A few posts back I started writing about the housing bubble. I started out talk about how consumers started buying homes using more and more leverage. In the second post in the series I talked about how the investment houses began writing insurance policies on the baskets of loans, figuring that home prices could never fall enough for those insurance policies to be used. Today I’ll talk about how the bubble burst, what government officials did, and what the results were.
On the public side, people had bid up the prices of homes to insane levels. In order to pay these huge prices people were taking out interest only loans or even loans in which they did not even pay the interest each month so the amount they owed actually increased each month. Some people were speculators who were using these types of loans to be able to buy several houses and have very low payments each month. Others were people who wanted to buy a house but did not have the ability to afford the payments for the homes they wanted with a standard loan. Both knew that the interest rate would reset within a year or two, and when it did the payment would be a lot higher, but they figured that the value of the house would increase by then and they would sell the house before that or just refinance into another loan, perhaps even taking out some cash for a vacation or a new kitchen.
On the investment house/mutual fund/hedge fund side, managers had bought baskets of these loans that the loan companies happily packaged up and sold so that they could make more loans and rack up fee income. Some had also sold insurance policies that would cover the losses of the buyer if the price of this basket of loans went below a certain level. To protect themselves in case the market did fall (not that they were expecting it to) they themselves bought some of these policies, perhaps with an earlier expiration date. In this way they made some money and protected themselves, they thought, against losses.
Eventually we got to the point where there were a lot of these loans outstanding, ready to reset their rates. As with all bubbles, we ran out of new people to pay even higher prices and those who had been paying high prices could borrow no more. At that point people began defaulting on loans as the interest rates reset and their payments went up. Because there was no one left to pay the huge prices the current owners paid for their homes, let alone pay more to allow them to recoup their realtor fees and other things they had rolled into the loans, the homebuyers were trapped with a payment they could not afford and no way to refinance.
They also stopped spending as much on other things like travel, restaurants, and shopping, both because they were paying more towards their mortgages and because they could no longer put the money they owed on their credit cards into their home loans. This resulted in businesses laying people off or closing completely. This meant that even more people were unable to afford their home loans and housing prices dropped further. Eventually people who could afford their payments but saw that the price of their homes was less than the loan value stopped paying because they felt it was unfair that they should continue making payments when the house was not worth the amount they owed.
The speculators on the banking side suddenly saw the baskets of loans drop in value, with many more defaults occurring than they ever thought was possible. Because of federal “mark to market” rules, which required the banks to guess the fair value of assets each day and report losses if the value is less than they paid, huge losses were recorded by the investment houses even though the true value of the baskets of loans was unclear since they were not being traded. Suddenly the insurance policies they had written were being used, but the companies that wrote the policies were unable to pay the claims. Because they could not be paid for the claims they were making, they could not pay the claims that were being made against the policies they had written. Thus we had a circular firing squad where everyone owed money and everyone was owed money.
Worst of all, money market funds, which can suffer losses but which make every effort not to, started to take losses. This made investors pull out of money markets. Because businesses rely on short-term loans from money markets to cover their expenses until they are paid for their services, it began to look like a lot fo companies would not be able to make payroll or buy supplies. This rattled the core of the financial markets and brought the Federal Reserve and the federal government in to save the day.
The most sensible thing that the government could have done was to become the money markets, providing the needed short-term loans until the regular money markets straightened out and could fill the need once again. This would have been very low risk to the American taxpayer.
Instead the government made loans to the large investment banks and insurance companies which were failing, essentially paying the claims these companies owed for them. This allowed these companies to keep operating (sometimes being sold to other companies through government arranged sales such as the sale of Merrill Lynch to Bank of America). This put the American taxpayer into a very risky position since they were making loans to (and then investments in) companies that were on very shaky financial footing. Instead of buying AAAA money market funds they were buying the junkiest of junk bonds. Officials at AIG, one of the companies that the government made huge loans to, went on their yearly spa retreat in the middle of the chaos despite the fact that, save the government loans, their company was bankrupt.
Also in this time period, the government went in and bailed out the auto industry, making huge loans to them that they may never repay in full. If this were not bad enough, they pushed these companies through bankruptcies in which bond holders in the companies, who normally would be paid first in a bankruptcy, were paid second or third and ended up taking pennies on the dollar instead of dimes on the dollar as they would have gotten in a normal bankruptcy.
This had a profound effect since it voided a fundamental requirement for a free enterprise society – that contracts be enforceable. Without this, people are reluctant to make new loans since they don’t know if the terms will be changed and therefore can’t determine their risk. This is probably the most damaging result of the whole crisis and is probably affecting the ability of the economy to recover today.
In the next post I’ll discuss government intervention into home loans and the effects.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.