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Credit-fuelled housing boom and why it went bust

Part II “Crash and Contagion” How the US credit bubble burst wide open and crashed.Contagion and Crash

As I outlined in the first segment of this column, I believe that the central cause of the global financial crisis that began in 2007, which is still ongoing, was the massive amount of debt that households and governments in the western developed nations accumulated in the period 1965 to 2010.

Compounding and complicating those debts is the huge amount of debt held by the private sector, especially the global banking and finance sector that financed those households and governments.

The current crisis is the result of a now globally held fear that a significant portion of this accumulated debt, whether it was borrowed by governments, by global banks and finance companies, or by households, now cannot be repaid

How was this “descent into indebtedness”, to the point of potential catastrophe, possible to arrive at?

The answer is that it was possible due to the following: 1 ) The initial relatively low level of outstanding debt held by these sectors (especially households) at the beginning of this debt cycle;

2) The strong AAA credit ratings ascribed to the United States and other leading western governments and economies by ratings agencies and lenders which gave the lenders comfort to lend;

3) The decline in inflation and market interest rates in the US, the EU, and elsewhere, after the former Communist Bloc nations in Eastern Europe and Asia opened their economies to global trade and competition.

Benchmark rates utilised to set US mortgage rates, for example, dropped from over 16% in 1981, to just over 2.75% in 2010;

4) The lower interest rates made housing more affordable and contributed to a nearly constant rise in house prices (the collateral for household borrowing) and stock and bond prices (collateral for corporate borrowing) in the US and the UK especially;

And 5) A deregulated, increasingly globalised, and increasingly aggressive banking and non-bank finance industry (known as the “Shadow Banking” Industry), which was very focused on property lending and financing.

The debts were accumulated slowly and incrementally, from the early seventies through the early nineties, financing every day activities like corporate mergers and acquisitions, new housing developments (public and private), public education, healthcare, University educations, old age pensions, and kitchen and bathroom refurbishments, among other things. A debt culture developed and was increasingly adopted all over the world.

A Man’s House is his … ATM machine?

As housing prices continued rising through the 2000 to 2006 period they outpaced the replacement costs of new homes by significant margins that had never been experienced before, especially in locales where financial leverage was being applied the most liberally. Thus the annual growth rates of debt accumulation tied to real estate accelerated as well.

This increased the level of household debt relative to household incomes, national GDPs, and relative to underlying collateral values.

Home ownership was increasingly hyped and marketed to the public, mainly by politicians and mortgage brokers in the US, and by banks elsewhere, as a sure path to prosperity and wealth.

The accelerating pace of house price appreciation encouraged large corporate residential property developers to debt-finance the purchase of more tracts of vacant land in the suburbs, and even the exurbs, of major metropolitan areas.

They launched new single family home development projects in places like the suburbs of Las Vegas, and new multistory housing developments in previously spurned urban areas, like downtown Miami, for example.

However, the steadily rising market also encouraged smaller scale speculators (small contractors and all sorts of other entrepreneurs) to buy, renovate, expand, and resell older homes for profit all over the United States, and in the UK and Ireland, as well.

Thus, the supply of housing grew in response to the increased returns being earned in housing (which were well publicised in the press) and the easy credit available to investors.

The US Census reported that in the years 2002 to 2006 the number of newly constructed single family home sales averaged 1.11 million units per year. The average annual sales for the years 1990 to 2000 was 609,000.

Finally, while some people were busy buying, building, and renovating homes for profit, others were

simply content to stay in their homes and refinance their mortgages to achieve a lower monthly payment, which allowed for a small increase in monthly consumption.

Other homeowners, perhaps encouraged by the aggressive marketing of loans by mortgage brokers, mortgage finance companies, and banks; decided to withdraw large portions of the equity in their homes via mortgage refinancing or home equity loans (second mortgages).

This was often done in order to lower their monthly payments, to finance home renovations and consumer spending, and to pay off credit card balances.

The US Federal Reserve reported that USD 750 billion of equity was withdrawn from US homes in 2005 by homeowners who refinanced; 350% more than the USD 166 billion extracted in 1996.

A Free Market or a Free-For-All?

The US housing market has a long and volatile history. One need not look any further than the fact that the US government has formed several major agencies since the great depression in the 1930s (real estate price declines contributed to that economic failure too) to try and bring stability to the US residential property market:

The Federal Housing Authority, Fannie Mae (Originally, the Federal National Mortgage Association), Freddie Mac (Originally the Federal Home Loan Mortgage Acceptance Corp), Ginnie Mae (Originally, the Government National Mortgage Corporation), The Federal Home Loan Bank System, and even the Veterans Administration.

All of these US agencies play critical roles in supporting housing market liquidity, access to credit, and therein prices, in what is supposed to be a free market system.

The US is a very large country geographically: 3.7 million square miles of territory; a population density of only 87 persons per square mile (in comparison, the figure is 1,275/sq mi here in Bermuda, and 16,500/sq mi in Hong Kong), with most of the population living within 30 miles of the Atlantic, Pacific, Gulf of Mexico, or Great Lakes coasts.

No shortage of land to expand housing there.

