Government and the Mortgage Crises

In 1961, three days before the end of his second term as President of the United States, Dwight D. Eisenhower addressed the nation as to his final thoughts before handing the reins of government to John F. Kennedy. In what has become known as the “military/industrial complex speech” President Eisenhower noted:

This conjunction of an immense military establishment and a large arms industry is new in the American experience. The total influence — economic, political, even spiritual — is felt in every city, every State house, every office of the Federal government. We recognize the imperative need for this development. Yet we must not fail to comprehend its grave implications. Our toil, resources and livelihood are all involved; so is the very structure of our society.

In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military/industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.

As a soldier (a captain in World War I and Supreme Allied Commander in World War II) Eisenhower had experienced the results of a dominant military/industrial complex — first in Otto von Bismarck and the German transnational companies that resulted in WWI and again in Nazi Germany that resulted in WWII. In both instances there was a pernicious scheme. The industrial barons created might and power for the government in the form of an enhanced military capability and the government, in turn, provided untold riches to the industrial barons in the form of purchases of the military goods and services. It was a symbiotic relationship and based on the devastation it caused in two world wars, Eisenhower worried that America’s burgeoning industrial power might find a similar unpalatable relationship with the government through its military.

Were President Eisenhower alive today he would have noticed that the same pernicious relationship exists between government and a whole variety of business, labor and “charitable” organizations. In each instance the government uses its power to increase the opportunities for the business, labor or “charitable” organization and they, in turn, provide support (financial, manpower, intellectual) to enhance the power of the government. In many instances the effect is rather benign and the power of both grow without significance consequence. In other instances the impact has a sudden and dramatic impact — usually at the expense of the taxpayers. (Let’s be clear, none of these instances come even close to the impact of the two major world wars. It is the cause and effect that is comparable, not the results.)

The latest such instance is the collapse of the housing market and the attendant turmoil in the nation’s financial markets.

In the economic boom occasioned by the fiscal policies of President Ronald Reagan and continued through Clinton years and well into the second Bush administration, the growth in homeownership was explosive. Most people were able to realize a portion of the American dream of owning their own home — most but not all. The ability to acquire a home continued to allude those just entering the job market and those stuck in the rut of minimum wage and or seasonal jobs were simply unable to meet the income requirements for conventional financing for home purchases.

For the low income advocates and the minority race hustlers this fact became an open running sore — proof that the system did not work and that the country intended to keep success beyond the reach of their constituents. Their complaints began to resonate with those politicians who owed, in part, their election to those constituencies and they began to use the power of their offices to demand that a means be found to “include” their constituents in the dream of homeownership.

The financial industry, never shy about finding a new way to make a buck — particularly when its government regulators are giving them the green light — noticed that the increased demand for homes was causing the average price of homes to accelerate beyond the normal rates of inflation thus creating “new equity” for homeowners. Both the financial institutions and the government regulators reasoned that even if a new buyer did not have the traditional ten to twenty percent equity to purchase a home initially, that they would “acquire” that equity within a short period of time because of the rapid escalation of the average price of homes. If, in a short period of time, the value of the home exceeded the mortgage by ten to twenty percent the bank regulators would be satisfied that mortgages were secure and the financial institutions were sound. All of that might be true if you assume that the average price of housing would continue to escalate at a rate greater than inflation forever more.

That boneheaded assumption is precisely the same assumption used by the stock market when it chose to reward top line revenue growth rather than net income growth as it had historically done. The assumption is valid so long as you believe that growth will never slow or end. When, inevitably growth does slow or decline (as it always has) those relying on those expectations find themselves overextended with no means of recovery.

