Housing Boom, Bubble and Bust

Posted by PITHOCRATES - April 15th, 2013

Economics 101

Building and Furnishing Houses creates Great Economic Activity

Central to any booming economy are healthy home sales.  For home sales unleash great economic activity.  From the first surveys of a new subdivision.  To the new sewers and water systems.  Gas and telephone.  Cable television and broadband Internet.  Concrete for basements, driveways and sidewalks.  Structural steel (that beam in the basement and steel poles holding up the house).  Rough carpentry.  Electrical work and plumbing.  Drywall, windows and roofing.  Painting, flooring, doors and hardware.  Heating and air conditioning.  Lighting and plumbing fixtures.  Brick, siding and landscaping.  Etc.

All of this takes manufacturing to make these construction products.  All these manufacturers need raw materials.  And raw material extraction needs heavy equipment and energy.  At all of these stages of production are jobs.  Extracting raw materials.  Processing raw materials.  Manufacturing products out of these raw materials.  Building this production equipment.  Interconnecting these stages of production is every form of transportation.  Rail, Great Lake freighter, river barge and truck.  Requiring even more jobs to build locomotives, rolling stock, ships and trucks.  And jobs to operate and maintain them.  And build their infrastructure.  Filling all of these jobs are people.  Earning a paycheck that will let them buy a house one day.

Then even more economic activity follows.  As people buy these homes and furnish them.  Washers and dryers.  Refrigerators, stoves, microwaves, food processors and coffee makers.  Furniture and beds.  Light fixtures and ceiling fans.  Rugs, carpeting and vacuum cleaners.  Telephones, televisions, music systems, modems and computers.  Curtains, drapes, blinds and shades.  Shower curtains, bath mats, towels and clothes hampers.  Mops, buckets, cleaning supplies and waste baskets.  Lawnmowers, fertilizers, hoses and sprinklers.  Snow shovels and snow blowers.  Cribs, highchairs, diapers and baby food.  Etc.  All of these require manufacturers.  And all of these manufacturers require raw materials.  As well as transportation to move material and product between the stages of production.  And to our wholesalers and retailers.  More jobs.  More people earning a paycheck.  Who will one day buy their own home.  And create even more economic activity.

Bill Clinton pressured Lenders to Lower their Requirements and Subprime Lending took Off

This is why governments love housing.  And try to do everything within their power to increase home ownership.  Which is why they changed the path to home ownership.  After World War II when the building of subdivisions took off there was the 3-6-3 savings and loan.  Where savings and loan paid 3% interest on savings accounts.  Loaned money to home buyers at 6%.  And were on the golf course by 3 PM.  And the mortgage was the 30-year conventional mortgage with a 20% down payment.

The conventional mortgage was the mortgage of our parents.  Who had no problem putting off their wants to save money for that 20% down payment.  They prioritized.  And planned for the future.  But the conventional mortgage has an obvious drawback.  It limits home ownership to those who can save up a 20% down payment.  Pushing home ownership further out for some.  Or just taking that option away from a large percentage of the population.  So the government stepped in.  To help those who couldn’t save 20% of the house’s price.

Mortgage Qualification Decreasing Down Payment

As we lowered the down payment amount it allowed lower-income people the opportunity of home ownership.  But it didn’t get them a lot of house.  That is, those who could afford a 20% down payment could buy more house for the same monthly payment than those who couldn’t afford it.  And a house in a better neighborhood.  Which some said was unfair.  Some in government even called it discriminatory.  As Bill Clinton did.  Who pressured lenders to lower their lending requirements to qualify the unqualified.  His Policy Statement on Discrimination in Lending helped to fix that alleged problem.  And kicked off subprime lending in earnest.  Leading to the subprime mortgage crisis.  And the Great Recession.

Conventional Wisdom was to Pay the Most you could Possibly Afford when Buying a House

But lowering the down payment wasn’t enough.  Even eliminating it all together.  The people needed something else to help them into home ownership. And to generate all of that economic activity.  And this was something the government could fix, too.  By printing a lot of money.  So banks had a lot of it to lend.  Thus keeping interest rates artificially low.  And we can see the effect this had on home ownership combined with a zero down payment.  It allowed people to buy more house for the same given monthly payment.  Even more than those buying with the 3-6-3 conventional mortgage.

Mortgage Qualification Decreasing Mortgage Rate

Falling interest rates bring in a lot more people into the housing market.  Which is good for sellers.  And good for the economy.  A lot more people than just those who could afford a 20% down payment can now buy your house.  As people bid against each other to buy your house they bid up your price.  Raising home prices everywhere.  Increasing the demand for new housing.  Which builders responded to.  Creating a housing boom.  As builders flood the market with more houses.  At higher prices.  That new homeowners move into.  And max out their credit cards to furnish.  Creating a lot of debt people are servicing at these artificially low interest rates.  But then the economy begins to overheat.  And other prices begin to rise.  Leaving people with less disposable income.  The housing boom turns into a housing bubble.  House prices are overvalued.  Those artificially low interest rates created a lot of artificial demand.  Bringing people into the market who weren’t planning on buying a house.  But decided to buy only to take advantage of those low interest rates.

