Wednesday, August 22, 2012

House of Cards: A Cautionary Tale

The Housing Crisis.  The Real Estate Bubble.  The Credit Crisis.  "The worst financial crisis of modern times."  We've all heard about it.  An incredible number of people experienced it.  I, for one, never understood it.  Economics is not my strong suit, and I was fortunate enough to be far too busy writing papers and studying for exams to give it much thought.  This documentary, House of Cards, made the whole process abundantly (and maddeningly) clear.  So, for anyone else of my generation who may have missed it, here's a breakdown of the financial train wreck we call the Housing Crisis.
  • September 11, 2001, happens.  Expecting a severe economic stall after the tragedy, Chairman of the US Federal Reserve Alan Greenspan preemptively lowers interest rates to encourage spending.
  • Encouraged by "the lowest interest rates in a generation," many Americans take the plunge, buying homes and committing to mortgages.  
  • Responding to demand, residential development increases.  Brand new neighborhoods start popping up.
  • While all this is going on, the actual price of a new home is increasing at a greater rate than the average American income because of the inflated demand.
  • Because the prices are rising, new homeowners (mortgage holders) find they have significant equity in their new homes as soon as they move in.  
  • As demand for real estate slows because of the rising prices, lenders and mortgage companies begin looking for new and appealing ways to package their product.
  • "Subprime mortgages" become popular, or mortgages for people with shaky credit who would ordinarily be considered a bad risk.  There is little or no vetting process for these mortgages, and as a consequence many people are granted loans they cannot afford.
  • A quick note about how the market works: Fannie Mae and Freddie Mac were government institutions established to increase homeownership by buying home loans from mortgage lenders.  As the new owners of these mortgages, these two companies would receive a steady flow of monthly payments, pool the money and sell shares.  These shares are called "mortgage-backed securities."  While they dominated the market, Fannie Mae and Freddie Mac were able to dictate the terms of the mortgages they would buy, terms which used to be strict.
  • However, while Fannie and Freddie are momentarily distracted by internal accounting scandals, a crop of new mortgage lenders in California takes advantage of the chance to sell risky subprime mortgages to Wall Street.  Suddenly there are no more rules.
  • Wall Street likes to sell their mortgage-backed securities to foreign countries, like China and India, which are suddenly flush with cash.  These countries see American mortgage-backed securities as low-risk, high-return investments, which would have been true under normal circumstances.  However, international demand in turn leads Wall Street to pressure the risky subprime mortgage lenders to supply more mortgages, regardless of quality.
  • Mortgage lenders drop all standards in order to meet Wall Street's demand, offering subprime mortgages to people who have no business taking out a loan.  There is no investigation, so it is simple for applicants to lie about their stated income.  Sometimes the lender will cook the books on the applicants' behalf, with or without their knowledge.  The lenders then flip the risky "liar loan" to Wall Street, which would then flip it to unsuspecting international investors.
  • None of the firms on Wall Street want to be the first to impose stricter standards, because such a move would be "suicidal" in that market.
  • Suddenly, many Americans in a lower income bracket find themselves able to "afford" a home loan, the American dream.
  • (Remember the rising cost of homes across the market?) "Adjustable-rate mortgages" become popular, mortgages with low interest rates for the first few years before jumping to a higher rate.  Borrowers who accept these terms usually plan to refinance before the rate changes, counting on the house continuing to increase in value.
  • When homeowners discover the new equity suddenly put into their homes by the rising costs of the real estate market, they are quick to refinance, a move which gives them ready cash but also a larger mortgage.  Small-town America goes on a spending spree, causing retail sales to improve.
  • While the mortgage-lending market is booming, everyone wants to get on the act.  People with no training and no qualifications begin selling subprime mortgages.  The more loans they close, the more fees they collect.  Any candidate is a good candidate.  Meanwhile, these are all profitable because of Wall Street's demand.
  • Encouraged by the sudden increase in homeownership (and the alleged economic recovery that implied) the government encourages the mortgage companies to invent still more kinds of mortgages to make them more accessible to those who essentially could not afford it.  They call these "greater mortgage product alternatives to the traditional fixed-rate mortgage."  Mortgage companies and Wall Street are both eager to comply.
