Housing bubble in America

Lately we are all hearing a lot about Sub prime in America. I was curious to know more about it and so I investigated through the many sources to get the information. I want to share that very important information with my readers since, it reflects on many things happening in our country also. The mistakes USA has made we should not repeat but to my dismay I find that, our great (?) economist Manmohan Singh is going to be Indian “Alan Greenspan”. I say this because this Pakistani refugee is now forcing our Banks to reduce interest rates to housing loans, jeopardizing banking business. Danger of floating interest loans is also very clear from this report. I hope this may help those who are immediately concerned about such loans. All that is given here on American background is absolutely applicable to India and so this study is worth reading. Floating interest offer is a type of “soft predatory lending” manner and so must be taken carefully. We should be doubly careful about this Manmohan Singh as he has already finished our Stock Market and virtually paralyzed many middle class families and now he is all out to destroy our Banking System.

Here goes the report:

In October 2007, the U.S. Treasury Secretary called the bursting of housing bubble, the most significant risk to U.S. economy.

Housing bubble may occur in local or global real estate markets. In their late stages, they are typically characterized by rapid increases in the valuations of real property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability. This may be followed by decreases in home prices that result in many owners finding themselves in a position of negative equity, a mortgage debt higher than the value of the property. The underlying causes of the housing bubble are complex. Some of them are unaccountably low interest rates, lax lending policy based on over confidence about the borrowers ability to repay and a speculative fever.

Former U.S. Federal Reserve Board Chairman Alan Greenspan said "We had a (economic) bubble in housing", and also said in the wake of the sub prime mortgage and credit crisis in 2007, "I really didn't get it until very late in 2005 and 2006." The mortgage and credit crisis was caused by the inability of a large number of home owners to pay their mortgages as their low introductory-rate (sub-prime in interest rating) mortgages reverted to regular interest rates due to “teaser” (effect of floating interest rates).

Any collapse of the U.S. Housing Bubble has a direct impact not only on home valuations, but the nation's mortgage markets, home builders, real estate, home supply retail outlets, Wall Street hedge funds (reserve funds) held by large institutional investors, and foreign banks, increasing the risk of a nationwide recession. Concerns about the impact of the collapsing housing and credit markets on the larger U.S. economy caused President George W. Bush and the Chairman of the Federal Reserve Ben Bernanke to announce a limited bailout of the U.S. housing market for homeowners who were unable to pay their mortgage debts, obviously at the expense of honest tax payers.

In 2008 alone, the United States government allocated over $900 billion to special loans and rescues related to the US housing bubble, with over half going to the quasi-government agencies such as Fannie Mae, Freddie Mac and the Federal Housing Administration.

The New York Times, which reported that Richard F. Syron, the CEO of Freddie Mac, received a memo from David Andrukonis, the company's former chief risk officer in 2003, warning him that Freddie Mac was financing risk-laden loans that threatened Freddie Mac's financial stability. In his memo, Mr. Andrukonis wrote that these loans "would likely pose an enormous financial and reputation risk to the company and the country." The article revealed that more than two-dozen high-ranking executives said that Mr. Syron had simply decided to ignore the warnings out of over confidence about Americans capability. Reuters reported in October 2007 that a Merrill Lynch analyst too had warned in 2006 that companies could suffer from their sub-prime investments.

The Economist magazine stated, "The worldwide rise in house prices is the biggest bubble in history," so any explanation needs to consider its global causes as well as those specific to the United States. The then Federal Reserve Board Chairman Alan Greenspan said in mid-2005 that "at a minimum, there's a little 'froth' (in the U.S. housing market), it's hard not to see that there are a lot of local bubbles"; Greenspan later admitted in 2007 that froth "was a euphemism for a bubble." Greenspan further admitted that, "all the froth bubbles (local) added up to an aggregate (national) bubble”. Among other statements, the reports stated that people should [not] be concerned that home prices are rising faster than family income". This is a clear indication that American administration has over confidence about their people and their capacity to repay the mortgages. Greenspan later admitted that, "I really didn't get it until very late in 2005 and 2006. My knowledge of the intricacies of economic affairs is short”.

Senator Chris Dodd, Chairman of the Banking Committee held hearings and asked executives from the top five sub prime mortgage companies to testify and explain their lending practices. Dodd said that "predatory lending practices" had endangered home ownership for millions of people. In addition, Democratic senators such as Senator Charles Schumer of New York were already proposing a federal government bailout of sub-prime borrowers in order to save homeowners from losing their residences.

Predatory lending practice means, forcibly making people to take loan at sub-prime lending facility.

Forecloser means, to forfeit property due to non payment of the installments of the loan.

Teaser means floating loan provision

Bail-out means paying the liability to Bank by government and save the property to the buyer free of cost. Such offers are given by professional politicians at the cost of tax payers with an eye on election. Bail-out policy is rejected by all responsible economists. It would only promote imprudence in the future. A bailout was not a panacea (cure-all) to heal the ailments of the housing sector. Economists suggest that such loans should be converted into long term/low interest rate loans (25-50 years) in place of outright bailout to save the economics of the country.