Conventional wisdom was to pay the most you could possibly afford when buying a house.  For all houses gained value.  You may struggle in the beginning and have to make some sacrifices.  Say cut out steak night each week.  But in time you will earn more money.  That house payment will become more affordable.  And your house will become more valuable.  Which will let you sell it for more at a later date letting you buy an even bigger house in an even nicer neighborhood.  But when it’s cheap interest rates driving all of this activity there is another problem.  For printing money creates inflation.  And inflation raises prices.  Gasoline is more expensive.  Groceries are more expensive.  As prices rise households have less disposable income.  And have to cut out things like vacations.  And any discretionary spending on things they like but don’t need.  Which destroys a lot of economic activity.  The very thing the government was trying to create more of by printing money.  So there is a limit to the good economic times you create by printing money.  And when the bad consequences of printing money start filtering through the rest of economy the government has no choice but to contract the money supply to limit the economic damage.  And steer the economy into what they call a soft landing.  Which means a recession that isn’t that painful or long.

The Price of Artificially Low Interest Rates is Inflationary Booms, Bubbles and Great Recessions

As interest rates rise home buying falls.  Leaving a lot of newly built homes unsold on the market.  And that housing bubble bursts.  Causing home values to fall back down from the stratosphere.  Leaving a lot of people owing more on their mortgage than their houses are now worth.  What we call being ‘underwater’.  And as interest rates rise so do the APRs on their credit cards.  As well as their monthly payments.  And those people who paid the most they could possible afford for a house with an adjustable rate mortgage saw their mortgage interest rates rise.  As well as their monthly payment.  By a lot.  So much that these people could no longer afford to pay their mortgage payment anymore.  As a half-point increase could raise a mortgage payment by about $50.  A full-point could raise it close to $100.  And so on.

Increasing Monthly Payment dur to Increasing Mortgage Rate

With the fall in economic activity unemployment rises.  So a lot of people who have crushing credit card debt and a house payment they can no longer afford lost their job as well.  Causing a rash of mortgage foreclosures.  And the subprime mortgage crisis.  As well as a great many personal bankruptcies.  Causing the banking system to struggle under the weight of all this bad debt.  Add all of this together and you get the Great Recession.

This is the price of artificially low interest rates.  You get inflationary booms.  And bubbles.  That burst into recessions.  That are often deep and long.  Something that didn’t happen during the days of 3-6-3 mortgage lending.  And the primary reason for that was that the U.S. was still on a quasi gold standard.  Which prevented the government from printing money at will.  The inflationary booms and busts that come with printing money.  And Great Recessions.

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Financial Crises: The Fed Giveth and the Fed Taketh Away

Posted by PITHOCRATES - December 3rd, 2010

Great Depression vs. Great Recession

Ben Bernanke is a genius.  I guess.  That’s what they keep saying at least. 

The chairman of the Federal Reserve is a student of the Great Depression, that great lesson of how NOT to implement monetary policy.  And because of his knowledge of this past great Federal Reserve boondoggle, who better to fix the present great Federal Reserve boondoggle?  What we affectionately call the Great Recession.

There are similarities between the two.  Government caused both.  But there are differences.  Bad fiscal policy brought on a recession in the 1920s.  Then bad monetary policy exasperated the problem into the Great Depression. 

Bad monetary policy played a more prominent role in the present crisis.  It was a combination of cheap money and aggressive government policy to put people into houses they couldn’t afford that set off an international debt bomb.  Thanks to Fannie Mae and Freddie Mac buying highly risky mortgages and selling them as ‘safe’ yet high-yield investments.  Those rascally things we call derivatives.

The Great Depression suffered massive bank failures because the lender of last resort (the Fed) didn’t lend.  In fact, they made it more difficult to borrow money when banks needed money most.  Why did they do this?  They thought rich people were using cheap money to invest in the stock market.  So they made money more expensive to borrow to prevent this ‘speculation’.

The Great Recession suffered massive bank failures because people took on great debt in ideal times (low interest rates and increasing home values).  When the ‘ideal’ became real (rising interest rates and falling home values), surprise surprise, these people couldn’t pay their mortgages anymore.  And all those derivatives became worthless. 

The Great Depression:  Lessons Learned.  And not Learned.

