The Great Housing Bubble and The Subprime Mortgage Crisis

Posted by PITHOCRATES - December 27th, 2011

History 101

Putting People into Houses trumped Sound Monetary Policy, a Sound Currency and good Lending Practices

Housing has for a long time been the key to economic prosperity.  Because to build a house you need a lot of economic activity.  Industries produce lumber, concrete, sheetrock, brick, shingles, door frames, doors, windows, glass, flooring, plumbing pipes, plumbing fixtures, sump pumps, furnaces, heating ducts, insulation, air conditioners, electrical wiring and fixtures, carpeting, tile, linoleum, etc.  The bigger the house the more of this stuff there is.  Once built people have to buy them (stimulating the mortgage banking industry) and then furnish them.  This triggers a monsoon of economic activity.  Drapes, shades, blinds, paint, washers, dryers, stoves, refrigerators, freezers, microwave ovens, toasters, blenders, food processers, plates, dishes, knives, silverware, ceiling fans, televisions, home theaters, sound systems, computers, cable and internet services, utilities, shelving, furniture, beds, cribs, art, etc.  And, of course, the exterior of the house creates further economic activity.

This is why one of the most important economic indicators is new housing starts.  For each new house we build we create a whirlwind of economic activity.  So much that it boggles the mind trying to think about it.  That’s why governments do whatever they can to stimulate this particular economic activity.  They encourage borrowing by allowing us to deduct the interest we pay on our mortgages.  They use monetary policy to keep interest rates as low as possible.  They’ve created federal programs to help veterans.  To help low income people.  And to remove risk from lenders to encourage more risky lending (as in Fannie Mae and Freddie Mac).  They’ve even used the power of government to force mortgage lenders to qualify the unqualified (Policy Statement on Discrimination in Lending).

You see, putting people into houses trumped everything else.  Sound monetary policy.  A sound currency.  Good lending practices.  Everything.  Because that was the key to a healthy economy.  A happy constituent.  And healthy tax revenue.  Not to mention you can score a lot of points with the poor and minorities by helping them into houses they can’t afford.  So this coordinated effort to put people into houses did two things.  Made money cheap and easy to borrow.  And created a boom in new housing starts.  Which resulted in a third thing.  A housing bubble.

Subprime Mortgages were for those who didn’t have Good Credit or Stable Employment with Reliable Income

Builders couldn’t build enough houses.  People were buying them faster than they built them.  And the houses they bought were getting bigger and bigger.  As they qualified for ever larger mortgages.  Poor people and people with bad credit could walk into a bank and get approved without documenting income.  House flippers could walk in day after day and get loans to buy houses.  Fix them up.  And put them back on the market.  Without using any of their own money. The market was soon flooded with new McMansions.  And refurbished smaller homes that people were moving out of.  Demand for homes was high.  And interest rates were low.  So the supply of homes swelled.  As did home prices.

Interest rates were low.  But they didn’t stay low.  All this coordinated effort to put as many people into homes as possible created a lot of artificial demand.  Heating up the economy.  Increasing prices higher than they had been.  Leading to inflationary worries.  So the Federal Reserve began to raise interest rates.  To temper that inflation.  Which didn’t sit well with those low income house owners.  Who got into their homes with the help of the Policy Statement on Discrimination in Lending.  Which forced lenders to get creative in qualifying the unqualified.  To avoid undo federal attention.  And legal actions against them.  So a lot of poor people had subprime mortgages.  As did all of those house flippers.  People who used little of their own money.  Who put little down.  And had little to lose.

What is a subprime mortgage?  In a word, risky.  It isn’t a 30-year fixed-rate mortgage at a good interest rate.  No, for those you need a good credit score and years of stable employment with reliable income.  And enough money saved up to put close to 20% down.  Subprime mortgages were for those who didn’t have a good credit score.  Years of stable employment with reliable income.  Or any savings.  These people didn’t get the ‘prime’ mortgages.  They got the expensive ones.  The ones with the higher interest rates.  And the higher monthly payments.  Why?  Because risk determined the interest rate.  And the higher the risk the higher the interest rate.

In their Effort to sustain Economic Activity the Government caused the Worst Recession since the Great Depression

But this posed a problem.  Because of the Policy Statement on Discrimination in Lending.  Making loans available to the unqualified was no good if the unqualified couldn’t afford them.  Enter the adjustable rate mortgage (ARM).  These mortgages had lower interest rates.  And lower monthly payments.  How you ask?  By making them adjustable.  A fixed-rate mortgage has to account for inflation.  And adjustable-rate mortgage doesn’t.  Because if there is inflation and the interest rates go up the ARM resets to a higher value.  Which is what happened right about the time housing prices peaked.