But even with the new “no equity” loans, many still did not have the revenue stream to qualify for payment of the loans. The financial institutions, ever creative, derived, with the approval of government regulators, a new series of “sub-prime loans” which essentially matched the payment schedules to the available revenue stream of the borrower rather than determining whether there was sufficient revenue stream to amortize the loan over thirty years. In most instances this took the form of reduced payments for an introductory period followed by escalated payments somewhere down the road. In many instances, the borrower’s loan increased annually to account for the difference between his payment and the amount actually needed to amortize the loan. The banks and the government regulators reasoned that so long as the value of the house was increasing annually, the borrower’s equity was growing and was available to be “loaned against” to subsidize the low initial payments. Said more simply, for the initial period, the borrowers were required to borrow more to pay the interest on the amount they borrowed initially.

And said yet another way, these borrowers could not afford the loans on the day they borrowed, could not afford the loans for the initial period of reduced payments, and more than likely would not be able to afford the loans when payments escalated. The financial institutions were counting on the fact that housing prices would continue to accelerate and that their loans would be secure regardless of what happened to the borrowers.

For the housing market, the growth in the number of persons now able to find this “new financing” meant even greater demand and the builders and developers launched an unprecedented wave of construction on the assumption that the demand would never abate. The demand was further accelerated by the entry of speculators who would buy, not with the expectation of living in a home, but with the anticipation that they would resell it in a short period of time with a nice return based on escalating demand.

But, as always, the marketplace corrects when supply outpaces demand. In this instance, the results were calamitous.

When the supply of houses began to exceed demand, the first to feel the pain were the speculators. Average prices flattened and the expected return on resale stopped. In many instances because of the new “standards” for home loans, the speculators were one hundred percent financed and found themselves with no equity, significant mortgage payments and limited opportunities to resell in a saturated market.

They were followed by those holding subprime mortgages. The expectation of the financial institutions and homeowners that the average price of homes would continue to escalate proved, once again, to be a pipe dream. The period of reduced mortgage payments ended and homeowners found themselves unable to pay the new increased amounts. They also found that their expected growth in equity had disappeared and that, because of a decline in home values and the impact of an increasing financed debt (borrowing to pay the interest on the initial loan) left them with no equity and, in many instances, negative equity — owing more than the value of the home.

Now the financial institutions found themselves with securities worth far less than the loans they secured. Because of their own arcane accounting practices, the financial institutions were able to suppress the disclosure of what they well knew was a financial calamity. Instead of acknowledging the breadth of the problem, these financial institutions have trickled out the acknowledgement of the problem in each succeeding financial reporting period.

We are now at least eighteen months into the collapse of the housing market and its attendant impact on the financial institutions. And yet the stock market remains unsettled that these financial institutions have not wholly disclosed the impact of their imprudence.

But that is not the end. Now each day we read of new efforts and commitments by the federal government to bail these lenders out. Having assisted in creating the problem, the government is now about to absorb the impact. That is all well and good for the financial institutions and their investors but that impact falls on us — the taxpayers who will ultimately bear all of the burden of this ill conceived symbiotic relationship between government and the financial institutions.

Greed and government will be paid for by the taxpayers.

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Posted by at 06:00 | Posted in Measure 37 | 8 Comments |Email This Post Email This Post |Print This Post Print This Post
  • Jerry

    The completely moronic left with its push to make sure anyone who could sign their name could get a mortgage is to blame for this mess.

    • Rupert in Springfield

      I would have to concur with that. I have bought several houses in my life but my most recent one, four years ago, really bowled me over. I literally walked in to the bank, and had a mortgage approved within 20 minutes. This is being self employed, having no tax returns with me, nothing. I had a good credit rating and that was it. They didn’t even have a limit on the loan amount. I was incredulous, they were willing to lend me $100k, $500k, virtually anything I wanted. This was Wells Fargo. I should mention I have had an account there for 20 years.

      I came right out and asked the loan officer, “you seriously aren’t going to check a damn thing here?” And he said no, it was all based on credit rating and that was pretty much it. I asked him if this was in response to Janet Reno’s attempt to re-drum up the whole Red Lining myth a few years back. He told me yes, it was partially in response to that. If they considered any criteria beyond something real objective like a credit rating, it probably cost them more in law suits than failed loans.

