The mortgage crisis—or housing crisis, as it is often referred to—formally began in 2006. After home prices reached an all time high, they began to steadily decrease. By 2008, the housing market was in the midst of a veritable panic as a record number of Americans defaulted on their loans and foreclosure signs became ubiquitous across America.
But how did we get to this point? What were the causes of such a huge market failure? How do we move forward?
To understand the factors that led to this problem, it is first necessary to understand the history of American home ownership and the role it played it shaping the fabric of this country.
- The American Home
- Housing and Urban Development and the Federal Housing Administration
- Fannie Mae and Freddie Mac
- And the Wall Came a’ Tumblin’ Down: Subprime Mortgages, Inflated Home Values and the Burst Housing Bubble
- The Stagnant Lending Market and Obama’s Homebuyer Tax Credit
The American Home
The romanticized ideal of owning one’s own land—and home—has been a part of the collective American ethos since the nation’s inception. For many immigrants, one of the major draws of America was the hope of home ownership.
In 1862, President Abraham Lincoln signed into law the Homestead Act. The legislation granted settlers up to 160 acres of land on the western frontier. Correspondingly, millions of Irish, Italian and Slavic immigrants flocked to the United States, lured by the prospect of owning land.
The phenomena of westward expansion became so prominent that historian Frederick Jackson Turner hypothesized, in 1893, that the idea of moving west—owning your own land, working the soil, building a house—was the lifeblood of the American dream.
Politicians would declaim that what made America America was homeownership. It was, they said, what distinguished America from medieval feudal societies. Home ownership virtually became an American religion; buying a first home became a ritual part of Americanism.
In the 20th century homeownership drove the agendas of many politicians. The 20th century gave rise to many government policies that sought to make home ownership an obtainable goal for all Americans. The federal government’s role is evident in the creation of the Federal Housing Administration, the Department of Housing and Urban Development, and Fannie Mae and Freddie Mac. President Obama’s tax credit for first-time home buyers is further evidence that the country remains wedded to a policy of home ownership. The single biggest federal tax break is the home mortgage deduction.
Housing and Urban Development and the Federal Housing Administration
President Franklin D. Roosevelt helped to establish the Federal Housing Administration (FHA) in 1934. The FHA functions as a mortgage insurance provider—not a mortgage provider—and helps low-income families and first time home buyers finance their mortgages.
At the time of its creation the housing market was stagnant. Two million construction workers were unemployed and banks required loans to be repaid in full in just 3-5 years—a staggeringly short time frame when compared with today’s 20-30 year mortgages. Just 4 in 10 Americans owned their own home.
By providing insurance on mortgages—meaning that the FHA agreed to repay banks if the borrower defaulted—the FHA gave banks the confidence to begin loaning money again. Low-income families now discovered they could obtain mortgages that banks previously would have denied them.
Still, the FHA did not insure every loan; the agency established specific criteria borrowers were required to meet before they were eligible for an FHA approved loan.
In the 1940’s the FHA helped veterans returning from Europe and the Pacific purchase their own homes. In the decades that followed it provided insurance on loans for the elderly, the handicapped, and low-income families.
In 1965, the Department of Housing and Urban Development (HUD)—which had been established independently in 1937—was given cabinet status.. The move included a merger with the FHA; more specifically, the FHA became a sub-department of HUD.
The mission statement of HUD calls for making housing affordable and obtainable for all Americans.
By the turn of the millennium roughly 2 out of 3 Americans owned their own home. Since its inception the FHA has insured 34 million mortgages.
Fannie Mae and Freddie Mac
In 1938, Congress established the Federal National Mortgage Association, most commonly referred to by the moniker, Fannie Mae. Like the FHA, Fannie Mae was established under President Roosevelt as part of the New Deal.
When Fannie Mae was first instituted it functioned primarily as a mortgage finance lender—it provided federal dollars to private banks so that they could finance more home mortgages at lower interest rates. The idea was to get more families in their own homes at a time when the mortgage market was slow.
However, changing times and changing markets transformed the primary function of the mortgage giant. In the 40s, 50s and 60s, Fannie Mae all but created what is now referred to as the secondary mortgage market. Because Fannie Mae was essentially a government enterprise, it was able to borrow money at extremely low interest rates. It began using this line of credit to purchase already existing mortgages from banks. Buyers could then refinance their mortgages at lower interest rates.