When the ARMs reset a lot of people couldn’t make their monthly payments anymore.  Having put little down and having made few monthly payments, these homeowners had little to lose by walking away from their homes.  And a lot of them did.  Including those house flippers.  And that was just the beginning.  With higher interest rates the new home market contracted.  Those artificially high house prices began to fall.  And when the ARMs reset they caused an avalanche of defaults and foreclosures.  The market was correcting.  There were far more houses for sale than there were buyers looking to buy.  Home values began to fall to reflect this real demand.  People who bought the biggest house they could afford because they thought real estate prices always went up soon discovered that wasn’t true.  People were making monthly payments on a mortgage that was greater than the value of their house.  Some walked away.  Some got out with short sales.  Where the lender agreed to eat the loss equity.

The housing market was imploding.  Thanks to a great real estate bubble created by the government.  In their quest to put as many people into houses as possible.  By making mortgages cheap and easy to get.  Relaxing lending standards.  And encouraging risky lending.  None of which would have happened had they left the housing market to market forces.  Where the market sets interest rates.  And housing prices.  The irony of the subprime mortgage crisis is that in their effort to sustain economic activity the government caused the worst recession since the Great Depression.  The Great Recession.


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Gold Doesn’t Lie

Posted by PITHOCRATES - September 19th, 2010

Gold and money have an intimate relationship.  Sort of a love/hate thing.  Because, in general, if you love one, you hate the other.  Actually, those are pretty strong words.  Let’s just say it’s a like/disinterested relationship.

During times of reckless, irresponsible monetary/fiscal policy, many people prefer gold over hard cash.  Why?  Two reasons.  Monetary inflation.  And currency depreciation.  Actually, these are two sides of the same coin.  No pun intended.  Well, maybe a little.

When the government spends more money than they have, they have to get more money.  They can increase taxes.  They can borrow it.  Or print it.   And we the people ultimately get poorer when they do. 

If they increase our taxes, we grow poorer.  And…, well, I guess that’s self-explanatory.

If they borrow it, they have to pay interest on what they borrow.  And, ultimately, we pay that.  When they borrow, they sell government securities.  And when they do, there’re more securities on the market.  They have to compete with corporate and municipal bonds (and other debt offerings).  And these have to compete with the government securities.  And how do you do that?  You attract investors with higher interest rates.  And we grow poorer when we have to pay those higher interest rates on our mortgages, car loans and credit cards.

If they print money it means they can no longer borrow.  Meaning they are so far in debt or so un-creditworthy that no one wants to buy their securities.  This is bad.  Real bad.  Because ‘printing’ is really their only option.  I put ‘printing’ into single quotation marks because most money is electronic these days.  Just numbers in columns.  In the old days, though, more of the money was paper.  And they really printed it.  Like in Weimar Germany following World War I.  Depression and reparations caused their printing presses to spit out cash at staggering rates (inflation).  So much so that the value of each individual note plummeted (currency depreciation).  The Germans actually used it for firewood.  Why?  It took less cash to burn than it took to buy firewood to burn.  And when Germans got any cash that they didn’t burn, they tried to spend it as fast as they cold before it became worthless.

This is how we get poorer with inflation.  It makes our money worth less.  Which makes everything cost more in dollars.

This is why gold is attractive during times of reckless, irresponsible monetary/fiscal policy.  It’s a lot harder to ‘inflate’ the quantity of gold.  You just can’t flick a switch.  You gotta mine it.  Process it.  Transport it.  Then introduce it into the market.  This takes time.  And involves a lot of costs.  It just doesn’t happen overnight.  So gold is a relatively safe asset to park your wealth in.  It holds its value.  And, in dollar terms, it increases its value the more money is depreciated.  As the dollar loses its value, it takes more and more dollars to buy the same amount of gold.

So, a high gold price is basically a rejection of a government’s monetary/fiscal policies.  And governments don’t like this.  Especially the Obama Administration.  Which has raised the bar on being irresponsible.  Gold prices are up.  So Rep. Anthony Weiner, Democrat of New York, is investigating.  And he wants to regulate (see Weiner, Waxman Set Gold Hearing from the Future of Capitalism website).  Because gold-selling companies advertise on conservative, cable programming.  Thus he can kill two birds with one stone.  He can try to hide the consequences of the administration’s irresponsible policies.  And he can hurt the advertising revenue of the news outlets that report on those irresponsible policies, thus muzzling the ‘free press’. 

Rep. Weiner can say what he wants to about the gold-selling companies and the conservative outlets but that doesn’t change one significant fact.  The price of gold is up.  And there is a reason for that.  The current monetary/fiscal policies are heading in a very bad direction.  A politician can lie all he wants about that fact.  But the market, left to its own devices, can’t.  And that’s why they want to regulate it.  So they can make it lie.

(Note:  PITHOCRATES does NOT offer investment advice.  Whether or not gold is a good investment is up to you and your financial adviser.)


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