By 2006 everyone thought Real Estate couldn’t go anywhere but up and nobody questioned the Triple A ratings that Wall Street had given these extremely high risk mortgages when they were packaged up and ‘securitized’.
Then, in early 2006, prices in America started to fall when some potential US homebuyers concluded that home prices were becoming fundamentally overvalued. As a result you had falling demand in a few bubbly cities such as San Diego and Miami.
The falling demand created relatively high levels of housing supply. This high supply/low demand triggered a modest drop in prices.
And that’s all it took. A modest drop in prices in a few bubble centres.
Had house prices actually continued to rise, many subprime mortgages could have been reset at higher rates without much damage. But when this modest drop in housing prices got going, it started a domino effect that has been catastrophic. Modestly lower prices, along with higher reset rates on the exotic mortgages resulted in a substantial wave of foreclosures.
Suddenly a bloated housing inventory started to overwhelm itself.
As the housing inventory rose, the more downward pressure was reinforced on house prices – a typical supply and demand situation.
When more and more subprime mortgages came up for reset, the reduced value of the property made renewal impossible. And a vicious, perpetuating cycle began.
And that’s all it took. And the entire system collapsed from there.
For years housing prices rose only slightly year over year. Suddenly, in the last five years, they shoot drastically higher. If you plot it on a graph you have a straight line moving upward at a slight angle and then, it curves straight upward.
I used to go on television and talk about housing prices going to fall. And people would say, “that’s not going to happen. That had never happened, certainly not since the Great Depression.” Which was true, but housing prices had never shot straight up like they had in the past five years. That had never happened either. For the first time housing prices were not supportable by rents and incomes. But everyone seems to think it is going to stay up high that it should somehow plateau there.
In many ways it’s kind of funny. Everyone now recognizes that we had lending practices that were too lax, the lack of a downpayment, too many people buying houses and credit was too cheap.
Everyone knows all these things that we did wrong which caused people who shouldn’t have been buying houses, to be able to go out and buy a house. And everyone knows that this artificially drove up the value of houses.
And everyone can agree that we need to go back to a prudent mortgage lending process.
But nobody wants to go back to prudent pricing.
Everyone wants to go back to sound lending principles but leave the bubble prices intact. But that’s impossible. Nobody can afford to pay these high prices without all these lending gimmicks.
The reality is that the best thing that can happen to the lending industry is for these high prices to come down. It used to be that the mission of Freddie/Fannie (before they went broke) was to try and make home ownership affordable. Now their mission is to keep home prices high.
And this is where the government is making a huge mistake.
This keeps homes unaffordable. It makes sure that we have to mortgage ourselves to the hilt to buy a house.
The government’s solution is high prices with low mortgage payments subsidized by the government. The free market solution is low prices. Because if real estate prices go down, you don’t need to borrow that much money to buy a house. And if they do, it doesn’t matter that interest rates go up a bit, because your payment will be lower anyway.
So now we get into the foundation of our current financial crisis. The government still looks at the problem as being one of falling real estate prices. That’s not the problem, that’s the solution.
The problem is that they went up.
Now that the housing bubble has burst and the stock market has collapsed on the backs of this real estate collapse, we are having this massive – necessary – recession which is just getting started. And it has just started, we have barely gotten a taste of it.
Unfortunately all the blame is on the free market. All the blame is on capitalism. People are running around saying “it’s because there wasn’t enough regulation, there was too much greed.” President Bush summarized it by saying “Wall Street got drunk.” And he was right, they were drunk. But so was Main Street. The whole country was drunk.
But what he doesn’t point out is… where did they get the alcohol? Why were they drunk? What was the root of the problem?
Obviously Federal Reserve Chairman Greenspan poured the alcohol, the Fed got everyone drunk and the government helped out with their moral hazards, the tax code, all their programs, the incentives, the disincentives, the way they interfered with the free market. It removed the necessary balances that would have existed, that would have kept all this from happening.
But now that it has happened, we have to deal with it.
So we are back to where we were in 2000 after the dot.com bust, only this time the recession we are facing is far more severe.
Tomorrow: The Threat of Hyper-Inflation