In 1968, at the behest of President Lyndon Johnson, Congress privatized Fannie Mae. However, this was mainly an accounting ploy intended to remove Fannie Mae’s expenses from the federal budget. While the company was technically “privatized” and its shares were indexed on the New York stock exchange, it retained many of the benefits it was accustomed to as a part of the federal government. For instance, the newly classified Government Sponsored Enterprise (GSE) was exempt from paying taxes and remained outside of the watchful eye of the SEC (Securities Exchange Commission), which all other private traders are accountable to.
In 1970, the federal government chartered the Federal Home Mortgage Corporation, Freddie Mac, in an effort to break Fannie Mae’s death-grip monopoly over the secondary mortgage market. Freddie Mac was structured using Fannie Mae as a template; it receives all of the same federal benefits and immunities.
As pseudo-private companies, Fannie Mae and Freddie Mac experienced unprecedented growth rates in the years that followed. They looked for new ways to expand and further stimulate the housing market
The solution was to “securitize” mortgages. It’s a simple concept. Fannie and Freddie already owned millions of mortgages. Securitizing them meant simply bundling them in packages for sale to investors. The bundles featured mortgages that shared similar qualities (value, risk rating). The bundles proved attractive to investors who were told they could count on the interest from the mortgage payments for a fairly predictable income stream. Fannie and Freddie used the investors’ money to buy more mortgages in what was believed to be a so-called virtuous circle. Currently, the twin mortgage giants owe nearly $4 trillion dollars (that’s right, trillion) in obligations to their investors.
But it wasn’t just Freddie and Fannie who practiced this business model. It became the strategy of many foreign banks and domestic investment bankers.
On September 8, 2008, when the housing crisis began spinning out of control, the federal government reabsorbed the twin mortgage giants. As of July 2010, the federal government had already spent nearly $150 billion stabilizing them with government loans. The Congressional Budget Office (CBO) projects that the number could reach $389 billion before this is all over. And, since the government has reabsorbed the two companies, it also now holds the $4 trillion dollars in obligations to investors. And while the government now owns a massive portfolio of mortgages, the rate at which mortgagees repay or default upon these loans will ultimately establish how much of those obligations the American taxpayer is stuck with.
And the Wall Came a’ Tumblin’ Down: Subprime Mortgages, Inflated Home Values and the Burst Housing Bubble
The stage had thus been set.Americans had a three-century long love affair with owning their own land and own homes. The federal government had made it a recurring thematic priority to encourage homeownership. Then the system crashed.
Here’s how it happened.
NYU Economics Professor Robert Wright explains the commonalities between virtually all economic downturns: "All major panics follow the same basic outline: asset bubble, massive leverage (borrowing to buy the rising asset), bursting bubble (asset price declines rapidly), defaults on loans, asymmetric information and uncertainty, reduced lending, declining economic activity, unemployment, more defaults.” The housing crisis is no exception; in fact, this is exactly what happened.
Let’s start with the “asset bubble.” When economists use the term asset bubble they’re talking about a rapid expansion in the price of an asset—in this case, home prices. During the ‘90s and particularly in the new millennium, the average price of an American home skyrocketed. Of course, the intrinsic value of a home was not increasing, just its market price. The reasons for this are complex, but in short a booming economy and bull financial markets made real estate worth more.
Then came the “massive leveraging,” or borrowing of money to finance home purchases.
Because of inflating home prices real estate became a very popular investment. Everybody who could afford to take on a mortgage—and many who couldn’t—rushed to their local banks and lending institutions to get financed. After all, a home has always been one of the safest and most fulfilling investments an individual can make. Banks started granting loans at an unprecedented rate. They even began lowering their lending standards—granting subprime loans. Some lending institutions, out to make a buck at any cost, handed out mortgages like candy even when they knew the borrowers lacked the ability to keep up with the payments. Many borrowers were given loans with no money down. Conservatives charged that liberals in Congress pressured Fannie Mae and Freddie Mac to increase lending to the poor, though liberals disparaged the claim that loans to the poor contributed substantially the crisis.
A subprime loan is a loan granted to a mortgagee who is considered “subprime.” Banks set standards which loan applicants must typically meet—credit scores, level of income, records of steady employment. If an applicant meets all the requirements, they are a “prime” candidate for a loan. If the applicant doesn’t meet the requirements, they are a “subprime” candidate. Because home values were increasing so rapidly, banks were able to justify granting subprime loans. If a mortgagee should default on the loan, the banks fiogured, the home would resell at a higher price than purchased for, covering any potential losses.
