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Chapter 6 Housing – After First Revision

 

We Have the Biggest Houses

Here in America bigger is always better, whether it’s cars, waistlines, NFL linemen, or houses. If you don’t have three extra bedrooms filled with crap you’ve collected over the years, you are a failure—and worse yet, you’re hurting the economy. I’m talking stainless steel appliances, granite countertops, and a fenced-in backyard to keep the neighbors from sneaking a peek at your daughter by the pool. How about that new seventy-inch flat-panel TV, surround-sound home theater, and matching La-Z-Boys for you and the missus? No sir, that quality of life ain’t gonna fit into a nine-hundred-square-foot studio on the Upper East Side.

Here in America we go for quantity over quality, and we’re proud of it. Bigger is the American way! When I was a kid being raised by the Sylvania because both parents worked, I decided I would live out my days in space. So much space, in fact, that it would be a burden. I wanted a yard so big I’d need a commercial mower to keep it from turning into an African safari. I wanted a garage massive enough to park two F350s with room for my Harley. I wanted windows so large the electric bill would jump 50 percent when the shades weren’t drawn.

Yes sir, every American wants a castle. Just one drive through any suburb will show you that this dream has become a reality. Our cities sprawl for miles in every direction, with subdivision after subdivision filled with ginormous five-bedroom, three-and-a-half bath, two-car-garage behemoths. My heart swells every time I see one of my people finance his dream for no money down on a two-year, interest-only loan, because I know he has finally reached Nirvana: homeownership. I’m an American, not some fruity apartment-sharing European, and it is our God-given right to own a big freaking home. Jefferson, big freaking home. Washington, big freaking home. G. W. Bush, many big freaking homes. Hell, even Obama got himself a big freaking home.

 

One interesting aspect of Americana over the past half-century is the change from the house being a place to live to it being a retirement account. Being a homeowner seemed ingrained in the American spirit from the times of homesteaders moving west. Back then a patch of earth was the path to freedom; now lodgings are the path to riches. Everyone knows someone who made a killing in the housing market. We all heard a story about someone who started out with a two-bedroom townhouse and upgraded into a four-thousand-square-foot McMansion in the “right” neighborhood.

When we view our home as an investment, we play a game with divergent ends. On the one hand, we all want a retreat from the world where we can personalize our space and ground ourselves to an address. But when a home is in the same category as our 401(k), every decision must pass mustard with the real estate market. Want flower tiles in the kitchen? Think twice, because granite countertops sell. How about a nautical-themed bathroom that reminds you of your fisherman uncle? Not so fast: industrial styling is the new shag carpet. So what if you’ve been in the same home for the last twenty years and reminisce when you see the wood swing set you built for your first child? That guy on Flip that House said nouveau riche homebuyers are turned off by the trappings of family life, so get out the hammer and start disassembling.

Is it in our best interest to base decor decisions on resale value? Pools are a pain in the butt to maintain, but if your family could spend lazy Sundays swimming, grilling, and getting closer around the Johnson Family Lagoon, should you forgo the joy because pools may deter homebuyers who just want a bed and a roof?

In the past, people like my grandparents built their own houses—or at least knew something about construction, maintenance, and repair. Now the gulf between the people building houses and the people buying houses grows larger every day. Most people couldn’t tell you the difference between a frame, block, or prefab house, let alone the benefits of each, so how can they evaluate what they’re buying? Nowadays, houses are built in every style under the sun. There are subdivisions filled with Italian piazzas and old colonials, yet they’re as fake as the mechanical shark at Universal Studios.

Not understanding the intricacies of interior décor, home building or maintenance isn’t a life-threatening problem. There are many situations in which customers lack field-based knowledge and must rely on experts—doctors, mechanics, and lawyers, to name a few—but this puts consumers at their mercy. In the housing market, these experts are Realtors and mortgage brokers. Most people don’t understand that these are basically sales positions, and the interests of the buyers, sellers, and middlemen aren’t the same.  In various studies, it was shown realtors sell their own houses for 3% higher prices than their client’s houses.[1] This doesn’t mean that Realtors are out to scalp consumers, but it does show that people are more motivated when dealing with their own properties. Mortgage brokers are the same way. Worse yet, during the housing boom that started in 2003, many people with no prior experience were drawn into the housing market. They chased big paydays but were as naïve about the nuances of homeownership as the ill-informed buyers. Anytime there’s a knowledge gap in an industry, one party has a distinct advantage, and some people will be taken for a ride. This is what happened to many unwitting people who bought houses they couldn’t afford during the market peak from 2005–07.

