October 31, 2006

Housing Problems

Studies have shown that Republican administrations produce worse economic results for the average American than Democratic administrations. As Kevin Drum, Washington Monthly's blogger in residence, reported:

Democratic presidents have consistently higher economic growth and consistently lower unemployment than Republican presidents. If you add in a time lag, you get the same result. If you eliminate the best and worst presidents, you get the same result. If you take a look at other economic indicators, you get the same result. There's just no way around it: Democratic administrations are better for the economy than Republican administrations.

May 9, 2005

Today as we head into the sixth year of the latest Republican administration, and one that has been particularly bad for ordinary Americans on a number of fronts we find the seeds for true economic disaster looming in the housing sector.

When George W Bush became President in 2001, he ran into the trailing edge of the tech boom bubble and when the bubble broke, the economy went into recession. What Bush's economic team did in response was to give tax cuts to the wealthiest Americans and to tell the rest that people were smart enough to fend for themselves. After 9/11, Americans were told that it was their patriotic duty to spend money to keep the economy moving and many responded by tapping into their home equity to do their part.

Alan Greenspan, the Fed chairman until just last January, was a major cheerleader for cutting taxes on the wealthy as well as a proponent for the addressing the problem of the deficit by suggesting that the government should default on the social security trust fund. To keep the economy floating, Greenspan and the Fed lowered interest rates until they were close to zero. The Bush administration said this would encourage more Americans to buy homes and to join the "ownership society."

It was out of this period of extremely low interest rates that our current calamity was born. Over the past few years, the economic engine of the country has been driven by the housing industry and the refinancing of mortgages which freed up equity for further spending. However, as in all things, the devil is in the details and devilish details this time are the number of option ARMS that have taken the housing sector from a good housing market into a true housing bubble.

(Option ARMS are adjustable rate mortgages which have several payment options: starting with a very low one where the borrower makes a minimum payment covering only a portion of the interest with the deferred interest added to the mortgage (known as negative amortization), one that covers all the interest but no principle (which operates as a balloon option mortgage), up to plans where one pays a higher amount such as would cover a payment including both the full interest and principle with two choices: one that would be the equivalent of a 15 year mortgage payment plan and the other to provide for a 30 year mortgage payment plan. Today, up to 80% of those who have option ARMS pay the minimum (part interest) amount.)

One of the people most responsible for the housing bubble about to bust is Alan Greenspan because in early 2004 he advised Americans to take advantage of option ARMS to maximize their residential equity. As the Wall Street Journal wrote then, "In a rare evaluation of interest-rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether American homeowners are well served by popular fixed-rate long-term mortgages." But even at that time, financial experts decried this advice because it would lead to the equivalent of "gambling with your home" when interest rates went up.

Nevertheless, based on the advice of the Fed chairman, mortgage brokers began to push all kinds of option ARMS, including loans with no money down, to expand the market for people buying and refinancing homes. Throughout the country, people took out loans believing that they would be able to refinance later based on rising house prices which they thought would continue to go up by 10% or more each year. In 2003, option ARMS made up a mere 0.5% of total mortgages, but by 2006, the number had risen to over 25% of all mortgages made throughout the United States (more than 40% in Salinas, CA, 26% in Wyoming and over 50% in West Virginia!).

As predicted, the Fed began raising interest rates sometime last year in response to the "booming economy" and the fear of inflation. These increases directly affect the rates set for the option ARMS and can lead to much higher minimum payments. Even worse, for over a fifth of the option ARM loans written up in 2004 and 2005, the value of the house covered by the loan is less than the amount due on the mortgage. This means that a great many American homeowners who cashed in on their equity to have cash to spend or who stretched to buy their dream home based on what they could afford with an option ARM will be facing a very nasty surprise.

Indeed, the results of the Bush economy for ordinary Americans built on a policy of encouraging option ARMS along with the rising interest rates are already coming in.

Foreclosures are up: during the second quarter California foreclosures were up by 67%. More ominously, even areas where housing prices are below-market such as San Antonio, foreclosures are increasing. And because so many mortgages are option ARMS and people have only paid the minimum payment, every time they make a payment, rather than paying down their mortgages they are falling deeper in debt.

The real estate industry expects over $400 billion of debt in option ARMS to be reset this year, and another $2 trillion reset to higher rates in 2007. Once these increases hit, many more people will find themselves too strapped to make their monthly payments. Furthermore, where people are losing their homes in foreclosures, a high percentage of the homes are being sold for 70% of their current market value. Thus, many people have found or will find themselves significantly in debt even after losing their homes.

So how did it happen that so many Americans are at risk of losing their homes? It turns out that under Bush's watch financial regulators changed the rules of what was considered acceptable business practice. Government regulations were rewritten to say it was okay for financial lenders to claim as revenue the amount of the highest payment option for the option ARMS even if the homeowner paid the lowest amount. The changes allowed mortgage holders to record huge profits on revenue that might never be realized. James Grant of Grant's Interest Rate Observer wrote that the negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity."

Because these loans were lucrative for the financial industry, mortgage brokers were commissioned to encourage them. And many, many people who would never have been eligible based on their income and credit-risk were given loans guaranteed to turn their dream home into a nightmarish debt trap.

The financial industry isn't too worried about the bad loans, because they've already built into their calculations some hedges to cover for the riskiness of the loans. In fact, they believe the only ones left holding the bag will be the people who were not smart enough to read the fine print on their loans. And who cares about them?

This administration has been very upfront in saying that individuals should be responsible for their own lives and that it is not the job of the government to regulate industry to prevent these types of problems. They've also been very helpful in writing the rules so the financial industry can rake in profits while helping a great many Americans to put their homes at risk through these creative financial gimmicks.

When the Bush administration is long gone, the financial situation for many Americans will be dramatically poorer. Thus proving once again, ordinary Americans do not fare well under Republican administrations.

For more on this subject, see: Nightmare Mortgages, BusinessWeek, September 11, 2006

[Ed: This was another of my articles written for the Vox Populi Nebraska eZine first published in the September 2006 issue.]

Posted by Mary at October 31, 2006 11:45 PM | Economy | Technorati links |


Very nicely done.

If that hissing sound we are hearing is the air going out of the housing "bubble", then the sound we are about to hear will be the canvas collapse of the wind going out of the sails of the McMortgage market.

Posted by: Thomas Ware at November 1, 2006 07:28 AM