In addition, the local banks which were granting the loans weren’t planning on holding on to the mortgage rights for very long—they were in the business of selling their mortgages to big banks and to Fannie Mae and Freddie Mac.
Fannie and Freddie, you’ll remember, were now in the business of bundling mortgages in groups and selling them to investors. The problem was, many of the mortgages in these investment portfolios were subprime mortgages; this was somrthing most investors never realized. Instead, they simply trusted the professionals handling their money and trusted the names of Fannie and Freddie who were, after all, basically arms of the federal government.
All of this would not have been problematic if it weren’t for one tiny problem: inflation of home values, the basis for all of the speculation and investment, was unsustainable. Eventually, the asset bubble burst.
As soon as the housing market recognized the gross overvaluing of housing prices, the market immediately began to move back towards equilibrium, like a balloon letting the air out. House values began dropping almost as quickly as they had risen, creating nightmares for homeowners across the country.
As other segments of the economy experienced shrinkage simultaneously, an unprecedented number of Americans defaulted on their loans. High unemployment and a failing stock market meant many people just couldn’t make their mortgage payments.
The numbers are staggering: since 2008 almost 60 million American homes have declined in value. In the calendar year 2010, more than 3 million households will experience foreclosure. Perhaps the scariest statistic is that almost 11 million Americans are “underwater” on their mortgages—this means that they owe more on their mortgage than their home is currently worth.
The twin mortgage giants, the FHA, and other large corporate banks are now stuck with millions of subprime mortgages in their portfolios. And as people default on these mortgages, the banks are liable for the losses—and indirectly, their shareholders are liable.
Compounding the problem are the hundreds of thousands of mortgagees who are “strategically defaulting” on their mortgages. In other words, some people could actually make their mortgage payments, but it’s in their best interest not to do so. For example, for the millions of Americans who are “underwater” on their mortgages, paying the remaining balance on their loan could prove harmful if over time the price of their home doesn’t rise enough to cover the money they laid out in payments. Fearful of this outcome, many people are simply walking away from their homes. This entails declaring bankruptcy, harming their credit score. But many calculate that they’ll come out ahead.
According to the New York Times, 588,000 Americans strategically defaulted on their loans in 2008 alone, leaving banks with undervalued homes and no income stream to repay investors. If everybody whose house is under water followed this example the economy would decline dramatically. While many find the practice of walking away from a debt you are in a position to pay ethically dubious, others point to large real estate corporations that are taking the same approach. In January 2010 Tishman Speyer Properties abandoned ownership of a large apartment building complex in New York City featuring more than 11,000 units. The decision, based purely on the company’s business bottom line, drew scorn from liberals.
The Stagnant Lending Market and Obama’s Homebuyer Tax Credit
The ancillary effects of the subprime mortgage crisis and foreclosures are many and far-reaching. The most direct however has been a credit freeze—and this has been one of the reasons the recovery from the recession has been so difficult.
Because banks are dealing with major losses from the defaulted mortgages and declining home values, they are extremely hesitant to offer new loans. Whereas a few years ago they were willing to give out subprime loans, they are now being stingy about granting prime loans. This means that the economy can’t grow. People need loans for houses; but they also need loans for business creation, investment and expansion. When banks stop giving loans, the entire economy stops—there’s no construction and no new job creation. This, in turn, aggravates the existing problems, and even more people default on their already existing loans. It’s a deadly cycle.
Solving the problem is difficult. The banks have an incentive not even to acknowledge the many loans that are in effect in default. As long as they pretend the loans are being serviced (paid off) the banks can keep the investments on their books as assets. Once they acknowledge a mortgage is in default the bank is required to change its status on its books into a liability, thus reducing the value of the bank.
The Obama administration sought to stimulate the home buying market by providing a tax credit for home buyers. Though the credit has since expired, the measure had a moderate impact on the housing market while it was in effect, from January 2009 to April 2010. The bill provided between $6,500 and $8,000 to qualified homebuyers.
Still, the current state of the housing market can be thought of in the most basic of economic terms: the supply curve is much higher than the demand curve. Millions of people are trying to sell their homes, and few can get the necessary capital to buy a home. This keeps home prices right where they are—low. And there aren’t any serious indicators that this will change anytime soon.
