by Patrice Hill
This year’s housing bust is shaping up to be one of historic proportions. Sales and construction have sunk to levels not seen since the 1990 savings and loan crisis, while foreclosures and price drops are the largest since the Great Depression — and expected to get worse next year.
Many parallels can be seen with earlier housing debacles. Each episode had some combination of easy money, loose lending, greed and fraud that turned a housing boom into a speculative bubble. But few housing bubbles have ended so badly as the one today, when the nation is confronting the prospect of mass foreclosures and family dislocations.
John Stumpf, president of Wells Fargo & Co., the second-largest U.S. mortgage lender and a survivor of the housing busts of the 20th century, blames today’s crisis on unscrupulous lending practices, which joined in a toxic mix with outright greed and extraordinarily low interest rates to send house prices soaring 90 percent between 2000 and 2006. When the bubble burst, house prices collapsed by 5 percent to 20 percent in cities nationwide.
“We have not seen a nationwide decline in housing like this since the Great Depression,” Mr. Stumpf told investors in New York last month as major banks and securities firms reported an accumulated $80 billion of losses on their portfolios of mortgage investments and widely cut back on lending as a result.
Now the country faces a vicious cycle: As house prices fall, homeowners lose equity in their homes, which makes it more difficult or impossible for them to sell or refinance. Many are not able to refinance their adjustable-rate loans when the starter interest rates expire and reset to reflect higher market rates, and so they are faced with sharply higher mortgage payments they cannot afford to pay.
The dilemma has sent defaults and foreclosures to historic levels — with potentially millions more in train in the next two years as more than $1 trillion in mortgages reset nationwide. As homes are sold under pressure, prices drop further and cast a pall over entire neighborhoods, driving down the value of homes of even creditworthy Americans and undermining their biggest source of wealth and security.
State and local governments also have been hit hard by the declining revenues from property taxes and real-estate transactions, and the housing slump is dragging down the manufacturing and construction sectors. The whole mess threatens to sink the broader economy the longer it wreaks havoc on consumer confidence and spending power.
While Americans have grappled with ballooning mortgages and adjustable interest rates in the past, the epidemic of resetting loans today is unprecedented and is the result of a bewildering array of mortgage options for consumers that banks and securities firms developed and mass marketed for the first time this decade.
Consumers often were given the option of not paying principal on their loans and even deferring some interest. Many seemed unaware of the consequences of postponing their obligations and chose to make only minimal payments during the first few months or years, backloading their loans so that the payments increased sharply and even doubled after the interest rates reset.
The complexity of the loans was exceeded only by the complicated schemes banks developed to package the loans and market them to sophisticated investors, which involved setting up off-balance-sheet investment vehicles and slicing mortgage securities into segments that supposedly allocated the risk of default away from top-rated tiers to junk-rated bottom tiers. Mr. Stumpf, a 30-year industry veteran, said even he was surprised when he read newspaper articles about what some banks were doing.
Wells Fargo avoided the riskiest practices and, as a result, is not suffering the major losses that are crippling top lenders such as Countrywide and Citigroup, though it, too, made some unwise investments in home-equity loans, Mr. Stumpf said.
“It’s interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine,” he joked.
While the unprecedented wave of creative and sometimes questionable loans was a key cause of the housing bubble and ensuing bust, lenders were aided greatly by the lenient policies set by the Federal Reserve from 2000 to 2004, economists say.
The housing boom started in the wake of the technology-stock bubble that burst in 2000, which ushered in the 2001 recession and prompted the Fed to dramatically cut interest rates.
Housing was just beginning to emerge from a long slumber in the 1990s, as it took much of the decade to recover slowly from the preceding housing bust of 1990-91. As the economy slumped and financial markets sank in the wake of the September 11, 2001, terrorist attacks, the Fed accelerated its rate cuts, adding fuel to the budding housing boom.
By mid-2003, the Fed had driven interest rates to the lowest in a generation, with rates on 30-year fixed-rate loans falling to a 40-year low, around 5 percent. The even lower short-term rates set by the Fed drastically cut rates on adjustable-rate mortgages as well as borrowing costs for banks and Wall Street firms, enabling them to invent an array of new mortgage products with irresistibly low starter rates, which appealed to home buyers.
While the Fed’s actions under former Chairman Alan Greenspan were applauded at the time, many economists now blame the central bank for nurturing the housing bubble.
“The Fed played an important role” by encouraging people to shift resources to real estate speculation, said Michael D. Larson, analyst with Weiss Research. “The Fed replaced one bubble, mostly confined to the technology sector, with another, far-larger bubble, encompassing most of the housing market.”
Mr. Greenspan forcefully rejects such accusations. He contends the housing bubble and credit bubble that accompanied it were worldwide phenomena. Moreover, he maintains the only way the Fed could have stopped the bubble was to have raised interest rates sharply, which would have not only deflated the bubble, but brought down the economy with it.
Mr. Larson also blames global investors — including many international banks and hedge funds — for misjudging the risks of the securities. And Wall Street firms, by setting minimal standards on the loans and then securitizing them for sale to distant investors, also “removed, minimized and postponed the consequences of poor lending decisions,” he said.
Global investors were thirsty for the high returns on subprime and exotic mortgages that were packaged as “collateralized debt obligations,” and they trusted the high ratings assigned to most of the debt by Wall Street ratings agencies Moody’s Investors Service and Standard & Poor’s Corp.
The global market “stressed quantity over quality” on loans, making it “easier and more profitable” for mortgage brokers and banks to convince consumers to take inappropriate loans, Mr. Larson said.
With their low introductory monthly payments and easy terms, the loans were easy to sell to the public. In many ways, mortgage brokers followed the playbook of auto dealers, who swamped their showrooms with people on car-buying binges in 2002 and 2003 by advertising zero-interest loans on their cars.
As they did with the car loans, many borrowers who acquired subprime and exotic mortgages with low starter rates rarely looked at the loan’s overall costs or terms other than the initial monthly payments that were loudly trumpeted in ads and brochures.
Loans with introductory rates as low as 1 percent made the obligations of owning expensive houses appear to be easy or manageable and had the effect of driving up home prices as buyers armed with such loans surged into the market and bid up prices.
Home sellers found they were able to raise prices by thousands of dollars from one sale to the next with seemingly no resistance. Even the highest-priced homes at the height of the boom in 2005 and 2006 sold quickly, sometimes within minutes with multiple bids.
The new-found wealth for homeowners was just as intoxicating as the easy-money loans that transformed millions of former renters, even those with shaky credit ratings, into proud homeowners. Consumers didn’t need to sell their homes to cash in on the double-digit gains in their home values; they used home-equity loans and cash-out refinancings instead.
Many people used their homes like ATMs, refinancing once or twice a year to take out equity and using the cash to buy cars, go on vacations and make down payments on second homes or investment properties. By 2005, nearly every homeowner in America had refinanced at least once.
The cash-outs, which typically extracted $20,000 to $30,000 from home equity, were an elixir for both consumers and the economy, enabling homeowners to supplement stagnant incomes while stimulating consumer spending, the biggest source of economic growth.
Loans came not only with minimal payments but often required no down payments or income documentation, enticing millions of people to jump into the market for second homes and investment properties. Coastal resorts and Sun Belt cities like Miami and Las Vegas became lucrative profit centers for “flippers” who weren’t interested in owning properties but only wanted to make quick profits buying and selling them.
Cable television offered 24-hour housing channels and TV shows demonstrating how anyone could become a “flipper,” putting down as little as $5,000 on a condominium and then reselling at a profit before construction was even finished.