Responses to

"A Decade of Despair"
by Alan J. Heavens

Edward J. Dodson

[ Responses to points made by Alan J. Heavens in a column titled "A Decade of Despair," posted online, December 2009. The following comments were forwarded to Mr. Heavens]

Alan Heavens:
The catalyst for much of what happened to the residential real estate market in this decade-about-to-end was a mind-bending tragedy: the attacks of Sept. 11, 2001.

"The boom happened, in large part, because interest rates began to decline after 9/11, and that juiced up housing demand," said Mark Zandi, chief economist for Moody's Economy.com in West Chester.

Ed Dodson:
Certainly, the drop in interest rates created a "window of opportunity" for millions of homeowners to refinance out of higher rage mortgage loans or to move from adjustable to fixed rate mortgage terms. And, rising property values enabled millions of homeowners to pay off higher cost credit card and installment debt by including this debt in their new mortgage amount. Homeowners gained the added benefit of a tax deduction for interest payments on their mortgage loans. What must be recognized, however, is that market forces quickly capitalized the interest-rate related affordability into higher land prices, setting the stage for a property market put at increasing risk of eventual collapse.

Alan Heavens:
But much also preceded that date, and it is helpful to track it all to appreciate why the U.S. housing market collapsed, taking homes from millions of families and shattering the American illusion that real estate values always rise and you can leverage that value to live beyond your means.

Ed Dodson:
The forces of an eventual depression-like economic collapse were actually put into motion early in the 1970s with the creation of the first money market funds. This was the first major withdrawal of regulatory oversight of the global financial system since the post-Second World War Bretton Woods system was established. A rapidly deteriorating balance of trade then caused Nixon's economic advisers to press for abandonment of the Gold Exchange Standard and devaluation of the U.S. Dollar. And, these measures were just the start of a long process of destructive decisions that exposed the U.S. and global economic system to intense speculative and outright criminal activities.

Alan Heavens:
When this decade dawned, all the stars necessary for a residential real estate boom began moving into alignment.

The dot-com bust of April 2000 stalled the surging, technology-driven economy of the previous five years. Fixed rates for 30-year mortgages were 8.20 percent that month, and they never dropped below 7 percent for the next two years, data kept by Freddie Mac show.

Although higher than they are today, those interest rates were half what they had been in the 1980s, and adjustable-rate mortgages provided an ever-more-popular alternative for home buyers.

Prices had been falling since residential real estate hit a wall in the aftermath of the October 1987 stock-market crash, the collapse of the commercial market, and the resulting savings-and-loan debacle.

All those forces suppressed home buying, even in the relatively prosperous second half of the 1990s.

Ed Dodson:
Another crucial change in government policy was the movement away from awarding investors with tax credits for investment in actual physical capital goods. The steep reduction in marginal tax rates on high incomes adding enormously to the disposal incomes of people who then sought the highest nominal rates of return without regard to whether any real economic wealth was being created. The result was a constant movement of financial reserves into highly speculative investments - into the stock and bond markets, into commodity futures, into hedge funds, into land, into commercial real estate, into precious metals. Alan Heavens:
Then came life-altering 9/11.

The Federal Reserve lowered the short-term federal funds rate to 1 percent, and the rest of the world fell in line, said Nigel Gault, an economist with IHS Global Insight in Lexington, Mass.

"The rate was low, inflation was low, and long-term rates followed suit," Gault said.

Ed Dodson:
And, as long-term mortgage rates fell and remained low, property (i.e., land) prices skyrocketed in many of the hottest markets around the world. Household incomes did not keep pace, and household savings was insufficient to meet standard down payment and closing cost requirements established by the GSEs. To keep the housing market going (and to satisfy Wall Street analysts' expectation of double-digit earnings), the GSEs came up with new guidelines that permitted lower borrower cash contributions. Total mortgage loan volumes climbed based on higher and higher loans taken on by homebuyers. The GSEs accommodated the inflation in land prices by annually increasing maximum loan amounts. At the same time, lax regulation opened the door for predatory lending practices and outright fraud in the sub-prime market.

Alan Heavens:
The decline in interest rates was accelerated by extensive securitization of mortgages and the proliferation of new loan products to make home buying easier, Zandi said.

Although Freddie Mac and Fannie Mae had long been buying back mortgages from lenders and repackaging them as securities for sale to investors on the secondary market to create a greater pool of home-buying capital, this was going to be a different time.

