Eric Harrington – The Real Cause of the Housing Bubble …
The Housing Bubble is Not Your Fault..
I have recently seen the “Conservatives” — those free-market believers who rabidly supported the Republican ticket for 7 years – abandon the sinking Republican ship of thieves and begin to go back to their Libertarian roots — asserting the infinite wisdom of the market and placing the blame for the Housing bubble directly on the shoulders of…yup…you guessed it… WE the consumer. They insist that it’s OUR lack of fiscal discipline that caused the bubble, buying houses we couldn’t afford, and there is certainly some truth in the fact that many Americans have a penchant for living above their means.
But the true story is much more insidious than that. I am personally faced with being “upside down” in a property and so I have begun to research the cause of this collapse to make sure I don’t fall for it again. But first, I want to discuss an earlier “bubble” that was very educational.
The dot com bubble created and erased trillions of dollars in wealth in just a few short years and left the world dramatically changed in its wake. Huge telecom infrastructure upgrades created with the boom investments, were sold for pennies on the dollar after the crash and so drastically reduced telecommunications costs in the market that it opened the door for outsourcing the many portions of the American service industry.
But the more important lesson is why the bubble occurred. New technologies like the Dot com industry have happened before without such frantic market fluctuations. The key to this bubble, and I suspect, all bubbles, is that were started with a dramtic change the rules of business.
Prior to the Dot Com Boom, Venture Capital firms had firm rules for investing. There were certainly grades of risk, but some basic rules were inviolate. One was, you never invest in a business that cannot clearly show how they will generate revenues. This may seem obvious, as what is the point of funding a business that is not sure how they will make money, but that is exactly what happened in the Dot Com Bubble. Venture capital firms viewed the internet as a huge virgin market, like opening a mall on the moon, and they perceived that controlling segments of that market would be valuable even if the process of actually making profit was not clear.
So while this strategy worked in limited instances, it opened the door for a bubble. As George Soros suggests in his amazing book “The Crisis of Global Capitalism”, bubbles are produced by a feedback loop of public perception driving the value of companies. This is complicated, but simply put the value of stocks like Google– with no clear path of revenue potential– were perceived as valuable because their values were high, not the other way around. Their value was driven not by the fundamentals of the company or the business model, but by emotions and speculation. Now, one can try to blame this market frenzy of the unsophisticated investor in these “Vapor Value” stocks as the cause of the bubble, but it really stems back to the basic flaw in the concept of the free market.
Restated, the real cause of the Dot Com bubble was that the big investors — they guys who have the money to SEED these new radically speculative businesses — changed the rules of investment. They did it with the understanding that they would be able to get their money out before the revenue potential was tested, and before the company they invested in ultimately was successful or failed. I suspect they also understood that a huge new group of less spohisticated investors using the internet stock trading sites could be emotionally inspired by this new internet world, and would come in at the later stages, and so the VC’s effectively became “middle men” investing the start-up money early, but selling during the speculative frenzy and well before the real wake-up call of actually needing to make profit came knocking. You also had these middle-men creating new rules for investments without really sharing in the repercussions.. Then on top of it the investment banks (again) hyped these vapor companies to the hilt, knowing that they would also get out before the business model was really challenged.
Hundreds of Venture Capitalists and early stage investors made huge fortunes this way before the bubble popped, and much like the typical pyramid scheme it was, all those who got in late lost big. But the real cause was the divergence from time tested rules of investment, counting on the emotions and greed of a whole new breed of inexperienced investors, who had no understanding of corporate financials, and bought stock purely with their emotions and a perception of value (as opposed to tangible financial data or experience) to float it until they got out. It was a classic pyramid scheme.
The recent and devastating U.S. housing bubble shares this trigger of changed rules. The first link in the chain reaction was the relatively new process of chopping up mortgages and including them in larger securities which could be sold to foreign investors as low risk investments because they were secured by real property instead of the traditionally more volatile value of a corporate stock. As more foreign investors were attracted by the investment banks (ala Bear Sterns) promise of low-risk high-yield securities, the demand for Mortgage based securities increased dramatically. They were high-yield only because the U.S. had already started into it’s own much smaller housing bubble, a product of the dot com crash in 2000 that ultimately drove many investors into the relative safety of real estate and mortgages. But this was just a normal cyclic fluctuation and would have never escalated to dangerous levels we see today.