The deregulation of the lending industry wrought a horrible toll on consumers and the world economy, culminating in the current financial crisis. The subprime mortgage boom of the last decade put many folks into houses, and some of these are success stories—people realizing the dream of homeownership despite shoddy credit. Their lives were made better because of financial trickery and the explosion of securitization, which pumped trillions into the home lending market. Unfortunately, many more bought houses they couldn’t afford with no plan B when the market soured.

The subprime mortgage market became a leviathan following the tech-stock crash at the turn of the millennium, during which many investors saw their portfolios halved. With easy credit due to the insanely low interest rates offered by Greenspan’s Fed and the gun-shy public’s aversion to stocks, all that money had to find a home.[2] That home was the American housing market, which touched off the biggest run-up in housing prices in a century.[3] The demand for mortgage-backed securities with the higher yields they offered was insatiable, and investment banks scrambled to meet that need. Thus the sub prime mortgage industry, only 6% of total mortgage origination at the start of the decade exploded to more than 20% by 2006.[4]

A subprime mortgage is a loan to a person who would not qualify for the prime mortgages offered by local credit unions at the rates you see in your local newspaper. Prime mortgages are backed by government agencies, which allows lenders to offer reasonable rates. People who can’t get these mortgages because of bad credit scores, questionable incomes, or a high level of debt have to look elsewhere for financing. Since they don’t qualify for government-backed loans, they pay a higher interest rate to compensate banks for the extra risk they take on. Before the 2000s the subprime industry remained small because few investors were willing to lend to people with poor credit. But a decade ago, this industry took off thanks to the increased securitization of these subprime mortgages, with an assist from the credit rating agencies Moody’s, Standard and Poor’s, and Fitch.

To understand securitization, we need to look at how banks lend money now compared to how banks used to lend money. In the old days, a local bank would take deposits from people in the area and then lend that money back to neighbors in the form of business, personal, and home loans. This system was in place for more fifty years after the banking reforms that followed the Great Depression. In the late 1980s, however, it was upended by the savings and loan crisis, which was caused by small banks not having enough money in the vault because they’d lent all the money to local borrowers. The solution was securitization. Basically, banks sold their loans to investment banks, and those investment banks sold bonds to investors, who then received the interest paid by the original borrower.

For example, imagine Bill wants to buy a car. He borrows $10,000 from his local credit union for sixty months at a 5 percent interest rate. Bill gets his car, and the bank now has a promise from Bill to make payments of $250 a month for the next five years. Over those five years the bank will collect $15,000 in payments—the original $10,000 Bill borrowed plus $5,000 in interest. The bank wants to lend more money, but it only receives $250 per month, so it calls an investment bank on Wall Street. The investment bank offers to buy the loan for $10,500, which would give the bank the original $10,000 it loaned and a $500 profit today instead of a $5,000 profit over the next five years. The local bank gets its money and lends it to Bill’s neighbors, while the investment bank collects $4,500 in profit over the life of the loan. The investment bank buys one thousand of these loans from all across the country and creates a giant pool of loans for similar cars with similar interest rates. Then the investment bank sells shares in this pool to investors. Each investor will receive money each month until all the loans are fully paid off.

When this system works, it’s great for everyone. Bill gets to buy his car, the local bank makes a small profit and has money to lend immediately, the investment bank lines its pockets, and investors across America collect the interest that Bill and thousands of others who bought cars with borrowed money paid.

But then the investment banks ran out of the prime loans to pool and sell to investors. Investors were looking for places to park their money, and investment banks were eager to fill this need. This led to a hunt for people who would borrow money and the subsequent eruption of the subprime market. This insatiable appetite for loans to securitize led to the creation of subprime lenders. With new financing options available to people who previously couldn’t afford a home, Realtors found they had a huge number of potential new customers.

We’re now dealing with the aftermath. During the boom years, people who couldn’t afford homeownership were buying homes with no money down and interest-only loans.[5] They bought homes they couldn’t afford—and people who could afford a modest home bought palatial estates. Hence, we have a glut of people underwater in homes they should never have been financed for.

