The 2008 BustPresentation by Dr. Kevin T. Brady

What Caused the 2008 Crash?What Caused the 2008 Crash?

• What was the Cause?• What was the Crash?• Why did it happen?• Did anyone see it coming?• Did we recover?• Can we recover?

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Let’s Look at Housing

Most experts trace the cause of the 2008 BUST to:

• Housing costs• Low mortgage interest rates• Creative financing• Bundling risky securities• GREED!!!!

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Was the Housing Bubble National?The Housing Bubble seemed to be located in

just a few places.• The California Coastline• Arizona• Las Vegas• Florida

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Building Restrictions

• In areas where there are various building restrictions “Smart Growth,” or Growth Management Plans (GMPs), housing costs skyrocketed.

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Types of Restrictions:Types of Restrictions:

• Farm preservations• “Open Spaces”• Protecting the environment• Historical preservation

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National Bureau of Economic GrowthThe effects of restrictions on housing prices

National Bureau of Economic GrowthThe effects of restrictions on housing prices

Less Land – Higher Prices• Chicago: add $140,000 to

every ¼ acre.• San Diego: add $285,000 to

every ¼ acre.• New York City: add $350,000

to every ¼ acre.• San Francisco: add $700,000

to every ¼ acre.

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Just to put available land into perspective:

• Less than 10% of the land in the U.S. has been developed.

• Trees cover an area 6 times the area of all cities and towns in the U.S.

US DOA stats

FORESTS

• 651 million acres of forests• 587 million acres of pastures• 442 million acres for cropland• 297 million acres for parks• 228 million acres miscellaneous• 100 million acres Urban and

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Developed

Most of the country did not experiencethe Housing Bubble

• During the Housing Boom, housing in the 10 most expensive areas were 2 times the price of the national average.

• People had to spend half (50%) of their income on housing. Seven of the top 10 were in California.

• Only 21% in Tampa Bay• Only 13% in Dallas

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Growth Management Plans (GMP)

Middle manager Home

2,200 sq. ft.Four bedrooms,

2½ Baths2-car garage

• Markets without a GMP– $150,000 to $200,000

• Markets that had a GMP for 10 to 15 years– $300,000 to $400,000

• Markets that had a GMP for 25+ years – $500,000 to $1 million

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For example:

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A $155,000 house

in Houston costs more than $1 million inSan Jose.

• Houston and Dallas have family incomes above the national average.

• California has family incomes below the national average.

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How Can People Afford High Prices?How Can People Afford High Prices?

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• Creative Financing–No longer 20% down and a

traditional 30-year fixed rate, by 2003.• No money down• Interest only for first 2 to 3 years• Adjustable Rate Mortgages (ARMs)

Big ChangesBig Changes

• In 2002 only 10% of new mortgages in U.S. were interest only.

• Up to 31% by 2005.– In San Francisco,

however: 11% in

200266% in 2005

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Working the System

• In San Francisco one could pay $600,000 for a fixer-upper, with two-year interest only.

• Two years later the payments are then too high.

• Sell for $800,000.• Pocket $200,000.

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Great Deals AppearGreat Deals Appear

• Buy a house in Chicago for $90,000 in 1992.

• In 2005 take out a $200,000 loan on a now $700,000 house.

• Consolidate credit cards.

• Buy boats, bikes, vacations, etc.

• People who owed $300,000 at 8% could take out $400,000 at 6%.– Pocket $100,000.

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2nd Mortgages2nd Mortgages

• In 2003 2nd loans = $593 Billion

• In 2007 2nd Loans =$1.13 TRILLION

Consolidate debt; buy things; travel; live rich!

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Flipping HousesFlipping Houses• Buy fixer-uppers

– Invest money from 2nd mortgages.

– Spruce up the home.

– Refinance the fixer-upper and buy more, or sell it at a tremendous profit.

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The Government to the RescueThe Government to the Rescue

Affordable Housing(Never defined)

People used to rent if they could not afford a house, or they even lived with parents for a while.