This influx of investment in mortgages could only be fueled with more actual home loans, and while the housing market was brisk and appreciating, the basic fundamental rules or mortgage lending, namely that an borrower needed to put at least 10%, preferably 20% of their own money down, prevented highly speculative purchases by the less solvent.
So here is where the bubble was created. The Mortgage Banks saw a huge opportunity. They could relax the lending rules to attract millions of new housing purchases for people who could never buy previously, and do so without actually any exposure to the risk, because the banks could immediately sell the mortgages to the investment banks to be bundled and sold to offshore money. It was a perfect scam. And relax the rules they did. First it was no-doc loans, where a new loan applicant didn’t have to actually prove they could afford the payments through income verification, but instead only claim they could and have a good credit score. And even the personal claim of worthiness later became null and void as many unscrupulous mortgage brokers even began to write applications with bogus income claims sometimes without even telling the borrower. When I refinanced my second mortgage, my broker literally told me “don’t worry; I’ll put down whatever it takes to make it fly.” Admittedly, he and I knew I could afford it and I supplied my tax returns to prove it, but many thousands of people were kidding themselves and the absence of mandatory income verification made such misrepresentations very tempting. Housing purchases boomed as people with moderate incomes used what little cash they had, or growing equities in existing properties to buy new houses or remodels they could never afford long-term with the hopes of flipping them for an early retirement.
The last great barrier to virtually anyone buying a home was the down payment. 20% down is a huge barrier to entry in the housing market, albeit (as we shall later show) a necessary one. So to attract MORE new customers, the mortgage banks in their infinite wisdom and greed, created a process where a second mortgage would actually pay the down payment on the first. A very weak position for the second place lender, but of course, all those seconds were also immediately bundled up and sold to investors who were told they were still low-risk investments. You see another culprit in this ponzi scheme was the bond rating agencies, who didn’t tell the investors that the mortgages they were buying, were actually being created under entirely different rules than what the risk rating history reflected. There are on-going investigations of payoffs in this regard, and I wouldn’t be surprised a bit. At a minimum, the rating agencies failed miserably in their responsibilities and apparently must also be more carefully monitored by the government going forward.. So much for the wisdom of the free market..
So the next wave of no-doc and no-money down loans (part of the group of loans often referred to as sub-prime loans) hit, and that opened the flood gates for it allowed anyone who had simply paid their credit card bills on time to buy a house well above their means..
Now I know the conservative propagandists will chime in at this point and say that “no one held a gun to those peoples heads to take that loan they knew they couldn’t afford!” But that completely ignores the real reason why the majority of those people bought in, and the true genius of this ponzi scheme. They didn’t buy the house to buy it, i.e. actually pay it off or live there for many years. They saw people everywhere making huge gains as the housing values skyrocketed in the bubble and they bought these houses they couldn’t afford with the express interest of selling them in just a few years or “flipping” them, with windfall profits. Admittedly, it is highly risky for someone to put down 20% or hundreds of thousands in cash on a house they cannot afford to sustain the payments on, in the interest of hopefully getting a big gain if and when it sells. That being said, thousands did just that and they were indeed foolish. But they did not create this bubble– they could have only created a crash of the magnitude of the early 90’s California crash, i.e. a correction— but not a catastrophe. NO, it was the new no-down and no income verification (no-doc) loans that allowed anyone to speculatively buy the house with NO significant financial risk (except potential damage to their credit score) that was the real cause of this fiasco. And again, the Mortgage Banks who created these new rules had effectively eliminated their risk as well by selling off the loans to misled off-shore investors. Based on the very principles of the free market, no one can be blamed for buying a house with virtually no financial risk, but potential windfall gains. It’s almost foolish not to.
The basic fallacy of the conservative free market philosophy is the concept that the market will regulate itself in situations like this because there is no reason anyone should expect a mortgage bank or a first time home buyer to have the financial foresight or experience to understand the ultimate impact of what they are doing on the economy. Investors and Banks are looking for short term gains, within the law, and as long as the people creating the rules can do so without sharing the risk, the free market fails, and it fails miserably. Only government regulation can preserve the conditions whereby the free market actually works. The term Free Market is really somewhat of an oxymoron that is apparently beyond the depth of the most sophisticated Conservative pundit. There have to be rules to financial transactions, i.e. it cannot be free, and those rules absolutely cannot be set by entities with profit incentive but no risk, and that is precisely what happened in the Housing and the Dot Com bubbles.
So if you are facing loosing your house or your retirement to this most recent bubble, find some solace in the fact that it wasn’t your fault. You did what true free market theory would expect you to do…