Listening to congress, the Federal Reserve, and the Democrats discuss "the credit/mortgage crisis" is pretty depressing at times. There is plenty of blame to go around:
- The Federal Reserve has to take its share by creating a credit bubble with articifically low interest rates from 2003-2006. Their easy credit policies started the dot.com bubble then migrated towards the housing market. They created excess amounts of money which went into housing speculation. Worse of all, the Fed appeared to abandon all pretenses of protecting the integrity of the dollar from depreciation and inflation and looked to manage economic growth - a fool's errand. Part of this was using "core inflation" as a key target. Ignoring spiraling energy and commodity costs belies the real inflationary pressures that most families have to deal with in their budgets. As a result, American's have suffered a real drop in their standard of living due to this deliberate devaluation of the dollar, which must be remedied - dynamic economies do not survive on a weak dollar that masks structural weaknesses. It can also be argued that expanding the discount window to non-brokers in the circumstances it did to Bear Stearns/J.P. Morgan is unconstitutional. Although probably necessary - such actions should require an act of congress. Judge Andrew Nepalontano on Fox Business News strongly believes that such actions violate the general welfare clause of the constitution - which prohibits direct handouts to individuals and businesses.
- Congress - despite all the preening about caring about the "poor homeowners" Congress did it's part in cultivating this problem. Congress had many policies to foster home ownership - often to people who should not be buyers due to bad credit. The Community Investment Act essentially forced banks to lower their credit standards to questionable borrowers to help low income communities. The mortgage interest deduction and property tax deduction gives a tax subsidy to homeowners over renters, further distorting the costs of home ownership over renting. Some of the few saner voices in Congress have noticed this. I can't believe I'm saying this, but Barney Frank (D- Mass), Chairman of the House Banking Committee has said as much, stating that government policies create too many home owners and not enough renters. Current proposals to "fix the problem" only create moral hazard for marginal borrowers who should not have been owners or speculators who could never afford the houses to begin with. Finally, the issues with the "shadow banking system" of broker-dealers were never addressed with the end of the Glass-Steagall act in 1999. Though Congress at the time did not know at the time the ability of these firms to be critical cogs in the banking system, it is another example of the unintended consequences of legislation.
- Loan securitization - securitization of pools of mortgages started in the late 70's/early 80's, but really took off in the past ten years. The prime driver of this was record low long-term interest rates on Treasuries. With so many institutional investors hungry for yield, as many were required to have minimum fixed income positions, the investment banks stood ready to securitize loans to these investors. The rating agencies slapped a AAA rating on some of the tranches, pocketed the fees, and repeated. This created a viscious circle - lower interest rates created greater demand for additional yield, which created lowered lending standards to create product and nice investment and ratings fees. Securitization also created more revenue for financial institutions than holding them to maturity. If more of these loans were held on the balance sheet, they would be more thorough in terms of due diligence.
- Risk models - all financial institutions use modeling to determine the amount of risk their investments have to a significant decline. These models are quite complex and use a lot of historical data and assumptions. These models, while helpful, have two fatal flaws. The first flaw is that many of these models assume that returns are normally distributed - it under-estimates losses at the extreme ends of of the curve where most statistical relationships fall apart. The second problem is that it fails to account for changes in behavior. In this case, it assumed that homeowners with zero equity in the house would behave the same as homeowners with a significant amount of of equity in the house in the form of a large down payment. People purchasing houses "no money down" have no financial incentive to stay in the homes once they are in a negative equity position - thus the "jingle mail" phenomenon. It appears that these risk models never figured that part
- Developers. I worked with a lot of construction clients over the years, and many of these people are really smart and successful. What I don't understand is how they could keep building when there is all this supply lying around, thinking that it will sell quickly. The first rule of any business is to minimize inventory - and when stuff sits unsold, then it is time to stop building and take a vacation. Nope, can't do that. Then on top of it, selling properties to people probably have a good idea that they can't afford the house; no worry to them - FHA normally bailed many of these people.
- Borrowers. If you are looking to buy a home, there are a few cardinal rules: (i) have a good size down payment (i.e. at least 5-10%); (ii) mortgage, taxes, and insurance should take up less than 1/3 of your gross monthly pay with a standard 30-year fixed; (iii) the maximum home price you can afford is roughly 3 1/2 times your annual pay. So, with this in mind, are we surprised that there are foreclosures involving borrowers who bought with no money down for homes that are 8-10 times their income? I have an additional rule - couples, do not buy a home assuming both of you will be working. If you buy based on one income, there is always a good cushion and it opens up more work/life options.