• New government programs to allow people to live where they want and the government will find a way to make it work.

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New York Times

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“Since the 1980s a sharp decline in mortgage rates, a decline in mortgage fees, and the rise in incomes have more than made up for rising house prices in almost every place outside New York City, Washington, Miami, and along the coast of California.”

In the United States a house costs 3.6 times the national median income.In the United Kingdom a house costs 5.5 times the national median income.In Australia and New Zealand a house costs 6.3 times the national median income.

Lower Lending StandardsLower Lending Standards

• 1977 Community Reinvestment Act (CRA)– Very small agency

• 1990 studies found different rates for blacks and whites.– Government pressured banks to approve more

African-American applications.– G.H. Bush, then Clinton increased pressure.– Janet Reno threatened lawsuits and other legal

action.

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Media Sees DiscriminationMedia Sees Discrimination

• Nonetheless, statistical differences are both large and common in countries around the world, even when it cannot be explained by discrimination.

• Moreover, lenders are in business to make money.

• Those who argue “Corporate Greed” are often the same ones in the media who argue discrimination.

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Government Regulators impose quotas to get more minority loans OK’d

Government Regulators impose quotas to get more minority loans OK’d

• 1999 – Pending legislation to permit banks to sell investment securities.

• White House urged that banks given unsatisfactory ratings under the 1977 CRA be prohibited from selling investment securities.

• Banks make a Faustian trade-off.• HUD pressures Freddie Mac and Fannie Mae

to increase purchase of mortgages to people with low income.

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More PressureBottom-up & Top-down

More PressureBottom-up & Top-down

• Various community organizations, such as ACORN, picket banks and bankers’ homes and threaten to close the banks down.

• 2002 George W. Bush urges Congress to pass the American Dream Down Payment Act.– Subsidize down

payments.– Urges legislation to have

FHA approve $0 down payments available. (Down from 3%).

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Houses for Free?????Houses for Free?????• 2004 Federal Housing

Commissioner John Weicher said, “the White House doesn’t think it’s fair that people who can afford monthly payments need down payments.”

Traditional 30-year fixed mortgage2001 – 57% of all mortgages.2006 – 33% of all mortgages.

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Who Are Freddie Mac & Fannie Mae?Who Are Freddie Mac & Fannie Mae?

• They are responsible to stockholders, but they are “government-sponsored enterprises.”– They are created by the federal government.

• Institutions lend to them at a lower rate than they do to private institutions.– They assume that the federal government would

guarantee the loans.• Freddie’s and Fannie’s profits are privatized.• Their risks are socialized!

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• 1973 – 8% on a 30-year• 1981 – 18% on a 30-year!• 2005 – 6% on a 30-year

• $400,000 at 7% = $2,600• $400,000 at 5% = $2,200

• $5,000 a year difference• This covers a $500,000 home at

5%

BUY BIGGER!!

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Sub Prime LoansSub Prime Loans

SUB PRIME LOANS – to those with credit scores less than 620.

• A Loan-to-Value higher than 90%

• Debt-to-income ratio higher than 45%

• Stated income loans (no verification)

Between 2005 and 2007 Freddie and Fannie acquired $1 Trillion sub prime loans (40% of the value of mortgages).

The government calls this the “underserved population.”

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National policies to make buying housing easier were political in origin.

“Risky Loans” were seen as “good loans” by one of the key regulators of the housing market.

Freddie and Fannie were not just acquiring risky loans, they were pushing for more.

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Political not Sound Financial Policies

• Government regulations forced lenders to meet arbitrary quotas, eroding traditional mortgages and lending safeguards.

• MARKET CRITERIA• Required substantial

down payment• Adequate income• Credit histories

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They were all brushed away for “Affordable Housing” and bigger homeownership stats – an owner economy.

WARNINGS!!!!!

• The Economist 2003• The Economist 2005• Newsweek 2003• Josh Rosner at Medley Global Advisors• Fortune Magazine 2004• Peter J. Wallison, AEI• Barron’s Magazine• Alan Greenspan

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Barney Frank Chair of the House Committee on Finance Wants More!

