Prices on homes in America fell dramatically starting in late 2006, after an unprecedented run up in prices over the previous eight years. The fallout from this drop was felt around the world in the worst economic recession since the Great Depression. Its impact seems to have a long “tail.” For example, global jobless rates remain high five years later. How can the price of a home in Topeka, Kansas, affect jobs and governments half a world away? What factors came together to cause this to happen? And what can we learn from it? How can we reflect on this as Christians? This is the story we will try to unpack. It is a story of multiple, seemingly unrelated strands which came together as a perfect storm.
In the early 1990s, the world was just emerging from a modest recession and a long run of “good times” began. The Internet was new and it was the beginning of the “dot com” boom. Many nations of the world moved forward economically. In 1995, the U.S. revised its Community Reinvestment Act, adding fuel to policies that encourage home ownership for all (a practice deeply rooted in government leadership from both political parties). Demand for housing increased and prices started to rise. The half-century trend of one percent annual home price escalation jumped to seven percent in 1998, a pace that continued until 2006. But the Community Reinvestment Act was only one trigger for this period of growth.
In 1999, the Glass-Steagall Act was repealed. Enacted after the Great Depression, it had separated the roles of commercial banks and investment banks; its repeal now allowed any bank to get into the investment business. Some argue this had a minor role in the investment crisis, as provisions of the Act had been eroded steadily since the 1980s; but the timing of this repeal makes it appear as at least one factor in the change of banking behavior.
The collapse of the tech bubble in 2000 was another key event. Leading up to that time, any company with “dot com” in its name could attract huge investment. But investors finally began to realize that even “dot com” did not change the rules of business. Companies still needed a viable product and still had to make money to survive, and many companies were exposed as shams. The tech market (NASDAQ) dropped from 5,000 in early 2000 to almost 1,000 a couple of years later in what was often referred to as the “dot bomb.”
This seemingly unrelated event connected to the housing boom in an interesting way. Investors seeking better growth in their portfolios responded to the “innovation of the market” in the form of investment products built on home mortgages. With the run up of housing prices, investors could move their money to a new kind of investment vehicle based on home values, including the collateralized debt obligation (CDO).
The first CDOs were created in 1987. A number of mortgages were put together in a package and sliced up so each CDO contained a small piece of many mortgages, reducing the risk of owning one particular mortgage. The value of the investment is represented by the risk of default on the mortgages and the potential increase in value of the homes represented in the package. Not much happened with this market for several years until a spike began in 2000 and continued into 2007. In the U.S., a partial factor may have been the repeal of Glass-Steagall. More broadly, these mortgage derivatives looked like the new best opportunity for investment growth after the collapse of the NASDAQ. These packages were purchased by banks all over the world, by pension funds, and other financial institutions. The widespread purchase of these investment vehicles by banks and pension funds is what connected home prices in America to financial holdings in Zurich.
As this market grew, there were not enough mortgages being sold to satisfy the demand for the investment vehicles, and this resulted in two things. A new kind of mortgage broker emerged, loaning money for mortgages without keeping the loan on its books. After making the loan, it sold the mortgage to a broker who bundled it with other loans to create packages of securitized mortgages. The payment for these mortgages could then be loaned to the next group. Not to be outdone, traditional banks started selling their loans as well. Those selling mortgages were paid on commission, and were not really “bankers.” Instead of serving the public as a trustworthy financial intermediary, their motivation was to make money by increasing the number of mortgages sold.
Other factors fueled the growth of the sale of mortgages. Interest rates were at an all time low during this period, making a mortgage more attractive. Low interest rates also closed out traditional savings options as a way to grow retirement funds.
