been to Europe in the past few years, chatting up a few blokes in a pub, and you’ll find everyone is buying a second home in Spain, to cite but one prominent example; thanks in no small part to the prevalence of low-cost airlines that make it far easier to jet away for the weekend. But these same communities are going to slide like the rest.”

[Quoting Randall Forsyth in the 3/19/07 edition of Barron’s on the issue of former Federal Reserve Chairman Alan Greenspan]

“In a speech to the Fed’s Community Affairs Research conference in April 2005, The Maestro sang the praises of ‘technological advances’ that ‘have resulted in increased efficiency and scale within the financial services industry. Innovation has brought about a multitude of new products, such as subprime loans,’ he continued, adding that technology had allowed lenders to size up the creditworthiness of borrowers more cheaply.

“ ‘Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today, subprime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% or 2% in the early 1990s.’

“Since then, subprime mortgages have burgeoned to about twice that level, to around 20% of the total, according to most estimates. And the results are becoming apparent.

“Yet among the avalanche of coverage of the subprime debacle, the deterioration of adjustable-rate mortgages – even of prime quality – is still more dramatic. But three years ago, Greenspan was touting ARMs for Everyman. ‘American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,’ he told the Credit Union National Association in 2004. ‘To the degree that households are driven by fears of payment shocks, but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.’

“As Greenspan spoke, the Fed’s key interest-rate target, the overnight federal funds rate, stood at a mere 1%. Just over four months later, however, the Fed began tightening its monetary policy, eventually raising the funds rate 17 times, to the current 5.25% level.

“The impact on those who took Mr. G’s advice has been dramatic. The latest data from the Mortgage Bankers Association show a sharp jump in delinquencies and foreclosures in the fourth quarter. People with ARMs and low ‘teaser rates’ at the beginning are getting into trouble once they adjust up to prevailing market rates.

“But this latest fiasco goes beyond mortgages. ‘Subprime is today’s dot-com – the pin that pricks a much larger bubble,’ writes Stephen Roach, Morgan Stanley’s chief economist. ‘The actors have changed, but the plot is strikingly similar,’ he continues. ‘This time, it’s the U.S. housing bubble that has burst, and the immediate repercussions have been concentrated in a relatively small segment of the market - subprime mortgage debt.

“ ‘As was the case seven years ago, I suspect a powerful dynamic has been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the U.S. economy as a whole,’ Roach concludes.”

“The top man at the Treasury Department urged calm last week in the face of losses on Wall Street brought on by fears of defaults on the riskier kinds of mortgages. Really, he said, the damage is easily containable.

“But of all people, Henry M. Paulson Jr., former head of the New York investment banking house of Goldman Sachs, should know just how reasonable this near-panic was. Easy credit has long been the American financial lifeblood. Anything resembling stringency on the part of our formerly carefree lenders would tend to set the economy on its ear.

“Easy credit financed the bull market in houses and the flood of home refinancing. Americans felt richer and spent as though they were. It stands to reason that the withdrawal of this manna will lead them to spend less – with substantial collateral damage to the housing-centered U.S. consumer economy, and, perhaps, well beyond. Our captains of industry owe as much to their lenders’ leniency as does any subprime, or high-risk, home buyer. They, too, have been able to raise money on terms unimaginable only four years ago.

“All this sounds scary enough, and it is. But financial history offers some solace. The U.S. economy excels in the art of facing up to error – of identifying it, reappraising it and then repricing it. Loans, especially the risky kind, have been mispriced. They were, and are, too cheap. They will be repriced – as they were, for example, in the aftermath of the junk-bond and real estate troubles of the late 1980s and early 1990s. Borrowing costs will go up, and the value of the things that debt financed will tend to go down. In an attempt to ease the pain, the Federal Reserve will print more money.

“But the ripples from this cold bath go even further than the $8 trillion mortgage market. The truth is that the no-down-payment, no-documentation, interest-only mortgage loan has its counterparts in most branches of American finance.

“The date of the last ceremonial burning of an American mortgage is lost in the mists of time. Outright, unencumbered ownership of a house, a building or a corporation is no longer an ideal that most Americans embrace. The new goal is to borrow as much as possible, as soon as possible, against any asset that could be financed. And these days – thanks to Wall Street’s ingenuity – all manner of assets pass as good collateral for a loan.

“Nowadays, loans rarely rest on the balance sheets of the lenders who make them. Rather, they are scooped up and fashioned into securities – ‘asset-backed securities.’ And these are gathered up and refashioned into still other securities – ‘collateralized debt obligations.’ And the CDOs, many of them dizzyingly complex, are sold to investors the world over. No bank regulator watches over these financial sausage-making operations. As the Federal Reserve has receded in importance in this worldwide financial system of ours, so has the U.S. banking system. A parallel kind of banking system has come into existence. Wall Street calls it the ‘CDO machine.’

“In a speech two years ago, Federal Reserve Chairman Ben Bernanke pointed to a curious coincidence: Growth in U.S. mortgage debt tracks closely with the growth in the trade deficit – that is, the difference between what we consume and what we produce. ‘Over the past two decades,’ he said, ‘major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures.’

“If I were the head of state of one of our trading partners, I would be asking myself if these ‘major innovations’ were as wholesome as they used to seem. Deciding not, I would command my minister of investments to unload U.S. mortgage holdings. And I would imagine that I would not be the only head of state to whom this thought had occurred.”

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