Ed Dodson:
Yes, but the major innovations came not from Fannie Mae and Freddie Mac but from the private placement MBS market. What is hardly ever mentioned is that every mortgage loan purchased or securitized by the GSEs with a loan-to-value ratio above 80% required private mortgage insurance. Thus, the MI companies were there as a second level of underwriting risk management and to absorb the top losses experienced when mortgagors defaulted. The mortgages pooled as collateral for Mortgage-backed securities issued by the GSEs are not held by the GSEs; rather, the GSEs act as an insurer to protect the MBS investor from loss. The mortgage bank or commercial bank that originates the mortgage pays to the GSE a "guarantee fee" based on the characteristics of the underlying mortgage loans.

Alan Heavens:
"There was a push by both Congress and the White House to promote greater home ownership," said Econsult Corp. vice president and economist Kevin Gillen in Philadelphia. "So government agencies like Fannie, Freddie, and the FHA turned on the credit spigots.

Ed Dodson:
This was certainly the case. From the mid-1990s on, Fannie Mae established a network of field offices that worked very closely with Federal, State and local elected officials to channel "community development" funds into distressed areas, to increase the rate of homeownership among minorities and to increase the supply of housing affordable to first-time homebuyers. None of this activity was undertaken without thorough analysis of the various risks involved, and (until the general economy declined and unemployment skyrocketed) the performance on this book of business was as forecasted and the losses within acceptable limits. Alan Heavens:
"On the private side," Gillen said, "there was the perception that there was an exceptional return to investing in housing, so subprime mortgage lending began to proliferate, which was also encouraged by the federal agencies."

Ed Dodson:
To lump the GSEs in with the private placement subprime mortgage market is unwarranted. Both GSEs had their problems associated with the use of accounting methods that minimized the impact of short-term shifts in the value of assets held in portfolio. In the case of Fannie Mae, the decisions to under-report such losses eventually triggered the departure of the CEO and CFO and required the diversion of internal resources from the business segments to the accounting and regulatory compliance functions. Not unsurprisingly, the company's stock values - and confidence in its future - declined precipitously. However, Fannie's portfolio of mortgage loans continued to perform well until the private placement subprime disaster triggered a broad market collapse.

Alan Heavens:
The world - individual investors, pension funds, and governments such as China - was desperate for a safe place to put its money. And what appeared to be the most secure harbor was the American home, Zandi said.

"There was a lot of surplus savings in other countries, especially in Asia and specifically China," Gault said. "They lent the money back to the United States, which kept long-term rates low, and even when the Fed began raising short-term rates, long-term ones remained low."

The sputtering stock market wasn't a sure thing for investors foreign and domestic, and interest rates on savings, including long-term CDs, were very low.

That made trillions of dollars available for housing loans. And that, combined with a stagnating economy, sliced interest rates for qualified buyers to the neighborhood of 5.5 percent by the second quarter of 2002, and even lower thereafter.

The unprecedented volume of securitization severed the traditional link between those who originated the loans and those who serviced them, Gault said.

Not only that, but in an effort to spread the risk as a way to reduce it, "there was no way of telling if whoever was holding the loans could handle the risk," he said.

Ed Dodson:
A closer look reveals that the stated yields offered by Wall Street with the private placement MBS (and similar securities involving commercial properties) caused the conventional MBS market to contract. With Wall Street telling investors that the bond rating agencies were giving these MBS a AAA rating (when they were, in fact, as bad as or worse than junk bonds), investors bought into the game, looking always for the highest rates of return and willing to accept what Wall Street securities brokers told them regarding risk.

Alan Heavens:
With access to seemingly unlimited funds, borrowers confronted a limited supply of houses for sale, however - leading to bidding wars and even uncontested offers that propelled real estate prices, as it turned out, to heights far beyond sustainability.

"The feeling was that if I don't buy today, the price would only go up," said Peter Buchsbaum of Arlington Capital Mortgage in Jenkintown.

"Home prices were reflective of the frenzy," said Philadelphia mortgage broker Fred Glick.

Ed Dodson:
This is not a new phenomenon, of course. It happens at or near the top of very property market cycle. And, in this particular cycle, property price inflation was greatest in the investor-owned and secondary home markets. Other factors contributed as well. For example, many seniors living on fixed incomes were increasingly refinancing (too often under predatory terms) in order to obtain cash to meet rising property taxes, medical expenses, or to assist financially-stressed adult children.

Alan Heavens:
Another response to the terror attacks of 9/11 was in play, too.

"There was a lot of 'nesting' going on," Zandi said, and "consumer need for bigger and better homes became an important factor," especially as the rest of the economy softened in 2002 and 2003 and continued to bleed jobs.

To pay for it all, millions of homeowners began tapping into real or perceived home equity, "cashing out . . . and taking on larger loans, expecting their homes to continue to appreciate," he said.

