What Bank Regulators and Most Economists Do Not Grasp About Property Markets, Credit Markets and Economic Cycles

Edward J. Dodson

[Revised 12 December 2013]

In the United States, the Federal Reserve has failed to take an important step to slow the return of rising land prices. With property (i.e., land) prices falling back by one-third or more since 2007, the Fed (in conjunction with other bank regulatory agencies) should have prohibited member banks from extending credit for the purchase of land or accepting land as collateral for any borrowing. In the residential market, the effect would have been to restrict mortgage loan amounts to the actual value of housing units.

Instead, after a long period of investigation by Congressional committees and testimony by individuals invited or summoned to appear, the one new regulation consider by critics and insiders alike as a game changer is the so-called Volcker Rule imposed under the Dodd-Frank financial oversight law. This rule prohibits banks from trading for their own benefit, a practice by which banks systematically profited at the expense of their own customers. Banking analysts believe this measure will reduce revenue derived from fixed income trading operations of major banks by 25 percent or more. Others with a far better understanding of these markets than I are at opposite ends of the debate over what this Rule (and Dodd-Frank generally) will really accomplish.

When the banks, insurance providers and Wall Street investment firms join forces to generate high fees for themselves and promise investors high returns, the smart investor will remember private label mortgage-backed securities collateralized by sub-prime mortgage loans. Right now, many institutional and individual investors are positioning themselves to ride property prices as they emerge out of the recessionary bottom.

Historically-low rates of interest have been providing the fuel to restart the demand for residential properties, but most of the demand has come from investors with deep pockets looking to acquire and lease properties, then sell them once the general economy, employment and the land market cycle rebounded. Theirs has turned out to be quite a gamble. Today, nearly one in five workers is employed only part-time, which means they have few, if any, benefits normally associated with being employed.

Another important insight into where the U.S. economy is heading is revealed by the number of people who are filing for protection under bankruptcy laws. On the surface, the numbers suggest improvement. Analysts reported in July "that a paltry 1 million Americans will be filing for bankruptcy in 2013, a 14 percent decline from the previous calendar year."[1] However, the same analysts also provide posit a very different possible explanation:

"Still, many experts postulate that Americans' bankruptcy rates are falling because they simply cannot afford to pay for the legal representation required to expunge their debts. An average bankruptcy filing will end up costing about $1,500, with some variations around that mean. If people are so financially insolvent that they cannot afford to file for bankruptcy, their money situation could be even worse than previously imagined."[2]

What the central bankers and most economists are silent about is the disappearance of savings from the accounts of millions of retirees faced with rising living expenses. Even worse, near zero returns on savings have provided investment managers with the argument that remaining funds should be moved into mutual funds or individual stocks or real state in order to recover some of what investors have lost. Thus, the safety net of insured deposits has fallen dramatically as a consequence of Federal Reserve actions. Desperate people are taking desperate steps to save their future.

The U.S. Census Bureau now classifies 6.6 percent of all Americans as living in "deep poverty" because they have incomes of less than one-half the official poverty level. Only one in four U.S. households have savings sufficient to cover just six months of living expenses. A significant percentage of these households live paycheck to paycheck and have no savings at all, one illness or emergency away from disaster. A long list of metropolitan areas - topped by Las Vegas, Riverside-San Bernardino (California), Cleveland, and Phoenix - are still experiencing high levels of bank foreclosures on residential properties. Sales of bank-owned properties accounted for 10 percent of all U.S. residential property sales in September of this year.

With all of these troubling signs in front of us, Barack Obama delivered a powerful speech on December 4th pointing to the concentration of income and wealth as a very serious threat to American democracy. Yet, he had nothing to say about the fundamental problems that are the cause:

"And now we've got to grow the economy even faster, and we got to keep working to make America a magnet for good middle- class jobs to replace the ones that we've lost in recent decades, jobs in manufacturing and energy and infrastructure and technology.

"And that means simplifying our corporate tax code in a way that closes wasteful loopholes and ends incentives to ship jobs overseas. We can -- by broadening the base, we can actually lower rates to encourage more companies to hire here and use some of the money we save to create good jobs rebuilding our roads and our bridges and our airports and all the infrastructure our businesses need.

"It means a trade agenda that grows exports and works for the middle class.

"It means streamlining regulations that are outdated or unnecessary or too costly. And it means coming together around a responsible budget, one that grows our economy faster right now and shrinks our long-term deficits, one that unwinds the harmful sequester cuts that haven't made a lot of sense -- and then frees -- frees up resources to invest in things like the scientific research that's always unleashed new innovation and new industries."

What it means, unfortunately, is that the speculation-driven nature of our land markets will continue as always to stimulate an artificial boom for the top 1 percent who have been winning the rent-seeking game, followed by a very real bust for everyone else.

