Insurance

How we got into the housing mess (and are we out of it now?).

Below is a history of the housing meltdown. I want to confirm that indeed part of the cause of the meltdown was due to corporate greed and malfeasance. However, a very large part of the real estate mess was due to governmental manipulation and political maneuvering. Here is a short summary of how it happened:

There were several causes of the housing meltdown. Here is a list of the main culprits:

1. Low interest rates for several years.
2. The change in capital gain treatment on the sale of a primary residence.
3. Government entities Fannie Mae and Freddie Mac
4. The Community Reinvestment Act of 1977
5. Credit Default Swaps
6. Mark-to-Market Accounting
7. The Repeal of the Uptick Rule

In 1977 Congress passed the Community Reinvestment Act. This Act was passed to compel banks to make mortgage loans to borrowers in the low-to-moderate income categories, and especially in areas where there was a large concentration of minorities. Over the next 20 years more and more pressure was exerted on banks to make loans to this segment of the population. Separately, back in 1938, the government created the Federal National Mortgage Association (Fannie Mae), and later, in 1970, the Federal Home Loan Mortgage Corporation (Freddie Mac). These 2 entities were created as Government Sponsored Enterprises (GSE's), part government owned and part privately owned, with the express purpose of providing liquidity in the real estate housing market in the U.S. They work directly with banks and mortgage companies to buy their mortgages so that those banks and mortgage companies can use that money to lend to other borrowers. They do not work directly with consumers. In 1992, both Fannie Mae and Freddie Mac were given the directive that they had to hold a certain, ever increasing percentage of low-to-moderate mortgages in their portfolio. These mortgages became referred to as sub-prime mortgages, due to the increased risk these loans brought to the market. Meanwhile, political pressure was put on Fannie and Freddie to hold more of these sub-prime loans, even though they were risky, and put these 2 GSE's in an unsafe position. Barney Frank, a Democratic Congressman from Massachusetts, was a leading proponent of this movement. In 2003, in a hearing regarding Fannie Mae and Freddie Mac, he said "These 2 entities - Fannie Mae and Freddie Mac - are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." In a hearing 2 years later regarding the increased concern over Frannie and Freddie, Frank made this comment: "We have an excessive degree of concern right now about home ownership and its role in the economy. Obviously, speculation is never a good thing. But those who argue that housing prices are now at the point of a bubble seem to me to be missing a very important point...we are talking about an entity, home ownership, where there is not the degree of leverage that we have seen elsewhere." These comments were in the fall of 2005. Less than one year later, the hosing meltdown was well under way. Note: Last week, on October 21, 2010 it was announced that the bailout of Fannie Mae and Freddie Mac could actually get to $363 Billion, up from the $148 Billion number that had currently been reported.

As most of you know, there are 2 ways the government can stimulate economic activity. One way is through the Federal Reserve's monetary policy (mainly interest rate manipulation). The other way is through fiscal policy (passing laws like ObamaCare and the Frank-Dodd Wall Street Reform and Consumer Protection Act). In the last several years the Federal Reserve (the Fed) has kept interest rates very low. This has allowed borrowers buying homes to borrow money at very low interest rates. The government has also offered mortgage products that allow a very low down payment on a home purchase. Also, banks and mortgage companies have offered adjustable rate mortgages (ARM's) with a very low interest rate that increases after a period of years. At one point, banks and mortgage companies were offering no doc (no or little documentation) loans, jokingly referred to as NINJA loans (no income, no job, no assets), This concoction of variables brought the demand for housing to a fever pitch between 2000 and 2006.

The icing on the cake was the law passed in 1997, the Taxpayer Relief Act, which changed the law on the way capital gain was figured on the sale of a principal or primary home. The new law allowed, following certain guidelienes, the ability for a married couple filing jointly, to sell a home and avoid the first $500,000 of gain on the sale of that home.