When you hear stories about migrant workers who make $1,500 a month buying $800,000 homes, it’s clear the bank should retake the home and suffer the loss. Extreme examples are always easily dealt with. But there’s also the much more common case of families who stretched to buy their modest dream house, lost their jobs in the recession, and then saw the value of their home cut in half by the housing crash. What do we do with these folks? Kick them out on the street? Of course we don’t want to reward people for making stupid decisions, but how can you tell the difference between people who made a conscious decision to take a huge financial gamble and those who were misled or misinformed by greedy brokers and Realtors?

More than 30% of American home owners are underwater, which means they owe more on their home then the price for which they could sell the home.[6] They have no equity built into the price of their homes. They don’t have the option of moving to a different city for better employment or schools. They have only two options: stay in the home and hope to one day pay off the loan entirely, or walk away and let the bank deal with it. More and more people are walking away when they realize it will take five to ten years for their home’s sales price to eclipse what they owe on the mortgage. In turn, many Americans are currently bitching about these deadbeat homeowners sinking the economy, but we must first investigate the true cost of a foreclosure before jumping to conclusions.

When your neighbor walks away from his home loan, who bears the burden? First and foremost, your neighbor. In our society, your credit score is your reputation, and everything from credit cards to interest rates to employment is subject to the whims of credit compilers Equifax, Transunion, and Experian.[7] Your neighbor must also live with the stigma and emotional guilt of absconding on a debt.

The next group is the company that owns the mortgage. This may be a bank, or the mortgage could have been bundled with other mortgages and sold as a mortgage-backed security. If the bank holds the mortgage, it will have to maintain the house until it can be sold and will take a loss on the difference between the sales price and the loan value. In good times, a mortgage holder who must foreclose on a property expects to recoup about 70 percent of the loan value, but in the current market, that figure is probably below 50 percent.[8] When a bank loses money, the people hurt are not the CEO, board members, or some cabal in New York, but the bank’s shareholders—usually average folks who invest in mutual funds through their 401(k) accounts or large retirement pension funds that buy these banks’ shares. So, if a bank holds the mortgage when a house goes into foreclosure, the people hurt are the Average Joes who commute two hours to work, work a nine-to-five, and take the kids to Little League on the weekends—Main Street, as the politicians like to say. If your neighbor’s mortgage was bundled with thousands of others and broken down into bonds, these bonds were bought either by overseas foreign investors or American retirement funds, in which case once again soccer moms and NASCAR dads are taking the hit.[9]

The last group affected by the foreclosure, are those who live in the neighborhood. They not only lose a neighbor but also have to deal with the blight caused by a home left unmaintained. Moreover, their home prices will be dragged down by the fire-sale price of the foreclosed home. So, all around, the people who lose are average Americans.

Alternatively, who pays if the government steps in to keep the homeowner in the home he can’t afford? Again, average Americans, as every dollar the federal, state, or local government spends to keep a distressed homeowner afloat is a dollar either added to our national debt, recouped in higher taxes, or taken away from education, infrastructure, security, or other government services. Regardless, we lose.

In coming years these underwater borrowers will be a drag on our society, and until we come up with a solution we’ll see uncertainty in financial markets, government budgets, and home prices. This is just the fiscal cost, but the social costs may be even greater. What psychological issues will persist in the minds of homeowners who lost their homes? How does the surplus of empty homes affect local crime rates? How will the job losses in construction-related industries affect our economy, as many of these jobs may not return for at least five years—if ever?

On top of all this, there is the much more publicized money that has flowed into the coffers of the big banks on Wall Street. During the so-called bank bailout, the Troubled Asset Relief Program, hundreds of billions of dollars were printed at the Federal Reserve and given out to banks to keep them solvent. Banks must maintain a certain ratio of debts to assets. Debts include money received from depositors plus any money they borrowed from other banks or the Fed. Assets include liens on property, cash on hand plus any profits they’ve made and kept. Banks also have income generated from loans not in default, and some banks “trade” with their own money, meaning they make bets in the stock, option, and swap markets. So on one side of the bank’s balance sheet you have liabilities: deposits, money borrowed, and potential losses from loans and trading activities. On the other side are the assets: the bank’s own savings, its income stream from loans, and any trading profits. In the years following the Great Depression, banks that took deposits from customers were banned from trading on Wall Street by the Glass-Steagall Act, which separated investment banks from deposit banks. Investment banks were speculative, meaning they were free to gamble, but the government didn’t guarantee their deposits. Deposit banks, meanwhile, weren’t allowed to do much trading and were required to maintain high ratios of capital to debts, but they had a government guarantee. The Glass-Steagall Act was repealed in 1999, which allowed the deposit banks to enter the casino.[10]