Some Historical Perspective

The process of deregulation and business consolidation in the financial services sector began in the early 1970s, the first important step being the introduction of money market funds. The withdrawal of billions of dollars of deposits from the nation's thrifts and into the money market funds triggered the later S&L crisis. The effects of deregulation, on the whole, have been to guarantee that every cyclical downturn will be more destructive and last longer than the one before.

Looking back to the early 1900s, the main arguments for establishing the Federal Reserve System in the United States were to centralize the issuance of paper currency, to create reserves of currency that could be channeled to member banks when needed, and to prevent the loss of purchasing power due to over-issuance of currency. The Federal Reserve Banks were also charged with regulatory oversight to ensure the banks were well-managed. By any objective measures one might apply, none of these objectives has been achieved.

A long list of critics have offered detailed analyses of why central banks consistently fail in living up to their statutory responsibilities. A few even manage to put their finger on the most fundamental failure of central bankers: their ignorance how land markets operate as a primary driver of the so-called business cycle. Had the central bankers come to grips with the intense level of speculation in the property markets during the 1999-2007 land market cycle, they might have been able to at least mitigate the depth and duration of the recessionary downturn that hit the United States, the United Kingdom and then spread around the globe.

Until the 1970s, residential mortgage loans were kept to a maximum of 80 percent of the lower of sales price or appraised value. In the United States, baby-boomers reaching adulthood and forming new families dramatically increased the demand for housing. Developers competed with one another almost everywhere to bid up the price of developable land, and residential property prices climbed. A tenuous market equilibrium managed to exist because of the rising number of two-income households formed. Greater than average returns on land attracted companies specializing in land banking, with the result that residential property prices began to climb faster than household incomes. People living in apartments found it increasingly difficult to accumulate savings sufficient to meet the traditional 20 percent cash down payment and the additional funds associated with a purchase transaction.

Mortgage insurance providers responded by agreeing to protect mortgage investors from losses associated with mortgage loans with loan-to-value ratios greater than the traditional 80 percent. From that point on, land markets quickly capitalized every attempt to prop up property sales and refinances into higher prices. Additional fuel was added as long-term interest rates began to fall during the decade of the 1990s, settling to around 7 percent by 2003. After the 2007 crash, the Federal Reserve, with support from many economists, adopted the strategy of lowering and lowering interest rates to stimulate demand for residential properties. As property values bottomed out and started to increase, some property owners were able to refinance out of high cost sub-prime mortgage loans (although it was already too late for several million others whose properties went to foreclosure sale). Critics observed that the primary beneficiaries were the major mortgage loan investors saved from having to absorb additional losses.

What Did I Know and When Did I Know It?

Every day for some thirty-five years after completing college I worked for companies that funded and/or managed real estate properties. My first employer appointed me an office manager, then I joined the subsidiary of a commercial bank doing project and construction loan accounting. Five years later I was brought into the bank as a mortgage loan officer and eventually promoted to manage the bank's residential mortgage lending program. When a merger eliminated my department at the bank, I left to join Fannie Mae to supervise and then manage what was referred to as a team responsible for "quality control" analysis of the mortgage loans sold to Fannie Mae. Ten years later I took on a new assignment as a business manager with market analyst responsibilities in Fannie Mae's new Housing & Community Development group, where I remained until retiring in 2005.

My working life in the financial sector spanned decades of almost continuous anxiety over economic uncertainties and dramatic shifts in public policies and regulations. I somehow survived three or four reorganizations at Fannie Mae, undertaken to modernize and upgrade the company's operations and expertise. Yet, the most stressful period for many of the people I worked with came after my retirement.

During the last few years at Fannie Mae one of my responsibilities was to monitor the health of property markets in the Northeastern United States. Every quarter we would bring together industry representatives, and I would present an update on the "housing" sector. I was also communicating with analysts outside the company, sharing insights and sources of what we thought was important market data. From time to time Fred Harrison would contact me and ask for assistance with research on the U.S. economy. I began to share the results of this research with others in my industry in an effort to alert them to the underlying problems.

The Fannie Mae Experience

What was unique about Fannie Mae, from my perspective, was its charter as a shareholder owned company with a public mission and a restrictive set of investment options. When I joined Fannie Mae at the end of 1984, the company was in serious financial trouble. It bought and held fixed rate mortgage loans at a time when the cost of funds was skyrocketing. Fannie was in the same situation as the thousands of thrifts scattered across the country -- bleeding red and with no regulatory relief in sight.

Fannie's presence as part of the secondary mortgage market allowed mortgage originators to pass on interest rate and even credit default risk. When loan volumes were relatively low, Fannie's underwriters would look at each and every loan file before approving a purchase. However, as my own generation of "baby-boomers" reached adulthood and began to enter the work force and create new families, transaction volumes forced the industry to adjust. Delegated underwriting, shared risk structures and what were called "post-purchase reviews" by Fannie were introduced in response.

