Chains of Fiscal Discipline

Richard (Rick) Mills

Ahead of the Herd

Page 1 of 4

As a general rule, the most successful man in life is the man who has the best information

Alan Greenspan was chairman of the Federal Reserve from 1987 to early 2006. Greenspan used monetary policy to ignite one of the longest economic booms in history. Of course booms can soon turn to bust and nowhere was the boom more evident than in the housing industry – the sub-prime crisis collapsed the housing boom just after Greenspan left the Fed.

Sub-Prime Crisis

“The banking problems of the ’80s and ’90s came primarily, but not exclusively, from unsound real estate lending.” L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation

Between 1997 and 2005 mortgage fraud increased by 1,411 percent. In 2001 the US Federal Reserve lowered the Federal funds rate eleven times, from 6.5 percent to 1.75 percent. Mortgage denial rates were 28 percent in 1997, in 2002 – 2003 they were 14 percent for conventional home purchase loans. “Fog the mirror loans” were common, if you breathed you got a loan.

In June 2002 President George W. Bush set out to increase minority home ownership by 5.5 million. Bush’s lofty goals would be accomplished by tax credits, subsidies and Fannie Mae committing $440 billion to establish Neighbor Works America.

In June 2003 Federal Reserve Chair Alan Greenspan lowered the federal reserve’s key interest rate to one percent –  the lowest rate in 45 years.

Throughout 2003 Fannie Mae and Freddie Mac bought $81 billion in subprime securities. President Bush signed the American Dream Down payment Act – the Act provided a maximum down payment assistance grant of either $10,000 or six percent of the purchase price of the home, whichever was greater.

U.S. homeownership rate peaked to an all time high of 69.2 percent in 2004.

From 2004 to 2006 Fannie Mae and Freddie Mac purchased $434 billion in securities backed by subprime loans.

In late 2004 the Securities Exchange Commission (SEC) suspended net capital rule for five firms – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley. Free from government  imposed limits on the amount of debt they could assume, they all levered up, as much as 40 to 1.

The United States housing market bubble burst in the fall of 2005. By year-end a total of 846,982 properties were in some stage of foreclosure. From the fourth quarter of 2005 to the first quarter of 2006, median prices nationwide dropped off 3.3 percent.

The U.S. Home Construction Index was down over 40 percent as of August 2006. A total of 1,259,118 foreclosures were filed in 2006, up 42 percent from 2005. Homeowners were going underwater (they owed more than the house was worth) and many had had questionable credit to start with.

In 2007, lenders started foreclosure proceedings on nearly 1.3 million properties, a 79 percent increase over 2006.

Foreclosure proceedings increased to 2.3 million in 2008, an 81 percent increase over 2007 and increased by another half million in 2009 to 2.8 million. By January 2008, the mortgage delinquency rate had risen to 21 percent and by May 2008 it was 25 percent.

By August 2008, 9.2 percent of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4 percent.

From September 2008 to September 2012, there were approximately 3.9 million completed foreclosures in the U.S. As of September 2012, approximately 1.4 million homes, or 3.3 Percent of all homes with a mortgage were in some stage of foreclosure compared to 1.5 million, or 3.5 percent, in September 2011.

Causes

The Great Recession started in December of 2007 and took a sharp downward turn in September 2008. It was started by the U.S. sub-prime crisis which burst the housing bubble. Businesses failed, consumers lost wealth estimated in the trillions of dollars and economic activity and international trade slowed.

So what caused the real estate crisis? Three things stand out:

Irrational exuberance – irrational exuberance was caused by a deliberate  easy credit fueled boom.

“Most economists now believe that low, stable, and—most important—predictable inflation is good for an economy. If inflation is low and predictable, it is easier to capture it in price-adjustment contracts and interest rates, reducing its distortionary impact. Moreover, knowing that prices will be slightly higher in the future gives consumers an incentive to make purchases sooner, which boosts economic activity.” Ceyda Oner,Inflation: Prices on the Rise

In other words, economic growth – prosperity at the national level – can be driven by consumption. Saving is bad because money sitting in bank accounts will not stimulate the economy. The world’s central bankers believe inflation is necessary because it discourages the hoarding of money and encourages consumers to consume.

“In January of 1959, the personal savings rate in the United States was 8.3 percent – this means that, on average, Americans were able to save 8.3 percent of their disposable incomes. In the early 70s, the average savings rate started to spike, hitting a peak of 14.6% in May of 1975. The spike in personal savings rates from 1973 to 1975 coincided with the deep recession that was ravaging the country over the same period of time…The recession of the early ’80s was a particularly nasty mix of high inflation and weak economic activity, otherwise known as “stagflation”.

The average savings rate spiked to 12.2% in November of 1981, which was right when the national unemployment rate in the country really started to trend higher.