      Frankly I don’t understand why anyone ever lends me money. I usually walk in covered in either cutting fluid or welding spatter and never want to put anything down. You know they did the same thing at the Harley Dealership as they did at the bank? Within 10 minutes and no employment verification they approved me.

      Which bike can I get?

      Well, anyone you want.

      Ok, Ill take that one.

      Great, how much do you want to put down?

      Do I look like an idiot to you? You just approved me at at 4% for a motorcycle loan. That’s lower than my mortgage, why would I put anything down on this when I could use that money to pay off the higher interest mortgage? I could put the money in an index fund, probably beat 4% pretty safely and make money on the deal.

      Hmm, OK, I guess that makes sense, it just somehow doesn’t seem right though.

      Hey, you are the guys who approved me. God knows why. If I was behind your parts counter, I wouldn’t even lend me a screw driver.

      So there you go. Twenty minutes tops, with no income verification, no pay stubs or tax returns I’m riding out of there on a brand new bike at 4% with nothing down. Now that’s the first and probably only new vehicle I ever intend to buy in my life. I think new vehicles are kind of a weird thing to buy, but if you are going to buy one, at least a new motorcycle makes more sense on the safety as well as depreciation side. Plus you get the added advantage of informing your wife it gets better mileage than a Prius. “Honey, its not like its just a motorcycle, I’m saving the planet.” And then I get to do the little Irish jig my ancestors used to call “The Commie BS Right Back at Ye”. She always really loves that one

      Anyway I don’t have a lot of experience with the new vehicle process but that whole process seemed really retarded. I don’t think I can handle it again.

  • Crawdude

    This alleged “bailout” is the worst thing the government can do. If they allowed the housing market to naturally filter this slowdown would last a year or two. By artificially propping up bad decision makers they guarantee that a huge bubble will burst later on.

    Economics dictates that we allow those who set themselves up to fail, fail. This will lower house prices and in a few years allow others to purchase a home. Think back, most of the people reading this bought their house on either a downside or emerging market. This bailout will stifle the natural flow of the housing market.

    Enclosed is a letter from the president of the company I use as my financial advisors, kind interesting.

    Big problem #1 – housing
    Falling home prices are the big driver behind our current woes. We have
    steadfastly held that the decline in housing prices is far from over and that
    this problem will take at least one year, and probably two, to work its way
    through the financial system. There is nothing that regulators can do to prop
    up the prices of homes and it’s not a good idea anyway as any attempt to
    support prices only postpones the inevitable adjustment. We live in a mostly
    free-market economy where prices are set largely through the laws of supply and
    demand. Right now there are too many houses at prices that are still too high.
    Housing prices will only stop declining when supply and demand are equal and we
    are still far from that point. This week’s Economist highlights the problem: Of
    the roughly 129 million housing units in the United States, 18.6 million are
    empty, which equals a vacancy rate of 12.9% — the highest level since this
    measurement began in 19561

    The fall in housing prices is enormously painful for two reasons. First and
    foremost, many consumers have lived far beyond their means by tapping into
    rising home equity to finance current consumption. As prices fall, that equity
    evaporates and consumers must adjust spending habits, which negatively affects
    a multitude of industries ranging from retailers and casual dining chains to
    banks and airlines.

    Second and far worse, in our opinion, is that any borrowings against home
    equity must be repaid. If that home equity has disappeared, the hapless
    homeowner may find himself owing more money to the bank than their home is
    worth. For those in debt, deflation (the phenomenon of falling prices) is a big
    problem because debt payments are fixed — there is no adjustment in
    indebtedness for falling prices.

    Big problem #2 – too much debt
    There is too much financial leverage in our economy and the debt burden needs
    to be reduced through repayment, write downs and losses, and taxpayer-financed
    bailouts. Our debt burden has grown largely because many of the financial
    problems of the last two decades have been battled through lower interest
    rates, organized takeovers or rescues of financial institutions, and increased
    fiscal stimulus. Each time a crisis was averted, the proper adjustments were
    postponed and thus the problem became far larger and more difficult than might
    have been necessary.

