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:

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.