• Frank – “ Freddie & Fannie have played a useful role in helping make housing more affordable. Critics exaggerate a threat of safety and conjure up serious financial losses to the Treasury, which I do not see.”

• “I believe that we, as the federal government, have probably done too little rather than too much to push them (F & F) to meet the goals of affordable housing and to set reasonable goals.”

• “I would like to get Fannie & Freddie more deeply involved into helping low-income housing and possibly moving into something that is more explicitly a subsidy.”

• “I want to roll the dice a little bit more in this situation towards subsidized housing.”

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As Does Chairman of the Senate Banking Committee, Christopher Dodd

He called Freddie & Fannie, “one of the greatest success stories of all time.”

He urges caution in restricting its activities and “doing great damage to what has been one of the great engines of the economic success in the last 30 to 40 years.”

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ERRORS

• Accounting errors of $11 Billion were discovered by Freddie and Fannie in 2007.

• Defenders still defended!

• Politics rules.

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The BUST!!!!!

• The Federal Reserve raises interest rates in fear of inflation.

– 2004 – 1%– 2006 – 5.25%

• Housing prices begin to fall! FAST!!!• Especially in areas with the most risky loans• Speculators caught owing too much on too

many houses. -- Lenders Foreclose!!

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California Leads the WayCalifornia Leads the Way

• Foreclosures inSan Francisco andSan Mateo double.

• 800% increase of deeds going to the lenders.

• Banks lost $40,000 per home.

• Prices continue to fall• 46.8% in the Bay area.

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Falling Prices by October 2008Falling Prices by October 2008

• San Diego – 27%• Los Angeles – 28%• Miami – 31%• Las Vegas – 32%• Phoenix – 33%• Of the 25 steepest

declines, 16 are in California.

National decline was only between 2% and 9%

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National Decline Was Between 2% and 9%

National Decline Was Between 2% and 9%

• Five percent decline or less in more than 50 metro areas of the country.

• Dallas decline was only 3%.• In 20 metro areas, with little

housing restrictions, the prices are still rising.

• In Houston and Dallas housing only takes 13% of the income. Buyers don’t have to go out on a limb.

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Less of a Housing Boom and BustLots of Local Bubbles

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The Sub Prime Crisis

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Originated in Four States:California, Arizona, Nevada, and Florida

All attracted speculators with rapidly rising housing prices.

Many foreclosures in states with high housing costs caused by Growth Management Plans.

Many with sub prime mortgages and speculators walk away from properties.

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Why the Crash?Why the Crash?• Freddie & Fannie and Wall Street bought mortgages at

inflated prices.• They bundled risky mortgages into securities.• They sold these securities based on the inflated values of

mortgages (the houses) across the country and overseas.• Sub prime mortgages were a new phenomena.

– No history to draw from.• Credit agencies had little experience with sub primes and

gave them high rating A+• Investment bankers would shop the securities for the best

rate.

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Dominoes, or a House of CardsDominoes, or a House of Cards

• As thousands foreclose, the value of the securities crumble.

• Investment banks lose equity; capital dries up.

• They can’t get credit.• Without credit, they

begin to crumble.

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Mark-to-Market AccountingMark-to-Market Accounting

• Government Regulation: Accounting practice that accounts for the value of an asset or liability based on the current market value of the asset or liability.

• Does not allow chance for recovering or variation over time.

• Banks can go bust immediately.

• They had to list sound mortgages (90%) on the balance sheet as worthless during a panic.

• They would show insolvency or near insolvency on the balance sheet.

• Creditors would cut them off.

• They lost liquidity.• Stock prices crashed.

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Why the Crash?Why the Crash?

• With 90% of solid mortgages paying on time, the giants still crumbled.

• Lehman Brothers• AIG• Merrill Lynch• Bear Stearns

• With historical cost accounting, they would have ALL survived.

• We wouldn’t have had the Stock Market Crash.

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