Warren G. Harding appointed Andrew Mellon as his Secretary of the Treasury.  A brilliant appointment.  The Harding administration cut taxes.  The economy surged.  Lesson learned?  Lower taxes stimulate the economy.  And brings more money into the treasury.

The Progressives in Washington, though, needed to buy votes.  So they tinkered.  They tried to protect American farmers from their own productivity.  And American manufacturers.  Also from their own productivity.  Their protectionist policies led to tariffs and an international trade war.  Lesson not learned?  When government tinkers bad things happen to the economy.

Then the Fed stepped in.  They saw economic activity.  And a weakening dollar (low interest rates were feeding the economic expansion).  So they strengthened the dollar.  To keep people from ‘speculating’ in the stock money with borrowed money.  And to meet international exchange rate requirements.  This led to bank failures and the Great Depression.  Lesson not learned?   When government tinkers bad things happen to the economy.

Easy Money Begets Bad Debt which Begets Financial Crisis

It would appear that Ben Bernanke et al learned only some of the lessons of the Great Depression.  In particular, the one about the Fed’s huge mistake in tightening the money supply.  No.  They would never do that again.  Next time, they would open the flood gates (see Fed aid in financial crisis went beyond U.S. banks to industry, foreign firms by Jia Lynn Yang, Neil Irwin and David S. Hilzenrath posted 12/2/2010 on The Washington Post).

The financial crisis stretched even farther across the economy than many had realized, as new disclosures show the Federal Reserve rushed trillions of dollars in emergency aid not just to Wall Street but also to motorcycle makers, telecom firms and foreign-owned banks in 2008 and 2009.

The Fed’s efforts to prop up the financial sector reached across a broad spectrum of the economy, benefiting stalwarts of American industry including General Electric and Caterpillar and household-name companies such as Verizon, Harley-Davidson and Toyota. The central bank’s aid programs also supported U.S. subsidiaries of banks based in East Asia, Europe and Canada while rescuing money-market mutual funds held by millions of Americans.

The Fed learned its lesson.  Their easy money gave us all that bad debt.  And we all learned just how bad ‘bad debt’ can be.  They wouldn’t make that mistake again.

The data also demonstrate how the Fed, in its scramble to keep the financial system afloat, eventually lowered its standards for the kind of collateral it allowed participating banks to post. From Citigroup, for instance, it accepted $156 million in triple-C collateral or lower – grades that indicate that the assets carried the greatest risk of default.

Well, maybe next time.

You Don’t Stop a Run by Starting a Run

With the cat out of the bag, people want to know who got these loans.  And how much each got.  But the Fed is not telling (see Fed ID’s companies that used crisis aid programs by Jeannine Aversa, AP Economics Writer, posted 12/1/2010 on Yahoo! News).

The Fed didn’t take part in that appeal. What the court case could require — but the Fed isn’t providing Wednesday — are the names of commercial banks that got low-cost emergency loans from the Fed’s “discount window” during the crisis.

The Fed has long acted as a lender of last resort, offering commercial banks loans through its discount window when they couldn’t obtain financing elsewhere. The Fed has kept secret the identities of such borrowers. It’s expressed fear that naming such a bank could cause a run on it, defeating the purpose of the program.

I can’t argue with that.  For this was an important lesson of the Great Depression.  When you’re trying to stop bank runs, you don’t advertise which banks are having financial problems.  A bank can survive a run.  If everyone doesn’t try to withdraw their money at the same time.  Which they may if the Fed advertises that a bank is going through difficult times.

When Fiscal Responsibility Fails, Try Extortion

Why does government always tinker and get themselves into trouble?  Because they like to spend money.  And control things.  No matter what the lessons of history have taught us.

Cutting taxes stimulate the economy.  But it doesn’t buy votes.  You need people to be dependent on government for that.  So no matter what mess government makes, they NEVER fix their mess by shrinking government or cutting taxes.  Even at the city level. 

When over budget what does a city do?  Why, they go to a favored tactic.  Threaten our personal safety (see Camden City Council Approves Massive Police And Fire Layoffs Reported by David Madden, KYW Newsradio 1060, posted 12/2/2010 on philadelphia.cbslocal.com).

Camden City Council, as expected, voted Thursday to lay off almost 400 workers, half of them police officers and firefighters, to bridge a $26.5 million deficit.

There’s a word for this.  And it’s not fiscal responsibility.  Some would call it extortion.

It’s never the pay and benefits of the other city workers.  It’s always the cops and firefighters.  Why?  Because cutting the pay and benefits of a bloated bureaucracy doesn’t put the fear of God into anyone.

Here we go Again

We never learn.  And you know what George Santayana said.  “Those who cannot remember the past are condemned to repeat it.”  And here we are.  Living in the past.  Again.

www.PITHOCRATES.com

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