According to the Case-Shiller Index, median housing prices doubled from 1987 to 2000 in major housing markets, including L.A., Miami, D.C. and San Diego. In less than half that time, from 2001 to 2006, housing prices in L.A. and Miami almost doubled, while prices in D.C. and San Diego shot up 1.5 times. Overall, nationwide median housing prices doubled from 2001 to 2006. In an economy as mature and developed as the United States, how could nationwide housing prices almost double in a span of only six years?
As emerging nations (particularly China) expanded, they exported more and more to the developing world. By the early 2000s, these nations were awash with unprecedented amounts of cash. Not wanting to re-invest in their own or other developing economies, foreign governments and investors began throwing cash back into the safest, most stable economy of them all: the U.S. economy.
This windfall of foreign capital changed the investment landscape on Wall Street, making money cheaper by driving down interest rates and yields on various fixed-income securities, including U.S. Treasuries. At the same time, from 2001 to 2003, the Federal Reserve cut interest rates from 6.5% down to 1% and kept it at this 50-year low for an entire year. By the end of 2003, yields for U.S. Treasuries were so low that, after inflation adjustment, they were actually negative.
Meanwhile, Americans began cashing in on record low mortgage rates. In 2003, Americans refinanced nearly $4 trillion in mortgage debt, more than 13 times the amount refinanced in 2000. Still wanting “low-risk” investments but with more return, foreign investors began buying up mortgage-backed securities – now being issued in record amounts by investment banks (mostly via their off-balance sheet affiliates) and government sponsored entities, Fannie Mae and Freddie Mac. As foreign investment continued pouring into the U.S., the demand for mortgage-backed securities and related instruments like collateralized debt obligations shot through the roof.
The mortgage industry made it increasingly easier for Americans to obtain mortgage financing. Americans, therefore, went on a consumption binge that included bigger, better and more expensive home purchases – often at unaffordable prices. Adjustable-rate, piggyback, low-doc, and zero-down payment financing options were some of the many examples of mortgage “innovation” that became commonplace during the boom. Housing prices continued rising.
As they made loans, the mortgage companies were simply turning around and “selling” the individual mortgages (at handsome profits) to investment banks and government sponsored enterprises – who were feverishly “securitizing” and issuing billions in mortgage derivatives (also at handsome profits). By 2005, mortgage lenders began to run out of prime borrowers, settling on less-than-creditworthy, or subprime, borrowers to keep loan volumes roaring. The mortgage companies made even more money with subprime loans because of the heightened credit risk. Housing prices kept rising.
Unfortunately, by 2006, the mortgage lenders ran out of borrowers, and demand for mortgages declined. Overzealous home builders had simply built too many homes, creating a massive supply imbalance. Housing prices stagnated. At the same time, many borrowers faced mortgage “resets” at substantially higher interest rates. This made monthly mortgage payments unaffordable to many subprime mortgage holders. Delinquencies, defaults and eventually foreclosures shot up, putting more downward pressure on housing prices. By January 2007, the Case-Shiller home index registered a nationwide price decline. Six months later, the financial dominoes built from these failing mortgages began to fall.
A couple of things should be apparent. First, blaming one specific group, like investment banks, is misguided. Granted, high finance had plenty to do with the severity of the crisis, but there were a number of other factors that had to be present for this to have gotten so bad. Second, you’ll notice other oft-mentioned villains are not mentioned above. Aside from emphasizing homeownership, like most of its post-World War II predecessors, the Bush administration had very little to do with the current economic crisis. No significant legislation coming from this administration had anything to do with the mess we find ourselves in today.
Outright fraud, whether on the finance side or the mortgage lending side, was not the significant driver of the crisis. There is a difference between fraud and irresponsibility – one is against the law and one is just stupid. Yes, evidence indicates so-called housing “flippers” helped bloat prices in some markets. In the end, however, there is little evidence to suggest this contribution was the driving force.
Given what we know, what has to be done to make sure history does not repeat itself? We could impose restrictions on foreign capital inflows into the United States or place strict limitations on the growth of bank balance sheets. But, unless we’ve suddenly become the Chinese government or the workforce of key regulatory agencies quadruples, those aren’t preferable options.
Instead, we should fix the mortgage securitization process. This undoubtedly means more regulation, including tighter leashes on ratings agencies, clearer disclosure of what is collateralizing these mortgage derivatives, and stricter limits on the ability to securitize subprime mortgages. Off-balance sheet entities must also be addressed, as the lack of transparency became the fundamental contagion that infected the capital markets. Obviously, mortgage lending standards need to go back to the basics: good old fashioned income verifications and sizeable down payments would be a start. Finally, some overt efforts by the U.S. government to incentivize people to save more money would be nice, as negative personal savings rates like those witnessed during the boom helped spur the crisis.
Of course, a focus on implementing reactive policies to “fix” past crises has its own problems. But at this point, all we can do is learn from the past.
Colin Murphy is a dual-degree master's student in public affairs and business graduating in December 2008. He has worked for Deloitte Consulting and will join the Boston office of consulting firm Oliver Wyman in January 2009.