Yet at the height of the credit fuelled housing boom the 2003 to 2006 period prices for undeveloped lots of land were also rising with house prices in the US, with some real estate entrepreneurs pushing the view that there was a land shortage in the US. “Irrational Exuberance” was the term coined to describe the hype rampant around property and investment markets at the time.

Financial markets often move to the upside in five waves. Waves one, three, and five are up moves, interspersed with waves two and four, which are down waves.

The US single family home market began its first big move higher in the period 1983 to 1988 as interest rates started falling after the “Volker Austerity”, imposed to fight the post-Vietnam War inflation of the late 1970s, was relaxed and the banking system was deregulated.

This first move upward ended when the US stock market crashed on “Black Friday”, October 1987.

This led to a down wave in house and commercial real estate prices in the early 1990s.

The early 90s down wave in prices, and associated economic activity, caused the US Savings and Loan crisis during which many small regional lenders went bust from over lending on residential and commercial real estate (especially in the oil patch around Dallas and Houston, but that is another story!).

The second up wave could be dated from 1993 to 1999/2000 and was essentially driven by the personal computer, and later, the “dotcom” economic boom in the United States.

It came to an end when the dotcoms and related IT stocks crashed in the 2000 to 2001 period. The US mortgage refinancing boom entered its third and final up wave around 2002.

In the af ermath of the dotcomstocks crash, and the 2001 terrorists attacks in the US, the US Federal Reserve, and other Central banks, cut short term interest rates down to 1%, the lowest they had ever been in the modern era of finance.

This cheap credit encouraged the largest borrowing and mortgage refinancing boom in US history.

With economies by that time closely linked via the US dollar’s reserve currency role, similar credit booms erupted globally. The UK and Ireland are prime examples.

The low interest rates seen after 2001 encouraged the US banks and speciality housing lenders, who understood that rates could not go much lower than 1%, to shift the burden of financial risk in a mortgage to the borrower.

Thus (with the assistance of the mortgage brokers who were effectively their vendors) they began to steer new borrowers into floating rate loans rather than traditional fixed rate loans.

Borrowers, however, were at first reluctant to switch as they understood the implications: if rates were to move higher they would be forced to bear the increased cost of credit automatically.

Mortgage financiers responded by offering “teaser rates” and other features to lure home buyers (in some cases unwittingly) to sign up for floating rate mortgages.

These teaser rates were structured to have the first one or two years fixed at a “teaser rate” of say 2.5%, after which the borrower would have to start paying a floating rate, such as the one month LIBOR rate (a rate set in London each day by the world’s 20 largest banks), plus 3.5 percent.

With one month LIBOR at 1.5%, for example, the borrower’s rate would move to 5% after the fixed rate expired.

If one month LIBOR moved up to 3% nine months later, the borrower’s cost would jump to 6.5%, a 160 percent increase from the original teaser rate.

With the global economy awash in the liquidity (dollars and other currencies) injected into the global economy to prevent an economic contraction in the wake of the dotcom bust, and the 911 attacks, commodity prices such as food and oil began to rise.

The liquidity injection had collided with still-robust growth and expansion taking place in China, Brazil, and the rest of the developing world at the time, and the US invasion of the Iraq, a leading oil producing country.

Brent Oil prices (the UK blend that is the Western European benchmark) rose from about $30 per barrel in 2003 to over $140 per barrel in mid-2008.

The Federal Reserve, in response to rising inflation, began increasing interest rates, taking them from 1% in 2004 to 5.25% in 2005.

The hikes totally squeezed those homeowners who had taken on floating rate mortgages. Using our example above, the homeowner with the one month LIBOR rate plus 3.5% mortgage would have seen his/her rate rise from the 2.5% teaser rate, to a rate that might have climbed as high as 8.5% in 2007.

These higher interest rates experienced through 2005 and 2007 choked off (slowly at first, rapidly around the time of the peak in rates) the new buyers, and the speculators/developers, which caused prices to level off and start to fall.

The higher rates also caused a spike in interest arrears, and eventually, mortgage and loan defaults; as more people fell behind in their mortgage payments.

This is what blew the US mortgage and real estate markets up and crashed the global financial markets.

The explosion, the surge in homeowner arrears and defaults, and the failure and default of scores of developers, right through the levels expected by conventional Wall Street models (which were low to begin with, and did not envision a simultaneous, nationwide price decline) spread around the world; triggering similar explosions in real estate and mortgage financing markets in the UK, Ireland, Spain, and many other parts of Europe. Property prices and sales (residential and commercial) fell, stock markets sold off furiously and credit markets seized up, forcing prices to fall further.

The financial losses experienced by homeowners and investors sent the finances of major governments worldwide, many already deeply in debt, further into the red, as recession followed bailouts.

How did the US mortgage market crash spread worldwide and infect so many markets and economies, including Bermuda? I’ll explain in the next instalment.

Next Week: How the debt crisis spread globally, and sits on the world economy like a massive hangover. And “The Great Workout” (Workout “The process by which debtors and creditors agree to debt forgiveness and/or a different repayment plan when a debtor is unable to repay debts.)

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Published November 26, 2011 at 1:00 am (Updated November 26, 2011 at 7:09 am)

Credit-fuelled housing boom and why it went bust

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