Mortgage Meltdown: Defining the Changes We Need

While the Presidential primaries have been dominated by vague calls for change, the escalating crises of the housing and financial sectors have the potential to concentrate our minds on the specific reforms that our nation urgently needs. This requires understanding how our current problems are a direct result of the policies pushed by Republican Presidents from Ronald Reagan to George W. Bush.

The story begins with systematic efforts by Ronald Reagan to dramatically reduce the regulation of financial markets and facilitate a huge transfer of income and wealth to the highest income households. These policies were embraced and expanded by later Republican presidents and “succeeded” in producing a new era of income inequality and out-of-control financial activity. The hallmark of this new era has been the explosive growth of hedge funds-—giant pools of capital that have been completely free of any type of government regulation.

Since these funds were free to pursue extremely high returns by engaging in very risky investment strategies, they created a “race to the bottom” within the financial sector—a race to pursue the riskiest and most imprudent investments. Starting in the current decade, subprime mortgage loans became the major investment opportunity that these risktakers embraced. But when housing prices suddenly turned downward, both the housing sector and the whole financial industry were plunged into crisis.

Starting in 1981, Ronald Reagan set out to deliver on two major changes that he had promised his business supporters. He significantly rolled back government regulation of the financial sector, allowing banks and other financial firms much greater latitude to do as they wanted. Over the years new opportunities emerged for financiers to make huge fortunes and this helped drive the dramatic rise in executive compensation. At the same time, Reagan cut taxes for the very rich, a policy initiative that was replicated by George W. Bush. Taken together, these steps facilitated a dramatic shift of income to the very rich. According to one respected study, the percentage of income earned by the top 1 percent of households doubled from 8 percent to 16 percent between 1980 and 2004.

As the rich grew wealthier, they invested growing amounts in hedge funds that pursued risky strategies to earn annual returns that were far higher than those available for ordinary investments such as the stock market or real estate. The government never regulated these funds because they were closed to most people; one had to exceed a certain wealth threshold to play. The theory was that these already rich investors could cope if these highly speculative investments turned bad. After all, when you already have $100 million, it is not a big deal to put $10 million in very risky investments that produce very high returns.

As hedge funds grew increasingly successful, they produced rate of return envy among established financial institutions. Pension funds, for example, wanted a piece of the higher return action and started putting some of their money into these unregulated funds. The big investment banks, similarly besotted with envy started imitating the strategies pioneered by the hedge funds. Many of them, like Bear Stearns, were even allowed to create their own hedge funds. Ever more money flowed into the highly risky investment strategies initially popularized by the hedge funds.

This is where the subprime mortgages come in. Starting in the 1990s, some independent mortgage brokers and mortgage firms figured out how to make money by lending to poor people who could not qualify for standard mortgages. The firms acted just like the local pawn shop, appealing to relatively desperate people who would be willing to pay substantially higher interest rates if only they could own a home.

What the borrowers didn’t understand is that the mortgage brokers add adjustable rates and penalties for refinancing to make the lending more profitable. Since housing prices, even in low income neighborhoods, were rising steadily, the lenders thought they faced little risk. Even if the borrower defaulted, the lender could always foreclose and sell the house for an even higher price to the next buyer with yet another high yielding mortgage.

Under George W. Bush’s presidency, this mortgage scam started to take off; dedicated mortgage firms like Countrywide and big banks aggressively sold these subprime mortgages, often by using misleading teaser rates and deliberate deception to get established homeowners to refinance existing mortgages. Here is where it got truly out of control. The critical step was that bankers were eager to package large bundles of these mortgages and resell them to hedge funds and other investors. The buyers of these packages (or mortgage securities) would be promised interest rates of 11percent or higher that were paid for by the monthly payments of thousands of borrowers.

Hedge funds bought huge quantities of these packaged mortgages, usually using borrowed money, to multiply their returns from 11percent to 30percent or even 40 percent per year. Meanwhile, the firms initiating the mortgages were making money both at the front end by gouging the poor and at the back end by selling the dubious mortgages on to other financial institutions.

This whole house of cards rested on the assumption that housing prices would continue the rise that had doubled the average house price in the U.S. between the early 1990s and 2006. But as subprime lending expanded, so too, inevitably did foreclosures, and as more foreclosed properties hit the market, prices started heading downward. The price shift started in inner city neighborhoods, but it quickly spread as the psychology of the housing market shifted. This broadened the crisis because millions of middle class homeowners had also taken on large amounts of adjustable rate debt because they too assumed that housing prices would continue to rise. By February 2008, almost nine million homeowners were under water—they owed more on their mortgages than the house is worth, and that number is bound to rise as more foreclosures and walk-aways (when homeowners simply give up and send the keys back to the bank) occur.

For hedge funds and other investors who were holding the mortgage debt, rising homeowner defaults and declining housing prices is like when the music stops in a game of musical chairs. Many homeowners have stopped paying, the mortgage originators are long gone, and the speculative investors are left with no place to sit. The pieces of mortgage securities–that they are holding have suddenly dropped in value since there is no assurance that either the interest or the principle will ever be paid. And to make matters worse, the magnitude of their losses are impossible to calculate precisely because the size of the loss will depend on how far the price of housing ultimately fall.

Already, big financial institutions in the U.S. and

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