As home values continued to soar, growing numbers of potential buyers were being shut out of the market.

The solution was "alternative" mortgage products that went light-years past the simple adjustable-rate loans that had given marginal 1980s borrowers a choice.

These products - "option" adjustable rates, negative amortization, pick-and-pay, no documentation, stated income (without evidence) - accelerated the trip on the road to ruin, the experts said.

Ed Dodson:
And, it is hard to sympathize with those homebuyers who took on far more debt than was prudent, and did so knowingly based on the expectation of being able to "flip" the property before a teaser-rate ARM was adjusted to a full market rate, etc. Despite increased maximum loan limits set by the GSEs, most of this business fell to the "jumbo" market, the mortgages either held in portfolio by banks and investors, or pooled into private placement securities marketed by Wall Street.

Alan Heavens:
Federal regulators could have stepped in at any time to put the brakes on this throttle-wide-open lending, but didn't until it was too late - just as in the savings-and-loan crisis of the late 1980s.

"These innovations were based on an assumption that housing prices would never go down, and had the blessing of the ratings agency based on past performance," Gault said.

"The belief was that some mortgages may fail, but they couldn't all fail at the same time."

Said Glick: "When the economy is rolling or the economy needs to be pushed along, there is usually a softening of regulation and credit in order to get people jobs and get buyers buying."

Ed Dodson:
Not all financial institutions suffered "irrational exuberance," thankfully. Now that property (again, i.e., land) markets are at a low level in most markets, the U.S. Congress (and other governments) should strongly consider regulations that prohibit financial institutions that accept government-insured deposits from lending to finance the acquisition or refinancing of land value. This is the one measure that would protect the banks from themselves, and protect taxpayers from having to bail them out at the end of the next property market cycle crash.

Alan Heavens:
The situation worsened as speculators took control of markets such as Miami, Las Vegas, Phoenix, and California.

"Housing was the only thing appreciating," Zandi said, helped by "people forecasting with a ruler."

Though lenders were to blame "for allowing 100 percent financing and interest-only loans, they were simply satisfying what the borrowing community requested," Buchsbaum said.

The pendulum, said Glick, "swung too far to the left."

Ed Dodson:
Do not discount the presence of systemic criminal collusion among the parties to these transactions. Fraud was widespread and our criminal justice system seems incapable of pursuing the parties involved as the law requires.

Alan Heavens:
Unlike the 1929 stock-market crash, no one event signaled the bursting of the housing bubble.

"Housing prices certainly reached a point beyond most people's ability to pay," Gault said. "In addition, delinquencies started to increase, especially on some of the crazier mortgages where the buyers had no chance of even making the initial payment."

"Double-digit returns in perpetuity are only possible if credit is limitless," said Philadelphia economist Gillen. "And, on the supply side, both home builders and flippers were steadily adding to the inventory of homes available for sale.

"As yields on mortgage-backed securities began to decline, so did the availability of credit," he said. "As borrowers began to have more trouble qualifying for a mortgage at then-sky-high prices, sales began to decline. Declining sales and ballooning inventories finally began to exert downward pressure on house prices in 2006, and by 2007 the collapse was under way."

Ed Dodson:
There is also the problem that financial institutions experienced having to revalue assets based on true market value. This caused some institution to report insolvency (even though borrowers continued to remain current on loans) in the face of finding additional cash to meet reserves for loan losses and minimum capital requirements.

Alan Heavens:
While the experts agree unanimously that the real estate market is cyclical, Zandi is certain that it won't come roaring back, even though prices are close to bottoming.

"The key reason is credit," he said. "Investors are cautious, and unwilling to invest in loans that aren't safe."

Said Buchsbaum: "Instead of credit scores and automated systems, we need to return to simple real-time decisions by people trained to measure the borrowers' ability to repay the debt, and a history that shows a propensity to repay it."

Ed Dodson:
Transaction volume will not permit a return to manual underwriting. There is no reason to move away from automated underwriting systems and the use of credit scores to forecast loan performance. Getting data directly from the credit reporting agencies, from independent property tracking firms (to validate the accuracy of appraisal reports) are all valuable risk management tools. What is needed is a recognition that our economic system is prone to 18-20 year downturns and that the financial sector is prone to all sorts of fraudulent activities. Deregulation created an environment where criminals came to understand they could act with impunity; and, other players looked to their legal advisers and auditing firms to keep them within the bare minimum of compliance with applicable law and regulation. Administration after administration, Congress after Congress, reduced funding and staff at the regulatory bodies, while appointing compliant political allies who had no inclination to protect the public interest if this might disrupt the new economy (and the constant flow of campaign contributions). At least that is how I see things.