To meet the investment demand for more mortgages, new types of loans were created to attract more “home buyers” who may not have qualified for a loan under the old arrangements. ARMs (adjustable rate mortgages) became one of these instruments, allowing very low interest rates at the beginning (sometimes as low as 3%) with the stipulation they would rise to something higher (say 10%) in five years. They even came with no initial payment, since the lender knew this would attract more buyers and they would minimize their risk by selling the loan anyway. Since the buyers believed they could re-sell at a profit before that time, they thought they were limiting their risk as well. And if the buyer actually lived in the home, then they thought they could simply refinance before the higher rate kicked in. More and more people entered the home market because of these favorable terms. But still there was a demand for more mortgages.
Fewer and fewer borrower qualifications were checked, since the market became obsessed with the growth of sales. Some loans required interest-only payments, with nothing paid toward principal over the first few years. Some reduced even this, resulting in growth of the principal. Loans were made with no paperwork, merely the borrowers’ verbal assurance of his or her earnings. Not surprisingly, these became known as “liars loans,” and “subprime” loans were made to buyers who would otherwise not have been considered qualified.
Assessors, supported by lending institutions, were encouraged to raise the valuation of homes, allowing larger and larger mortgages. Contractors were motivated to build more and more homes since the demand seemed insatiable. Rating agencies placed AAA ratings on CDOs made up of pieces of bad mortgages.
Abuses also abounded on the buyer side. Speculators in New York purchased condos in Florida sight unseen, multiples at one time, with the intent of “flipping” them to make money. Poor people bought homes they could not afford (one migrant worker earning $20,000 per year bought a home valued at $1.8 million, according to Michael Lewis in The Big Short).
Not surprisingly, this practice was unsustainable. As things began to crash, innocent and many not-so-innocent people got hurt. Home prices went into sharp decline in 2007, and the packages sold around the world started to fail. Highly-leveraged banks and pension funds that owned them began to crumble. Owners who were stuck with multiple houses and condos were defaulting. Adjustable rate mortgages moved up and people could neither refinance nor sell their homes. When the market stopped buying the mortgage packages, many lenders were stuck with unreasonable and uncollectable mortgages on their books. The resulting lack of available capital and the losses for banks forced businesses to lay off workers or close altogether. Those who had bet that prices would always rise were caught and punished by the market. Home builders, mortgage brokers, and banks went out of business. Washington Mutual became the largest bank failure in U.S. history, having built its strategy on vastly increasing its position in subprime loans; the Federal Depositors Insurance Corporation filed suit (and lost) against its top officers for reckless leadership. Other long-standing investment firms like Merrill Lynch and Lehman Brothers were bought for pennies on the dollar with the government’s help. Meanwhile, unemployment on Main Street peaked at 10.2% in the U.S. with similar numbers in many parts of the world.
Assessing the risk of a total financial collapse, many world governments insured bank deposits, leading to deep government debt. The U.S. government put money into automakers, banks, and other institutions to keep them viable, fearing a much broader collapse.
Innocent parties were also hurt. Banks that never entered the subprime business and held the mortgages they made found that many people owning homes could no longer make payments when owners lost their jobs. Unable to sell the homes which had dropped in value below the amount of the loan, owners walked away and left the bank holding a mortgage for more than the asset was worth. Those who were duped into buying something more expensive than they could afford lost whatever they had put into the mortgage and were forced out of their homes.
Some not-so-innocent parties prospered in this mess. Investment banks which had bought and sold toxic packages of bad mortgages sometimes bet against them as well, hedging their own liability while simultaneously promoting the value of the assets. And in the wake of the crisis, new exploiters emerged. Agents purporting to help those in need sometimes merely took money with the promise of helping cash-strapped households get out of debt, but did nothing. As in other crises, some stepped in to help, and some stepped in to exploit.
In the aftermath of these events, governments acting to help were punished at the polls. The government of Ireland was toppled early in 2011; Democrats lost their majority in the U.S. Congress; many states in the U.S. are deeply in debt; Greece, Portugal, and other countries need varying degrees of rescue from financial collapse. The crisis has gone deep and wide.
Part 2 - "Who is to blame?"
Al Erisman is Executive in Residence at Seattle Pacific University.