TARP was put in place to help banks make the two sides of their balance sheet equal again. Deposit banks made a lot of terrible subprime loans to people who couldn’t afford their houses. These same banks were buying bonds in the pools of subprime mortgages sold by investment banks. Finally, the prime loans made to folks who could afford their homes began to default because of job losses and plunging home values. All of these problems coalesced at the same time, and many of the large American banks became insolvent. So the federal government pumped money into the largest banks, and we taxpayers got the bill. A lot of that money has been recovered, but much more is still owed.[11]

The real threat from the bank bailout is not the huge sums funneled to the likes of Goldman Sachs or Deutsche Bank (yes, the US government sent money to Deutsche and other European banks when it bailed out AIG), but rather from the moral hazard.[12] We have now bailed out the banking industry three times in the last thirty years: the savings and loan crisis in the late eighties, the long-term capital/Mexican peso crisis in the late nineties, and now TARP in 2008. Since the banks know that they will get a handout from the government if they are large enough to tank the whole economy if they fail, they’re in a no-lose position. If they make risky bets with depositors’ money and they’re right, they make huge profits. If they’re wrong, Uncle Sam will come to the rescue (and pay all the contractual bonuses due to top executives). This is the best business model in America: you win either way!

Banking crises are not new. It seems a huge crisis like the one in 2008 happens at least once a generation—and after every crisis the rules change, things go smoothly for a while, and then the regulations are relaxed. After that, there’s a wild surge in profits and fraud, and finally, another crash. Rinse, repeat.

So, how can we stave off another banking crisis for a generation and get our housing market back on track?

One solution to our foreclosure crisis is to keep most people in their homes and stop banks from repossessing properties. This would obviously make delinquent homeowners happy. Unfortunately, this is tough to do. Who would take the hit on the back payments? The government could step in and buy up all the delinquent mortgages and restructure the loans in such a manner, that homeowners could essentially rent the property back at much lower rates.[13] In this scenario, the tax payers would be on the hook. Another alternative is for banks to repossess the home, but rent the property back to the homeowner at below market rates for a set period.[14]

Both of these options require average Americans to take losses, either as tax payers or shareholders in large banks. Additionally, there will be a large public outcry when stories surface reporting folks who clearly gamed the system during the boom and now get to keep their property. On the other hand, keeping people in homes may stabilize home values and therefore help average Americans, as their home values would stop plummeting and possibly recover.

On the flip side, we could accelerate the foreclosure process and kick out all delinquent homeowners. The immediate impact would be a drastic drop in home values as the foreclosed homes were sold by banks at a steep loss.[15] Rents would probably rise, as the displaced homeowners would be looking for new lodgings. Banks would again take a massive loss, which would be transferred to shareholder and tax payers.

Both of these scenarios would destroy the homebuilding market, as either there would be a flood of used properties on the market at steep discounts, or people would be stuck in their homes and not looking to buy. Neither of these plans are very feasible through lack of political will. The right will be outraged about “deadbeat” bail-outs if we let everyone stay in their home. The left will be outraged if we kick everyone out in the street. It seems we are destined to have a long, slow and painful process of liquidation in the mortgage markets. But, this long restructuring process may just remind us how long it will take to sort out the subprime mess.

To prevent another banking crisis, we could strengthen regulation. Beginning in the 1980s, we have had a constant climate of deregulation, through both republican and democratic administrations. If this process is reversed, many argue we would strengthen our banking sector and prevent future collapses.

From 2008-2010, there were many bills to strengthen regulation and create firewalls between trading banks and FDIC insured institutions. In the end, most of these faltered or were watered down. If stricter regulations are passed, banks argue their profits will dwindle, but from the end of the great depression until the 1980’s, the regulatory climate was much stronger, yet bank survived.

