Five years ago, Lehman Brothers filed for bankruptcy. The collapse caused the markets to swoon and billions of dollars in taxpayer support was handed out. I remember it well because in many ways it was the final vindication of the warnings I had been giving over the previous two years, after I had left UCLA’s Anderson Forecast and started Beacon Economics. Even as we commemorate the collapse and look at the economic toll it has taken on the middle class, the housing markets, and the broader economy, I still wonder if people truly understand what happened, why the bounce in today’s market is not the beginning of more carnage, and why we haven’t truly fixed the problem.
There is little doubt that housing played a central role in the ‘Great Recession’ and continues to play a role in the slow recovery. The numbers are dramatic. According to the Case Shiller index, national prices fell by 33% from 2006 to 2011. To put this in perspective, the last time nominal home prices at the national level fell by any amount was during the Great Depression.
The collapse in prices came with unprecedented turmoil in the debt markets as well. At one point during the crisis 6.5% of all mortgages in the United States were 60 days or more behind on payment, while another 4.5% were in the process of being foreclosed on. While exact numbers are hard to come by, estimates indicate that over five million homeowners have lost their homes to foreclosure since the crisis began in earnest in 2007. Another large number of households were forced into a short sale—where the property was sold for an amount less than the outstanding debt. Slightly less than eight million households are still underwater according to a recent report issued by Core Logic.
And the construction market was similarly affected. In 2008, the pace single family home starts fell below half a million units annually—the first time that has happened since these statistics started being collected in the early 1960’s. Five years later and the pace of construction is still at rock bottom levels—600,000 units annually, slightly more than half the normal pace of activity.
But what many do not understand is how this crisis evolved. The simple answer—that excessive borrowing by households caused prices to rise sharply and then collapse again—turns out not to have been the main driver. Indeed, the housing bubble from a pricing standpoint was quite ordinary from a historical standpoint, despite the extraordinary consequences of its collapse.
It is true that nominal prices grew very rapidly between 2000 and 2006 (the price peak). According to the Case Shiller index for the nation, prices rose 90% over this span of time, far more than seen in previous bubbles. Households picked up $7 trillion in household debt over the same period of time—of which more than 80% was mortgage debt. This pushed the debt-to-income ratio for U.S. households up to record high levels.
But this number has to be kept in context. Incomes also rose by 20% over the same period of time. Even more importantly, interest rates dropped sharply. Mortgage rates fell from above 8% for a 30 year fixed rate mortgage at the start of the decade to well under 6% by 2005. The net impact of these changes was that the size of the ‘bubble’ from the standpoint of the decline in affordability was more or less on par with what happened in the last bubble period in the late 1980’s. Equivalently, the Financial Obligations Ratio (an estimate of the average share of household income used to support current financial obligations including mortgage payments, rent, auto loans etc.) peaked at less that 19%, roughly one percentage point higher than the previous peak in 1985.
This relatively ordinary bubble had such a cataclysmic impact on the economy not because of the amount of debt but because of who was receiving it.
For decades the GSEs Fannie Mae and Freddie Mac dominated the mortgage markets in the United States—acting as secondary consolidators in the market, buying mortgages from lenders, and funding those purchases through the sale of bonds. An implicit guarantee provided by the U.S. government meant that private sector mortgage providers could not compete on an equal footing with these two giants. Mortgage markets formed only for specialty products, such as jumbo mortgages for borrowers who wanted amounts above the regulatory limits on Fannie and Freddie loans, or for sub-prime products, high-risk loans given to those with credit issues.
In the 1990s, the banking system in the United States was largely deregulated. This, combined with the creation of new forms of derivative products allowed banks to expand their markets into areas formerly dominated by Fannie and Freddie. The mortgage loans banks began to make were financed by packaging loans up into bundles and selling them off to investors as bonds whose returns were based on the mortgage payments of the borrowers. The supposed safety of these packaged securities was such that the banks could compete with Fannie and Freddie by offering higher risk mortgage products to the market—serving parts of the market that normally would be shut out of Fannie and Freddie’s traditional set of products. These bonds offered better returns to investors that those of the GSE’s and, at least according to the major rating agencies, carried little risk for the upper tranches.