Write off means Bank forgetting the loan liability as a lost proposal.

The median price means changing mean price.

Despite greatly relaxed lending standards and low interest rates, many regions of the country saw very little growth during the "bubble period". Rapidly growing house prices and increasing price gradients forced many residents to flee the expensive centers of many metropolitan areas, resulting in the explosive growth of exurbs or suburbs in some regions. We are experiencing this phenomenon in Mumbai these days.

David Lereah, former chief economist of the National Association of Realtors (NAR), explains, what Happened in step by step as given below,

Boom ended in August 2005

Mortgage rates rose almost one point

Affordability conditions deteriorated

Speculative investors pulled out or say, gamblers pulled out!

Homebuyer confidence plunged

Resort buyers went to sidelines

Trade-up buyers went to sidelines

First-time buyers priced out of market

Actual cost of construction of a tenement is practically same in all places but the prices demanded are different for different locations. This has direct effect on the lending activity. The factual policy for the Banks while lending should be that they can give loan only for the actual cost + appreciation up to about 35% of the building cost and accept mortgage of the dwelling. For balance difference, buying party will have to arrange by negotiation with the builder, such as instalment payment facility or sub-prime loan by the builder himself. If this policy is accepted Banks can remain in safe position. If this policy is accepted undue rise in prices will be controlled and desire to over profiting from builders can be curbed. This advice was simply ignored by the concerned authority purely out of over confidence. One experienced estate agent from Mumbai suggested that if this policy is accepted there will be only genuine builders in the market and all those grabbers who have entered this profession for extra loot will automatically vanish; leaving this industry in good stead. Often it is found that the Ready Reckoner provided is not the correct price that means, explanation should be demanded from the concerned authority to that effect. How Ready Reckoner evaluates those values must be explained to public; unfortunately it is not happening here. Our government’s greed for extra earning from stamp duty is responsible for high rates at ready reackoner, said on builder; others commented, politicians have put their black money in building activity and so this high rate.

In India, builders can give sub-prime loan facility and earn some instalments until the borrower is paying; if the borrower fails to pay the further instalments foreclosure is effected and the apartment is sold to other buyer at the fresh price this way builders can make more money from the same apartment without extra investment. This possibility shall make builders to expect such borrowers who can not pay all instalments so that they will make more money. One builder and his agent told me this. That means sub-prime lending by builders themselves can work without creating any economic problem. However, this is not possible for a Bank.

In August 2006, slumping sales and prices caused economist Nouriel Roubini to warn that the housing sector was in "free fall" and would derail the rest of the economy, causing a recession in 2007.

A steep rise in the rate of sub-prime mortgage defaults and foreclosures has caused more than 100 sub-prime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation's second biggest sub-prime lender. The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The duration of the economic slowdown or recession will depend in large part on the resiliency of U.S. consumer spending, which now makes up approximately 70% of the U.S. $13.7 trillion economy. The evaporation of the wealth effect amid the current housing downturn could negatively affect the consumer confidence and produce further headwinds for the economies of both the U.S. and the rest of the world. Considering the fact that percentage wise, $6.5 trillion of damage in $13.7 trillion U.S. economy means (47%), the total economy of America is completely shaken up. As a matter of fact due to this, position of Dollar, actual exchange value of Dollar is reduced to about 70% of 2005, however; we see that it is not reflecting in the market for some inexplicable reason. The World Bank lowered its figures for the global economic growth rate due to the housing slowdown in the United States, but did not believe that the U.S. housing malaise would further spread to the rest of the world. The policy of the World Bank to impose certain growth rates on under developing nations is questionable but nobody cares. To save this lose many American sub-prime mortgage lenders designed beautifully decorated and attractive packages and sold the already lost mortgages to the less conscious but over confident Banks in Asian and European money market to save their skin and in that process many Banks in the world are now in trouble. Problem of America has become now the problem of the world! Indian Banks HDFC, State Bank and ICICI are victims of that trap, I was told.

The White House Council of Economic Advisers lowered its forecast for U.S. economic growth in 2008 from 3.1 per cent to 2.7 per cent and forecast higher unemployment, reflecting the turmoil in the credit and residential real-estate markets. This is really important since, India, a developing country, is talking of 9% economic growth while U.S. (most developed country) satisfied with 3.1 to 2.7 growth rate (what a joke)!!!

