The US Housing Bubble
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It is not uncommon these days for one to see newspaper headlines about the depressed U.S. housing market, high inflation, ever-increasing gasoline prices, bank failures and new lay-offs. All signs seem to indicate that America’s economy is going through one of the worst storms in decades. One of the primary causes behind America’s current financial crisis was the over-extension of credit by the Federal Reserve after the bursting of the dotcom bubble in 2000 and 9/11 in 2001. With the benefit of hindsight, what was then considered appropriate monetary policy to stimulate the U.S. economy in the face of economic difficulties and unprecedented threats to national security is now considered to have created a bubble in U.S. housing prices.
By lowering the cost of credit, the Federal Reserve increased consumer borrowing power, which made housing more affordable. The increased borrowing power of consumers drove increased demand for housing, which ultimately led to rising home prices. As home prices continued to increase, however, speculators entered the market and many people soon forgot that the value of real estate could also drop. Many home-buyers also became aggressive in the amounts that they borrowed to purchase not only their homes but also to purchase other speculative real estate investments.
The speculative increase in housing demand drove home-builders to build what is now clearly an over-supply of property. With declining property values and rising interest rates, a growing number of homeowners face the risk of default and foreclosure. As millions of people begin defaulting on their loans, the banks that have exposure to these borrowers stand to lose, and have lost, tremendous amounts of money. Current multi-billion dollar write-downs by financial institutions now make it abundantly clear that many banks sacrificed proper lending guidelines for short-term profits by having lent to potential home-buyers who were unable to service their loans. Since the mortgage crisis began last year, banks and brokerages have already written down over $300 billion of mortgage-backed securities.
An example of a failed bank that has been affected by its mortgage portfolio is IndyMac Bancorp. In the run up to its collapse, IndyMac had aggressively extended loans to people based on minimal documentation and income verification. Due to its concentrated loan portfolio (primarily in California) and its inability to securitize and sell its loan portfolio, the bank was forced to consolidate the loans onto its balance sheet. A loss of confidence among its depositors and the lack of liquidity in the bank’s portfolio finally led to its collapse.
Another cause for concern is news of the Fed’s backing of Fannie Mae (”Federal National Mortgage Association”) & Freddie Mac (”Federal Home Mortgage Corporation”), two government-sponsored institutions set up to buy mortgages away from banks so that banks have liquidity to provide more home loans. In response to a banking collapse of the 1930’s, Franklin D. Roosevelt created Fannie Mae to lend money to banks at a low interest rates to encourage the average American to purchase homes again at affordable mortgage rates. In 1970, Freddie Mac was created for a similar purpose. Today, the two institutions combined guarantee a total of $5 trillion in mortgage debt. As home prices began to fall and borrowers defaulted on their loans, Fannie Mae and Freddie Mac incurred substantial losses on their loan portfolios. What is most worrisome is that Fannie and Freddie hold much less than 10% in cash and liquid reserves, a hurdle that other banks are required to meet, because the two institutions are under special regulatory rules passed by Congress. In fact, their $5 trillion debt portfolio is only backed by approximately $81 billion of capital. They have a very small cushion to protect themselves from current and future losses.
What happens next? Not only has the bursting of the housing bubble significantly decreased the wealth of American homeowners, forcing them to cut back on consumption of goods and services on the rest of the economy, it has also hugely affected financial institutions, leaving them with large losses and non-performing assets on their balance sheet. As a result, banks are reducing the amount of credit that they extend, until they can raise money or sell some of the assets to restore liquidity on their balance sheet. The economy may be in danger of coming to a standstill until property values stabilize and banks restore their balance sheets
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