Along with stricter banking regulations, we could implement more consumer protections to prevent predatory lending. Some consumer protections have been reintroduced, but more could be done. We have an extensive and lengthy process to file bankruptcy, but NO consultation before taking an auto or home loan. Maybe we should have financial consultations before making these decisions, as a home purchase is the largest financial decision in a buyer’s life. The same is true in regard to credit cards. Credit cards are pitched to everyone, starting with incoming college freshmen and ending with seniors on social security. Providing consumers with accurate information and financial advice may prevent the overextension which has been common place.

Banking regulation and consumer protections would surely eat in to banking profits. Alternatively, the recent banking crisis destroyed shareholder value, so were the profits generated through subprime lending beneficial for shareholders, or only to the executive office? Plus, consumer protection would surely help some folks avoid being taken for a ride. But, we live in a capitalist free market society, so this would be more “big brother” government interference in our lives.

What makes the situation even scarier is the modern ubiquity of lobbyists and the complexity of financial markets. One of the reasons the executives from Goldman Sachs, Morgan Stanley and the like shuffle between the board room and Whitehouse, is that no one else understands what the hell the big banks are doing! Even if we understood how banks operated, they have an army of lobbyists telling our elected officials they can self-regulate and have everything under control. That is until they come hat-in-hand for more TARP funds.

How we regulate this industry in the future will be critical. We must find a balance between encouraging investors to take risks and protecting not just the savings of average depositors, but also taxpayer dollars.

 

Whoa, that was intense! How is a normal guy like me supposed to understand all this math and Wall Street mumbo-jumbo? I’m just going to blindly follow the TV pundits. Everyone seems to talk about this Adam Smith guy and some invisible hand that takes care of all our economic problems. North Korea regulates its economy—and look at them, they’re all skinny and hungry! We need less regulation and lower taxes. Regulation kills business and taxes drive American companies overseas! My people don’t need no big brother government looking over their shoulder, treating them like babies. We don’t care about the tougher bankruptcy laws passed under the Bush administration, because bankruptcy is for quitters and these colors don’t run!

All these bank bailouts are hogwash, and I wish they’d all gone under. In the famous words of Andrew Mellon, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate!” It worked for Hoover back in the twenties and it would have worked for us in 2008 if only Bush and Obama had learned their lessons from the Great Depression. Government has no place in the affairs of private citizens, and me and my people don’t need no help or protection from TILA, RESPA, or the Consumer Credit Protection Act.



[1]    Freakonomics by Steven D. Levitt & Stephen J. Dubner.

[2] http://www.forbes.com/2009/04/02/greenspan-john-taylor-fed-rates-china-opinions-columnists-housing-bubble.html – Many lay blame for the housing boom squarely at the feet of the “Maestro.”

[3] It should be noted that Alan Greenspan blamed the housing bubble on China. He believed the excess savings from Asia fueled the housing boom by increasing demand for CDO (collateralized debt obligations) and MBS (mortgage backed securities).

[4]    http://www.frbsf.org/publications/federalreserve/annual/2007/subprime.pdf – A good report detailing the rise of sub-prime lending, definitions and delinquency rates.

[5] http://www.msnbc.msn.com/id/8171385/ns/business-us_business/t/top-cities-risky-interest-only-mortgages/ – This article is from 2005 and reports up to 50% of new loans in some cities were interest only.

[7] http://www.frbsf.org/community/issues/toolkit/resource_guide.pdf – The report details how a foreclosure affects the lives of the delinquent property owner, and how long it takes to recover.

[9] http://www.azcentral.com/business/realestate/articles/2011/01/30/20110130foreclosure-losses-picked-up-by-taxpayers.html – Many of the foreclosed homes were purchased with loans through Fannie Mae and Freddie Mac. When these homes were “taken-back” by the bank, the losses were passed on to tax payers and investors in Fannie and Freddie.

[11] http://projects.propublica.org/bailout/main/summary – It is hard to understand the true bailout figures, because the government took equity share in many companies in lieu of repayment. For example, the US government owns 3/5 of GM stock, so even though GM has “repaid” their bail-out loan, they did so with money from Uncle Sam.

[13] http://www.huffingtonpost.com/miriam-axellute/eminent-domain-to-stop-fo_b_1696338.html – Seems this program is being considered, along with similar restructuring agreements to keep homeowners in their property, rather than renting it back.

[14] This program is being pioneered by Wells Fargo among others.

[15] More homeowners may choose to walk away from their mortgages when they find themselves underwater due to falling prices.

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