But the appreciation of home values far exceeded the income growth of many of these homebuyers, pushing them to force themselves beyond their means. They borrowed even more money in order to purchase homes whose cost was much greater than their ability to meet their mortgage obligations. Many of these homebuyers took out adjustable-rate mortgages during the period of low interest rates in order to purchase the home of their dreams. Initially, they were able to meet their mortgage obligations thanks to the low "teaser" rates being charged in the early years of the mortgage. However, as the Federal Reserve Bank of U.S. applied its monetary contraction policy in 2005, many homeowners were stunned when their adjustable-rate mortgages began to reset to much higher rates in mid-2007 and their monthly payments jumped far above their ability to meet the monthly mortgage payments. Some homeowners began defaulting on their mortgages in mid-2007, and the cracks in the U.S. housing foundation became apparent. Floating interest rates (Indian teaser) will have similar results in India and this policy of having floating interest rate to attract borrowers will prove to be catastrophic in the end endangering the Banking sector in India. Manmohan Singh has promised bail-out to Banks (clandestinely) in case of default by the borrowers, but that is again at the expense of honest tax payers and so, that offer is against the people of India and so must be challenged. Opponents of such a proposal asserted that a government bailout of sub-prime borrowers is not in the best interests of the economy because it would simply set a bad precedent, create a moral hazard and worsen the speculation problem in the housing market. As it is, our experience of bailout for farmers is very clear.

In March 2007, the United States' sub-prime mortgage industry collapsed due to higher-than-expected home foreclosure rates, with more than 25 sub-prime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale. The stock of the country's largest sub-prime lender, New Century Financial, plunged 84% amid Justice Department investigations, before finally filing for ‘Chapter_11 bankruptcy’ on April 2.

Bill Gross, “the most reputable financial guru", sarcastically and ominously criticized the credit ratings of the mortgage-based CDOs now facing collapse; he says, “AAA? You were wooed, Mr. Moody's and Mr. Poor's, by the makeup, those six-inch hooker heels, and a "tramp stamp." Many of these good-looking girls are not high-class assets worth 100 cents on the dollar... The point is that there are hundreds of billions of dollars of this toxic waste... This problem [ultimately] resides in America's heartland, with millions and millions of overpriced homes".

Tramp stamp means those ads to attract borrowers for the housings; these ads are showing girls in attractive beats.

Hedge funds means reserve funds

The New York Times report connects the hedge fund crisis with lax lending standards: "The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or sub-prime, credit, leaving many of them struggling to stay in their homes."

The Federal Reserve Bank stated that the recent turmoil in the U.S. financial markets had raised the risk of an economic downturn. Since economic activity of one sector is irrevocably connected to all other economic activities; when one suffers it always has effect on other economic issues.

Sub-prime and Alt-A loans (liar's loans), including "stated income loans", which are loans made to home buyers without verification of their incomes; as homebuyers tend to overstate their incomes in order to obtain their desired loan amounts in order to purchase their dream homes, the term "liar's loans" is often used to describe them. This was due to over confidence in the capacity of an average American in paying back the credits, shown by various Banks, stems from a peculiar typical American ego (‘WE CAN, WE WILL’ of Barrack Obama).

Goldman Sachs and Bear Stearns, respectively the world's largest securities firm and largest underwriter of mortgage-backed securities in 2006, said in June 2007 that rising foreclosures had reduced their earnings and that the loss of billions from bad investments in the sub-prime market was imperiling the solvency of several hedge funds. In addition, a number of big commercial banks such as Citibank, and investment banks such as Merrill Lynch, announced significant write-offs against 3rd- and 4th-quarter 2007 earnings. As a result, Citigroup's Board of Directors ousted its CEO Charles Prince and replaced him with Vikram Pandit, a former Morgan Stanley executive and hedge-fund manager, and Merrill Lynch's Board of Directors replaced its CEO Stanley O'Neal with John Thain, an alumnus of Goldman Sachs and former CEO of NYSE Euronext. All this was eye wash to evade action from appropriate authority but it did not work. Mere changing persons from posts can not solve these problems; US government had realized it of late. Blunder was already done! No one person was to be blamed!

New York Senator and 2008 Democratic Presidential Candidate Hillary Rodham Clinton suggested that the government should set up a $5 billion fund to assist homeowners on the brink of losing their homes. Moreover, she argued that nationwide foreclosures would devastate communities and encourage crime in their neighborhoods.

On Jan 11, 2008, Democratic presidential contender Hillary Clinton proposed a $70 billion emergency spending package to help homeowners affected by the U.S. housing crisis. A potential conflict of interest was possible because Senator Hillary Clinton had received major contributions from the mortgage banking industry and her strategist Mark Penn had been linked to Countrywide Mortgage, one of the major sub-prime lenders.

Shiller, Robert, asserted that a taxpayer-funded bailout will merely assist real-estate speculators, irresponsible homebuyers and mortgage fraudsters. Some of the economists wondered if bail-out is actually exercised it will also mean that, the government could next, compel credit-card companies to freeze the introductory rates of zero per cent offered to credit-card debtors when debtors got into trouble paying their credit card bills; setting a vicious circle in motion.

Economic experts opined that only market-based solutions would eventually solve the current housing problem. Any non-market-based solutions would only set an artificial floor for housing prices across the nation. This clearly indicates that high risk premium on the part of Banks leads to definite gambling trends in the market.

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