Any bust in history required three things: Government Intervention, Corruption and Federal Reserve Policies.
Government Intervention
From the 1930's n, the government has pushed home ownership, specifically special affordable loans. This became acute in 2000 when an additional push went from requiring 50% of loans to fall under the Special Affordable label to 60% and eventually 70%. The only way to accomplish this was by loosening lending standards. As lending standards are loosened by forcing banks to accept more risk (i.e. normally unqualified applicants), more loans were able to be filled. This rapidly led to what was commonly known as NINJA Loans. These were loans where the applicant had No Income, No Job and no Assets. You may be thinking, no....this isn't possible but it in fact was rampant. I talked to a mortgage broker from conservative lending institutions that stated they went from conservative to providing NINJA Loans. In other cases, the only requirement to grant a loan was the applicant attend a Credit Counseling Program. That was it. If they completed that, the loan was granted without regard to documented ability to repay.
Mortgage denial rates went from 28% in 1997 to 14% in 2003. Did we all of a sudden become more qualified? Subprime mortgages had risen by 292% from 2003 to 2007 with 40% of those completely from automated underwriting.
Lenders soon learned they could take various loans of different risk levels (High, Medium and Low) known as "Tranches" and bundle these together in what was known as "securitization." As the assets were securitized, they were able to be bought and sold around the world as a lending commodity. Banks were making money primarily of the trade of these securities. As they were a bundle of hundreds of various risk loans, it was impossible to know the risk of the entire bundle.
Protection of these investments was provided by credit risk swaps and insurance by firms such as AIG who never thought they'd have to pay out on the securities viewing the premiums as pure profit. The securities themselves were rated as AAA by Standard & Poor and Moody. The Commodity Futures Modernization Act of 200o exempted derivitives (such as mortgage backed securities) from regulation, paving the way for trading of these securities and Credit Default Swaps (CDS). In 2003 Warren Buffet described derivatives as "financial weapons of mass destruction."
Federal Reserve Policies
The Federal lending rate was kept at 2% from 2001 through 2004. This low rate encouraged banks to borrow a LARGE amount of capital which they passed along to borrowers at higher interest rates and encouraging interest-only loans. Lots of essentially free money with many loans bundled as securities that provided the real money for the banks. To do that required borrowers and if you could fog a mirror, you were good to go.
Alan Greenspan called these mortgages a "powerful stabilizing force" because it allowed people to extract equity from their homes. In 2004 he stated that "homeowners should consider using adjustable-rate mortgages to save on interest and pre-payment costs."
The above chart represents home prices, build costs, population and home price index. The home price has historically tracked above build costs and increasing with population. this is intuitively expected. What is NOT expected is the sharp upturn in 2005. This would be (in hindsight) a classic indication of a bubble. Inflated home prices that do not correlate with either population increase or increasing building costs.
So why? Why did this bubble occur under our noses? Were regulators sleeping? No, they weren't. They relaxed regulatory controls to allow these very dynamics at the pressure of community groups and "progressive" political forces.
Enter Fannie Mae and Freddie Mac....
Above represents the relative cost of borrowing money. Commercial lenders pay a higher premium for borrowing than Fannie and Freddie. This allowed an unfair competitive advantage for Fannie and Freddie allowing them to purchase most of the mortgage backed securities and sell them at discounted rates compared to their competitors.
Corruption
Representative Barney Frank and Senator Chris Dodd pressured Fannie Mae and Freddie Mac to ensure their constituents received affordable housing loans. This was evidenced by the increase in the requirement for Special Affordable loans from 50% to 70% though applicant qualifications did not warrant such an increase. a FICO score (credit score) of 660 had been the dividing line between "prime" mortgage loans and "sub prime." In Fannie and Freddie's own documents, they were reporting loans below these scores as prime.
In 2005, the Senate banking Committee attempted to pass legislation to tighten controls over Fannie and Freddie but it was passed out of committee with a vote along partisan lines and no democrat voting for it.
So now that the fed chairman encouraged Americans to take interest only, adjustable rate loans, in 2005, the Fed raises it's prime lending rate from less than 2% to more than 5%. Those with ARMs were finding significant increases in their mortgage payments.
So what to do with essentially a very liquid market? Money was pumped to banks. Banks now have a tremendous amount of money tied up in toxic derivatives with still a AAA rating but no one wants. With all that money, banks would normally lend money since that's how they make their own money. But with Billions in toxic assets with no clear valuation, banks hold onto the money to protect their investments.
The bailouts went to banks, not homeowners. Homeowners can no longer meet their mortgages and the foreclosures and short sales start to increase flooding the home-rich market with even more properties and still the banks are reluctant to lend. The cycle continues spiraling market values even lower and perpetuating the cascade.
Solutions
So what to do? There were really only 3 viable options to choose from:
1. Allow firms to go bankrupt.
2. Purchase bad assets.
3. Recapitalize by buying equity positions in firms.
Of the three, the one that should have been chosen, the first one, wasn't. We may have had a deeper recession, but most economists believe the valley would have been much shorter vice today not even knowing where or when the bottom might be. Allowing firms to go bankrupt allows them to start fresh with much debt relieved. This is a natural course of a free market society and happens daily. When you label "too big to fail" and artificially prop up sickened trees, you only prolong the inevitable.
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