    The debt balloon has so many ramifications and causes that it is hard to
    explain in a short article. However, here are some highlights:

    Ironically the world is awash in savings, but almost all savings are in
    emerging economies and oil-rich nations. The United States saves very
    little and foreign nations have been financing our excess consumption for
    years. This is one reason why the U.S. dollar is so weak.

    Excess savings pushed down returns for financial assets leading to an
    increase in the use of debt to magnify returns. Investment banks pushed
    borrowings to levels of almost $30 for every $1 in capital. Private
    equity firms justified purchases because most financing was debt. At the
    height of the boom, according to one lawyer, private equity firms handed
    banks a term sheet on which debt was to be issued. This is notable
    because the financial world is not supposed to work this way. Banks are
    supposed to dictate terms, not the other way around!

    Banks loaned freely to construction firms, real estate development
    companies and consumers to build and purchase more housing. Easy money
    fueled excess consumption until the laws of supply and demand took hold
    in the housing market.

    A lesson to be learned forever – reversion is mean
    This is a play on words from a financial term known as “Mean Reversion.” It is
    a law of gravity in the financial world that asset prices usually revert to
    their long-run averages. Despite a well-documented history of this truism,
    people still choose to ignore it. The technology bubble was supposed to teach
    people that price increases well above the norm result in a correction. It may
    take years, but a correction is coming and it may be long and painful if prices
    have risen well above historical averages. The bursting of the technology
    bubble was long and painful just as the bursting of the housing bubble surely
    will be as well.

    And now, of course, we have the new mania — commodities. Despite ample evidence
    that demand is dropping for a wide range of precious metals and gasoline,
    prices keep rising and plenty of “experts” are now available to justify why
    prices will go higher still. Does this sound at all familiar? The converse, of
    course, is also true. Assets with returns below the historical averages offer
    future potential for profit.

    The future
    Stock prices are falling as are many bond prices. While this is distressing,
    any investor knows that falling prices eventually create an opportunity to
    profit. Simply put, when the expected return of a stock or a bond falls to a
    point where a good return can be earned (without the use of debt), prices will
    rise. This is exactly what happened in the 1980s and 1990s after the tough
    markets of the 1970s. Stocks and bonds were dirt cheap at the beginning of the
    1980s and the long-term investor earned impressive rewards.

    In the meantime, there is going to be a continued shake-out in multiple
    industries. There will be more bank failures. There will be increased
    bankruptcies among retailers, casual dining chains and other weak players. This
    the way our system works — it’s not much fun to watch but survival of the
    fittest in our capitalist economy has always made our economy stronger in the
    long run.

    Time – friend or foe?
    In the world of investing, time is usually a friend but a lot depends upon age,
    financial circumstances, liquidity and a variety of other factors. For those
    with a long time horizon and some cash on hand, the fall in prices is a welcome
    opportunity. For those with a shorter time horizon, the fall in asset prices is
    very unwelcome. As such, the guidelines below need to be set in the context of
    a financial plan and each individual’s circumstances. Your financial advisor
    can help you assess your own situation.

    Suggestions for the uncertain future ahead

    Diversify your portfolio — as discussed in our last market outlook,
    portfolio diversification is absolutely necessary. A mix of financial
    assets has fared better over the last year than a single asset class,
    such as stocks.

    Diversify your product suite — no single product can accomplish all that
    is necessary to cope with future obligations and challenges. A mix of
    financial products, including fixed annuities, annuities that offer
    guarantees, insurance and bank CDs/certificates, can create additional
    layers of diversification beyond asset allocation. A diversity of asset
    classes and products can help in this environment.

    Maintain ample liquidity — many advisors suggest that clients maintain up
    to three to six months’ living expenses in cash or cash equivalents. This
    is sound advice. Cash is king in this environment. There will be many
    people who are forced to sell in this market. Profits accrue to those who
    can buy when others are forced to sell.

