The housing Crisis, How did we get Here?

During the years 2003-2006, the United States experienced the biggest housing boom in its history, a boom that began to deflate in 2007, causing a meltdown in the credit markets. The fault belongs everywhere in the system, but perhaps the great engine of the catastrophe was Wall Street. Large banks, hedge funds, and investment firms had losses of a magnitude never imagined, eroding their capital bases, and requiring large infusions of capital to avoid a systemic failure. The Federal Reserve worked to hold the system together to prevent catastrophic failure of the credit system. Lenders, Congress, the administration, and scholars have a lot to evaluate in making proposals to keep the system going, helping homeowners who are being foreclosed, and establishing regulations to prevent a future housing crisis.
Some of the causes for this event that is estimated to cost well over $250 billion to investors include:
  • Speculation by investors who put deposits on two, five, or ten pre-construction units that they expected to sell before they had to close. This resulted in a huge increase in the construction of new homes and condominiums that were not built based on a need for shelter, but based on the desire to make money by flipping the contracts. When the market slowed, the speculators walked away from their (usually small) deposits, leaving the builders with huge inventories of unsold homes.
  • Mortgage fraud situations perpetrated by mortgage brokers, lenders, appraisers, title insurance personnel, real estate brokers, buyers, and sellers.
  • People bought homes they could not afford because lenders made it easy. Many lenders made loans where the housing expense ratio was at 60 percent—meaning the house payment for a person making $5,000 monthly would pay $3,000 in mortgage payments. That was substantially higher that the FHA guideline of 31 percent (which says the individual should have payments no higher than $1,550).
  • Special purpose vehicles (SPVs) allowed loans to be bundled into large securities backed by mortgage payments. In 2006, mortgage origination volume surged to $2.5 trillion. Investors didn't know much about subprime loans, and they could never have been sold, except for bond rating agencies like Moodys, Standard and Poor, and Fitch, who put the gold seal on the securities. Moodys profits surged. When the bonds later soured, Moodys downgraded those securities, but it was too late for the investors. Later, collateralized debt obligations (CDOs) were set up that purchased SPVs then sold bonds to investors. These bonds didn't have real mortgages to back them up; they were one step removed, so the trouble was compounded.
  • Banks, brokerage firms, and hedge funds found the securitization of mortgages very profitable, selling "tranches," which are parts of a package ("tranche" is a French word meaning "slice"). The bond tranches have different risks, rewards, and/or maturities. It's similar to betting on a football game. The basic bet is who wins; however, another bet could be the point spread, another the number of touchdown passes thrown by a given quarterback, and so on. A typical security would have 10 or 12 classes of bonds, rated from triple-A to much lower grades. The highest-rated bond buyers, having lower risk, would accept a lower interest rate. The low-rated bonds, much riskier, would pay a higher rate, but those buyers would take the first loss. Many of these banks and investment firms had contracts with large mortgage companies to originate mortgages; for example, one contract required New Century Mortgage (now defunct) to originate and package $2 billion in loans each month. When the pressure is on to produce that kind of volume, one should expect that the quality of the loans will be lower than expected.
  • Now, because of the credit and liquidity problems, lenders are more cautious and private mortgage insurance companies are in financial trouble, so even qualified buyers find it more difficult to get financing for their purchases, further exacerbating the problem.
The price increases fueled by the rampant speculation almost certainly will have to be given back. If one takes the median family income of Americans over the years from 1980 to 2000 and divides it into the median home price, the multiplier was about 2.5 annually. That could be considered the norm. Looking at that statistic in 2007, the median home price divided by the median family income is at about 5.1. The implications are serious because median income is quite stable. As the ratio comes back to the norm, it is requiring prices to deflate significantly as we have seen over the last couple years.
It will take many years to work out of the mess. Investors lost billions, people lost their homes, jobs were lost, and even homeowners who were not involved have lost the character of their neighborhoods because of foreclosed, shuttered homes.
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