Enter the last 3 variables, the ones that helpes spell the doom of the real estate market. To make room for more mortgages, banks, along with Fannie Mae and Freddie Mac starting packaging mortgages and selling them in tranches (slices or portions of the entire package of mortgages). They were referred to as Mortgage Backed Securities (MBS). By selling these MBS, it allowed these entities to get more money to do more loans. To offset the risk of these loans going bad, Wall Street, in 1995, came up with the idea of Credit Default Swaps (CDS). A CDS wa a form of insurance to pay the investor back in the case that the mortgages went bad. There were 2 shortcomings of the CDS. One was that they were not regulated like a regular insurance is regulated. Secondly, and more importantly, they were highly leveraged in that there was very little money/cash/liquidity in reserve to pay the investor in the case that the mortgage backed security went bad.

In the middle of 2008, three of the companies selling these CDS encountered major problems. These 3 companies were Bear Sterns, AIG, and Lehman Brothers. Bear Sterns was bought out by JP Morgan Chase, Lehman Brothers declared bankruptcy, and AIG was taken over by the U.S. government. AIG had written $78 Billion in CDS, and it cost us as the taxpayers $45 Billion to bail out AIG. These events triggered the unofficial start of the Great Recession, which would last officially for 18 months, from Decenber of 2007 until June of 2009.

Enter the 2 final nails in the coffin, mark-to-market and the repeal of the uptick rule. The Enron, WorldCom, Global Crossing, and other corporate scandals of the early 2000's lead to the passing of the Sarbanes-Oxley Act of 2002. One of the changes as a result of this Act was to change how assets and liabilities were figured. In the past, assets/liabilities of corporations were figured on the book value of an asset, not on the current value of the asset. So a mortgage for $100,000 would have a book value of $100,000. However, using the current market value of the asset, referred to as mark-to-market, the value in 2005 or 2006 may have been $70,000 or $80,000. This new Act mandated that banks, insurance companies, and investment firms (in fact, all companies) use the mark-to-market value of the asset on their books. This led to financial statements that showed losses instead of profits for these companies, especially with the mortgage loans that had started souring. The side event that triggered even more uncertainty and disrupution in the financial markets was the general lack of liquidity in the financial markets, a death sentence to any company that buys and sells financial products.

In this scenario, banks and financial companies were out of favor, due to the uncertainty and losses these companies were showing. Prudent investors were betting that the value/stock price of these financial companies would continue to decline. With this situation, many investors act on this by "shorting" or selling short. What is short selling? Short selling is selling high and then buying low, the opposite of traditional investing, where you buy low and then sell high. To make this happen, you first must believe that the stock/financial instrument your are looking at will decline in value over a short period of time. Let's take an example. I want to buy a stock, ABC Corp. that is currently at $10 per share, but I believe it is going down to $7 per share in the near future. I can borrow the stock from someone who already owns the stock, say 10 shares, and sell it for $10 a share. At a later point in time, I can then buy the 10 shares of stock at 7$ per share and pay back the person I borrowed the stock from to sell at $10 a share. I have just made $30, less the cost to borrow the stocks from the other investor.

The uptick rule was originally passed by Congress in 1938. It said that if you sell a stock short, as in the example above, you cannot sell it again until the stock goes up in value first. That makes sense, because otherwise a stock can be beat up mercilessly and take a nosedive very fast. For reasons that are not clear, the Securities Exchange Commission (SE) repealed the uptick rule on July 6, 2007. What we saw was what we expected to see. A slew of banks, insurance companies, and investment firms took a beating in the stock market and their stock price took a dive, largely due to the loss of the uptick rule. Many of these companies were bailed out, most of whom have not fully recovered. The real estate industry is still bleeding after a record number of foreclosures and short sales. In fact, last month, there were over 100,000 foreclosure proceedings initiated, the first time that number has exceeded 100,000.

So are we out of this mess yet? Stay tuned for my response to that important question.