The demand for these supposedly high quality, high return bonds was very strong—so strong that the firms creating them began to stop caring about the risk of the mortgages being bundled. There was an almost complete collapse in credit standards at the origination end. Negative amortization loans, pick-a-pay loans, no-document loans, and loans with LTVs of 100% or higher began rolling out as never before. This process culminated with the creation of the so-called NINJA loans—products to those folks with ‘No Income, No Job or Assets’. It wasn’t just purchase loans—many new mortgages were taken out on rapidly growing equity. By Beacon Economics estimates, at the peak, close to $100 billion in equity was being extracted from the housing market at the peak in 2005.
For the first time, Fannie and Freddie saw their market share start to shrink rapidly. They responded by also reducing their standards. Combined with prices that were rising rapidly—particularly in Arizona, Nevada, California and Florida—the risks in the system began to build quickly. But it was not the quantity of credit that was the issue, it was that the loans themselves were very risky both in terms of their structure as well as the lack of accountability by the borrower.
But little was done—largely because the U.S. Congress was pleased with the resultant increase in home ownership rates. Regulators were unwilling to take the political heat for trying to stop the process—and largely sat back. And for a while it didn’t matter. As long as prices continued to rise, even the riskiest borrowers could simply refinance their way out of financial difficulty. The risks, while there, were not being realized in terms of losses.
In 2006, prices had reached record high levels and finally stopped rising. Sales then stalled and for the first time inventories started to grow. These are all signs that a bubble has reached its apex. The inability of many risky borrowers to refinance their way out of trouble quickly turned into foreclosures. It was an odd time—increases in foreclosure activity typically lag increases in unemployment. This time foreclosures began to rise way before any sign of a national recession came to the forefront.
By 2008 the scope of the problem started to become apparent to regulators and the rest of the story is now well known history. The losses from bad mortgages began to mount. And these losses quickly became destabilizing to the entire. system Bear Stearns went down, Merrill Lynch followed, and then in September of 2008 Lehman Brothers collapsed into bankruptcy. Eventually the U.S. government was forced to put $800 billion into TARP—and ended up bailing out Fannie, Freddie and AIG.
As for the housing market, the massive wave of foreclosures created by all the bad loans caused a huge dip in prices. Adding to the problem was an excess supply of single-family homes built during the bubble in response to demand driven by the uptick in ownership rates. In a very real way the market overshot on the way down as much if not more than on the way up.
The point of this history lesson is twofold. First and foremost it is to show that the severity of the last real estate crash was truly unique in the post World War II era. It was driven by the collapse in credit standards in the mortgage market and by the fact that regulators simply ignored what was going on. Today the pendulum has swung too far in the opposite direction with new rules and regulations and an entire new Federal bureaucracy—the Consumer Financial Protection Board—designed to prevent this kind of crisis from occurring again. It will be decades before a similar cycle could possibly take place—if it ever does again. The second lesson is that while the real estate markets seem hot today—they really are still just at the beginning of their recovery.
But that doesn’t mean we are completely out of the woods. Some basic Wall Street reforms that should be in place have more or less stalled in place. Even rules proposed by Dodd Frank are either being undermined with exceptions, or may never make it into the final rulebook. And of course for all the proposed rules being put into place, one major issue has never been addressed. For all the seriously adverse things key players committed during this whole debacle—think high level management at some of the failed investment banks, mortgage lenders, and sub-prime brokerages—they walked away rich.
Ultimately the lesson is that financial crimes, if committed under enough legal protection—do pay and they pay well. That lesson is one that is almost certain to invite abuses elsewhere in the system.