In September 2007, Alan Greenspan, former Chairman of the Board of Governors of the Federal Reserve System, was quoted as saying “we’ve had a bubble in housing” and, in the wake of the sub-prime mortgage and credit crisis, “I really didn’t get it until very late in 2005 and 2006.” It is interesting that Greenspan did not “get it” because he essentially started it. He lowered rates, kept them down during President Clinton’s administration, and continued to do so during the second Bush administration and that practice is a major reason for the current problems in the real estate market. Greenspan was able to get away with the rate reductions because government indicators showed that inflation was under control. However, these indicators are skewed because the government measures only core inflation, which does not count food and energy cost increases, causing economists to say that “Core inflation makes sense only for people who don’t eat or drive” (Cooper 2007). It also ignores selected items for other reasons; for example, the increase in the cost of cars is not counted because it is claimed that cars are always improving Nevertheless, beginning in the 1990s there was a reason many manufactured items did not increase in cost: the influx of goods made in China. With the cheapest labor costs in the world, China began exporting items at prices well below those for anything manufactured in the United States. This forced many companies to either go out of business or make their products overseas. As a result, prices for many items went down, even if the cost of other items increased. The average, however, made it appear that inflation was relatively low. All these factors gave the government an excuse to keep rates down for a prolonged period of time and eventually housing prices started to escalate. Typically, when Americans want to buy a house, they look at the monthly payment that fits their income, not the price of the property. Therefore, if interest rates are lowered, prices are bound to increase. Certainly, the argument could be made, as many have, that the Fed was acting irresponsibly. In the October 1, 2007 issue of BusinessWeek, Vitaliy Katsenelson, author and portfolio manager, speaking of the latest rate cut by the Fed said, “The 2001 rate cuts caused the bubble that is now a crisis. Indeed, at the core of today’s credit mess—whether in housing or the now battered markets for commercial paper—lies a glut of global liquidity. That has dramatically altered our perception of risk and fueled an unwillingness to accept traditional credit limits.”
This leads to the second factor causing these problems. Besides the fact that money became “cheap” when the Fed lowered rates, it also became more available because lending practices loosened. Irresponsible changes occurred, such as the Fed’s reserve requirements for banks, which were loosened in the late 1980s, allowing banks to keep a lower percentage of deposits and therefore lend a higher percentage of their funds.
Mortgage Lenders
As rates declined, mortgage lenders also loosened their requirements and invented new types of loans based on the fallacious supposition that people would be able to pay more in the future, since real estate and wages would continue to increase indefinitely. Many of these loans were given to people with good credit who wanted to buy more expensive homes than they could otherwise afford. With an adjustable rate mortgage starting at three percent, for example, the monthly payment on a $400,000 mortgage is only $1,686 per month, $712.00 less than the $2,398 required at a six percent rate. As Katsenelson goes on to say in the BusinessWeek article, “If a home owner couldn’t qualify for a conventional mortgage, brokers were more than happy to offer an exotic loan the borrower could never realistically pay off. If a loan was too risky to be sold as investment-grade, investment banks could always concoct elaborate bundles of good and toxic credits that (supposedly) eliminated risk.”
At the same time, the advent of sub-prime lending was perhaps the most serious development to lead to the present quagmire. One of the biggest players in that market was a company called Ameriquest, which targeted people with bad credit and made loans to them for exorbitant rates. In 2006, Ameriquest paid a record $325 million to settle a class-action lawsuit over allegations of predatory lending practices, such as bait and switch and usury. However, while Ameriquest was in its heyday, making millions of dollars with sub prime loans, other lenders noticed and joined in. New companies were created only for this business and many of them are now defunct. General Electric got into the business with WMC Mortgage and “A” paper lenders such as Countrywide, the largest mortgage lender in the United States, joined in with its Full Spectrum branch.
Moreover, lenders like Washington Mutual, although they did not make sub-prime loans, were buying packages of sub-prime loans from lenders like Ameriquest. If the Fed had been irresponsible, the lenders compounded it by their shortsighted practices. They also forgot a basic rule in lending: that people with bad credit who do not pay their bills generally do not change. Moreover, adding to this mess is the fact that the loan broker rarely has a stake in what happens to the loan after it is made, since it is generally sold off to another entity.
Appraisers
After the real estate meltdown in the 1980s, the government decided that appraisers should be licensed. Licensing was supposed to protect the public from fraudulent loans because appraisers would be sufficiently educated in the profession. That would have been a grand solution if education was really the issue before licensing was required. However, the real problem was, and continues to be, the fact that lenders can hire their own appraisers. This practice immediately puts the appraiser in the position of having to please the lender to stay in business. This is akin to the proverbial fox guarding the henhouse but the banking establishment has ignored it.
In fact, in the 1980s HUD/FHA appraisers were assigned to cases just as VA appraisers are today. It was a random assignment system that precluded any involvement of the appraiser with the lender to procure the work. However, that practice stopped after the banking industry lobbied Congress to allow lenders to choose their own appraisers for FHA loans.
Including owner concessions in the purchase money agreement is another factor that has inflated values. Once a rarity, it has become a common practice—probably because of the malleability of appraisers—for everyone to assume that the value will come in regardless of the padding of “thin air” to the sale price. For example, a buyer wants to make an offer that is $7,000 lower than the property’s listed price of $280,000. Instead of offering $273,000, the buyer offers the full price with concessions of $7,000. The concessions might be attributable to closing costs or to a rebate, but the effect is that the lender is financing a larger percentage of the market value of the property.
Concessions have a twofold effect on the market. First, as they have become common, they inflate values approximately two to three percent, depending on the amount. Second, when appraisers or buyers and sellers look at sales, many of the sale prices do not reflect the actual money paid for the house. Moreover, appraisers rarely know if there are concessions associated with the sale comparables they are using because they are not noted in most multiple listing services, and calling each party to the loan is too time consuming, and often agents are unwilling to cooperate.
Another reason for the decline in the current market situation in most areas is the fact that the majority of real estate investors has left the marketplace and instead is attempting to sell their properties. Many of those who invested in real estate in the past several years were previously in the stock market or had never invested before but wanted to “get in the game” because they saw large increases. Some first-time investors used equity lines on their homes to make the down payments for their purchases. These “amateurs” often paid more for homes than well informed real estate investors normally do, driving prices sky high. It is estimated that the amount of real estate purchases for single-family residences bought by investors is between 10 and 25 percent, depending on the region of the country. With these people no longer buying and with some selling, inventory is increasing and prices are decreasing.
In the multifamily residence market, capitalization rates have descended over the past several years. This drop is related to lower interest rates and optimistic over speculation. The lower the capitalization rate, the higher the value. And in many areas of the country capitalization rates decreased substantially as interest on FDIC insured certificates of deposit (CDs) decreased because of the decrease in the Fed’s prime rate, which also decreased mortgage costs.