As noted above, the same demographic shifts also added fuel to what had always been a speculation-driven part of the economy -- land markets. As new suburban developments went up around every major urban center, the asking price for still vacant land doubled and doubled again in only a few years time. A handful of city planners and economists who had some expertise in the operation of land markets offered warnings and advice to policymakers. Rarely did their input have an effect. And, as we know, the countryside everywhere retreated under the pressure of a sprawling demand for land. Developers kept going further out from the regional center to find land at a reasonable cost. Local governments looked to the state and federal governments for funding to help shoulder the cost of putting in new roads, bridges, sewage treatment plants, sewer lines, utilities and water systems. Few gave much thought to the possibility that economic recession and "tax reform" would combine to bring an end to the era of revenue sharing initiated during the Presidency of Lyndon Johnson and continued on through Jimmy Carter.

As it turned out, a combination of the Reagan recession and product innovation slowly brought Fannie out of its financial black hole. Cash was raised by selling off whole loans, but the losses were allowed to be amortized over the remaining life of the loans rather than immediately recorded. The adjustable rate mortgage loan was introduced, stimulating investor interest in mortgage-backed securities that offered protection against interest-rate risk. And, Paul Volcker's policies at the Fed gradually brought interest rates back down to single-digits. Deregulation did the rest, particularly the role played by money market funds and REITs (real estate investment trusts) providing the credit to anyone who showed the least bit of ability to act as a real estate developer.

Fueling the Speculative Markets

Those of us in the trenches observed many warning signs. Year after year Fannie and Freddie increased maximum loan limits in order to sustain transaction volumes. This only added more fuel to the speculative character of the residential property markets. By the time of the 1989 crash property appraisals in some markets were reporting land-to-total value ratios greater than 50%. In short, consumers were paying as much or more for land as for the housing unit itself. And, then the savings and loans (S&L) meltdown occurred. Delinquencies and REO (i.e., properties acquired by banks at foreclosure sale) climbed but these problems were kept manageable by a growing team of specialists in this part of the business.

By this time several economists had entered my circle of contacts, and they were warning that the next downturn would be far worse. The historical data indicated that the next crash would occur beginning in 2007 and continue getting worse through 2010. I was not yet convinced for the simple reason that there was no one national property market in the U.S. Our recent history was one of boom in one region even as other regions were busting. Labour and capital moved from low growth or no growth regions to where the prospects were brighter. For example, California's skyrocketing property prices and taxes opened the door for the economic diversification of Las Vegas and new growth in places such as Phoenix, Seattle and Portland.

My attitude changed after Fred Harrison recruited me to provide research assistance for his book on the next crash that would be published in 2005. In one of the great ironies of modern social policy, the creation of a uniform secondary mortgage market that simultaneously took over a huge portion of the former jumbo market and funded the sub-prime business formerly the province of finance companies and second mortgage lenders brought on a nationwide crash.

At the same time, Fannie and Freddie were beginning to lose market share to the private label mortgage-backed securities issued by Wall Street. Investors were attracted to the higher yields offered but closed their eyes to the inherently greater risk associated with the minimally and sometimes fraudulently underwritten sub-prime mortgage loans pooled into these securities. While I was still working at Fannie our credit risk management group stood firm against putting the Fannie Mae stamp of approval of mortgage-backed securities collateralized by these loans. Many of us realized we were fast coming to the conditions of a perfect storm.

I remember hoping that the collapse of Wall Street's shell game would not bring down Fannie and Freddie. I knew, as Fannie Mae's President (2005-2008) Daniel Mudd would later testify, that what was defined as Fannie's "Alt-A" business was far less risky than the sub-prime loans Countrywide and other lenders had generated. In 2008, Fannie's former CEO Franklin Raines testified that Fannie Mae "invested relatively little in subprime mortgages," which accounted for less than 1 percent of the company's guaranty obligations for mortgage-backed securities. Raines added that the primary cause of rising delinquencies and losses was unemployment, concentrated in mortgage loans made using the Alt-A conventional product.

Investors did not distinguish between the Fannie/Freddie mortgage-backed securities and the private label securities issued by Wall Street. They almost immediately abandoned the entire mortgage-backed securities market. Fannie had no real hope of raising additional capital as the stock price collapsed. Before long the sub-prime collapse expanded to a general financial crisis, business contraction, layoffs, rising unemployment, eviction notices, and millions of foreclosures. Almost unanimously, economists and analysts said the "housing" market was in free fall. As I hope I have made clear, what was falling everywhere were unsustainable land prices. In some markets (e.g., parts of Cleveland and Las Vegas and new condominiums scattered throughout Florida) demand collapsed which pulled property prices down well below the depreciated value of actual housing units.

Concluding Remarks

Should we be terrified by what we are facing? Some of us are. History is not on the side of those who continue to attempt to manage economies by applying the same old monetary and fiscal tools. The interdependence of the world's economies, subjected to the risks of a consolidating financial services sector means that labor and capital are less and less able to find regions of growth in a period of almost universal collapse.