    Utilize dollar-cost averaging — the long-term investor will celebrate
    falling prices by remaining committed to a dollar-cost-averaging program.
    By purchasing an asset at lower average prices, the investor may profit
    to a greater extent than those who sit on the sidelines waiting for the
    right opportunity. Market timing simply does not work.

    There is always opportunity in the market — the attached chart from
    Empirical Research Partners shows a fascinating opportunity. In this
    study, stocks are ranked based on their valuation. Those with good growth
    potential and cheap stock prices are the top quintile in this study.
    These stocks have performed very poorly over the last year as indicated
    by the peak in the chart. These stocks could correct on the upside.

    Hedging can help but be careful — hedging a portfolio effectively can be
    complicated and properly requires a holistic perspective on the portfolio
    and the objective, since any hedging strategy has the potential to
    disappoint in ways that are both clear and obscure in retrospect. Today’s
    markets offer a wide variety of ways to protect portfolio downside. One
    way to do this is to purchase ETFs that bet against an index or asset
    class. Some ETFs offer the ability to gain 1% for every 1% that the S&P
    500 falls. These strategies are inherently short-term in nature as it
    involves some judgment about market direction and their use should be
    confined to sophisticated investors.

  • Bob Clark

    I also blame the Royally knighted, retired federal reserve chief Allan Greenspan for this credit crisis. He dropped short-term interest rates too low for too long. Then at one point during the recent housing boom he advocates folks take on adjustable rate mortgages instead of the conventional 30 year, fixed rate mortgage. During 2005 if you traveled at all you saw all of these second home, trophy like homes, being built. I remember talking to other economists and thinking this doesn’t seem like the best way to manufacture an economic recovery coming out of the 2001/2002 recession (tech blow up).

    I can’t blame the current government efforts because we do have the preconditions for an economic depression. I don’t know if we should get away from government intervention as capitalism is prone to cycles, and some of them can be pretty nasty. Yet capitalism gives us the drive to invent and create a vibrant array of goods and services. So, I guess we have to constantly adjust the balance between government and free enterprise.

  • dean

    Of course its the fault of “the left!” Everything is the fault of “the left!” Damn socialists running our entire banking, financial, corporate, and political system. 20 out of 28 of the last years of republican presidents, republican appointed non-regulators, and 12 straight years of republican congresses that preceded the mortgage meltdown? Not their fault. It was the left that made them do it. Sneaky devils stopped red lining! Funny thing…I didn’t know Happy Valley (our local leader in forclosures) was redlined. But never mind.

    Life is so easy to figure out. Lost a war? It was the left! Wreck the economy? The left! Close facgtories and shift jobs overseas? The left!. Oil at $150 a barrel? The left! Global warming? Hot air from the left! I’m totally with it now. Thanks.

    • Jerry

      Calm down.

      It is the left in this case. Dems pushed for the relaxation of the lending requirements. Dems. Not repubs – their constituents already have the means to meet the normal lending requirements.
      Dems did this one Dean.


      Funny you would mention Happy Valley – dems approved all the housing out there. Dems.

      What happened to the high density nirvanna we are supposed to have?

      • Brian

        Geez, Jerry. You’re contempt for dems seems to have erased any critical thinking funtion you may have held. Dems haven’t had the power to do da-da for 12 years. Do you think they could have really passed a “social program” for the poor to buy houses during this time?

        Have you ever heard the term “lobbyist”, Jerry? Lots and lots of lobbyists, bought and paid for by the mega-corps who were raking in all the dough during the housing bubble? Now we’re seeing the effects of socialism. Socialism for corporations. Profits are free market risk rewards for the corps when things are good. But the free markets just don’t seem to be working for the financial corps right now, so let’s socialize the debts. Yep, the tax-payers will pay while the CEO’s fly off in their Lear jets. Or 747’s as the case may be these days.

  • Tim Lyman

    FNMA and FMAC have been in trouble for some time. Some Republicans sounded the alarm a year ago, but Democrats characterized their concern as an attack on low income people with home ownership aspirations and the “free market” jugheads in the administration went along for the ride.

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