  • Deceptively complicated products with cryptic names like the "pay option negative amortization adjustable rate mortgage" are created.  Laymen call it a "pick-a-payment mortgage," in which any unpaid interest will be added to the principal each month.  The end result is a mortgage that gets "paid up" rather than down, trapping the homeowner in debt.
  • All this risk is held together by the notion that home prices would continue to rise.
  • As the loans became riskier, the rating agencies (which the international investors relied upon to vet their investments) are convinced to bend the rules, giving a mortgage-backed security which originated in a risky subprime mortgage the same rating as another backed by a stable traditional mortgage.  AAA is the safest rating, and international investors would allegedly buy anything rated AAA.
  • While the market was booming, banks invent yet another way to repackage their product for investors.  A "collateralized debt obligation" (CDO) is a collection of several parts of several different mortgage-backed securities, a sneaky way to intermingle the bad mortgages with the good ones.  Only the mathletes understand them, and unwary investors take them on faith often without any idea what they are actually buying, trusting the fraudulent AAA rating.  Again, the appeal of these investments is predicated on the notion that housing prices would never fall and that homeowners would not default on their payments.
  • As international demand increases for CDOs and other mortgage-backed securities, Wall Street leans harder on the lenders and mortgage brokers, who in turn aggressively issue mortgages to anyone willing to sign the dotted line, qualified or unqualified.  All the while, everyone in the business is becoming fabulously wealthy.  This peaks in 2004-2005.
  • Fannie Mae and Freddie Mac find themselves missing out, and abandon the standards they had once enforced, embracing the subprime mortgage business.
  • Homeowners, made euphoric by the perception of their sudden affluence, spend whatever additional equity they have in their new homes.  With no ability to pay off such a huge mortgage, everyone plans on refinancing later to stay afloat, trusting prices to continue rising.
  • By 2006, subprime mortgages begin to default, beginning the avalanche.  Suddenly feeling the pain, Wall Street begins to cut off the risky mortgage brokers, driving them out of business.  With fewer mortgage brokers willing to make risky deals, prospective homeowners are no longer able to qualify for a mortgage.  With fewer prospective buyers, housing prices stall.  When housing prices stop rising, homeowners are not able to refinance and find themselves stuck with crushing debt, many trapped in adjustable rate mortgages.  As the interest payments on adjustable rate mortgages begin to increase, more mortgages default.  Many families find they owe more on their homes than they are now worth and abandon them to foreclosure.  Neighborhoods of new homes became ghost towns.  
  • As housing prices fall and mortgages default, the mortgage-backed securities and CDOs begin to sour.  International investors realize they have been sold a crate of lemons, setting off the global credit crisis.  Demand for those investments abruptly dries up, crashing the market.  Banks and investment firms begin dying like flies.  Hence the cry for bailouts.
This is why it's apparently a buyers market right now.  I think I'll pass.
The moral of the story: human nature is a b----.


  1. The problem with Fannie and Freddie wasn't that they abandoned their standards, so much as they couldn't compete in the market. It's a perennial problem for government-owned business enterprises. If you go back far enough, there's evidence that the sub-prime lending trend got started in the 1990s, under the Clinton administration. Back then, it was considered a part of affirmative action. Fannie and freddie became the dumping ground for bad mortgage bundles; the bubble was in place far earlier.

    Further, the onus for generating the housing bubble wasn't 9/11. It was the crash of the Nasdaq bubble (the dot-com bust) that threatened the Keynesian boom-and-bust cycle. To replace the Nasdaq bubble and keep the good times rolling, Nobel Prize-winning economist Paul Krugman called on Greenspan to begin a housing bubble (his words, not mine). This is the recurring theme of fantastic booms followed by recessions: the Fed's central planners fuel bubble after bubble hoping to stave off real market adjustment. It all goes back to Keynesian economics: the notion that you can spend your way into prosperity.

    1. Consider this the Idiot's Guide snapshot version.

  2. One must always stick to the fundamentals; borrowing is risky, you must always plan on paying it back and there is no free ride.