Economic Collapse of 2007-8

Economic Collapse of 2007-8

It is common practice in 2013 for the general public to be angry at the nation's largest banks for being the primary cause of the housing mortgage economic collapse from which the United States still has not recovered. That answer is only partially true.

Obtaining a loan to buy a home in America today is highly impacted by a long history of events, regulations, deregulation, tax structures, formation of Freddie Mac and Fannie Mae, and a myriad of other decisions made over 80 plus years.

Consider just one factor that is a current topic of discussion across the country; home mortgage interest tax deductions. Did you ever wonder why we have such a deduction? What is the impact on the nation's home buyers, home construction industry, federal income from tax impacts, and the price of homes? What would happen if that interest deduction were to be removed?

For decades there have been many efforts at the federal level to make home ownership more possible for more people, especially those at the lower income levels. Both conservative and liberal presidents have made it part of their policy to do what they could to make home ownership available to more citizens. Part of the logic is when a home is built that home has to be stocked with curtains, carpets, furniture, appliances, and landscaping, all creating more jobs. This may be true but it all falls under the category of Social Engineering.

I have a theory that I've long held which has yet to be unproven. That is the larger the social engineering project the longer it will take to fail, but it will fail. On a large scale Communism is an example. On a smaller scale Rent Control fails. Social Security and Medicare were great ideas at the time which have been massaged to the point where the country can't afford either of them and both are set to collapse in the decades soon to come. Sadly Obamacare is another large federal program that is just starting and will take a few decades to completely collapse on it's own. However Obamacare isn't starting in a vacuum, it is joining the already doomed Social Security and Medicare system so it is likely to crash much sooner than those other programs.

The home mortgage interest deduction was put in place to give the home purchaser a tax break so the cost of owning a home would be reduced. Most think it works fine but in fact it didn't work at all. Consider this. If the tax break were removed people would have less money to apply to paying their mortgage payments. They would have to factor that reduction of spendable cash when they purchased a home and would likely have to seek homes with lower selling prices. In other words if you were a seller you might have to lower your asking price to find buyers with enough money to buy your home. The reverse was true many years ago.

When the interest on a home mortgage was made a tax deduction people could afford a home with a higher asking price. Home prices went up because sellers could find more buyers with enough money to buy the home.

The bottom line is nobody was helped by the mortgage interest tax deduction except the very first people that were able to take advantage of it before home prices rose. All who owned a home during those days were given a gift because their home ownership costs went down, and when they sold those homes they received a bonus because prices went up. A gift from the federal government. Today the only people that will be hurt are all of those that own homes and pay a mortgage.

If you own a home today and the tax deduction were taken away you would be hurt in two ways. First your mortgage would essentially cost you more, and second the value of your home would drop so if you sold it you would receive less. This is too painful so if this deduction were to be legislated away it would likely be done in such a way as to minimize the impact on current home owners. But eventually everyone would pay one way or another. Eventually the price of all homes would drop by a small percentage making homes more affordable for everyone. In other words the social engineering would have accomplished nothing but heartache for today's home owners.

So what we've had is elevated home prices since the interest deduction was put into place. It is artificial and was partially to blame for the economic collapse.

Consider to the impact of lost federal income during those past decades. What we'd really like is for the federal government to spend less and not raise taxes. If all of these decades had passed without the interest deduction the federal government would have had more income to cover expenses, or sadly they may have increased spending. We'll never know.

The interest deduction isn't the only way the federal government was partially to blame for the economic collapse. They regulated banks and set standards for how large a loan the banks could loan for a given home shopper's income. More than once of the past few decades the federal government relaxed the standards so consumers with lower incomes could qualify for loans. This added risk to the mortgage industry. Make no mistake about it the federal government is intricately involved with this mess and some would say were the primary cause of the recent collapse.

Now the biggest factor is the formation of the federally backed home mortgage loan purchasers we call Fannie Mae and Freddie Mac. Those two financial firms exist to buy loans from banks so the banks can then go out and sell more loans. It is rare for any large bank to carry a home loan for the term of the loan. Most times before you make your second or third loan payment you find out that your loan has been sold. Banks make money through the fees they charge during the home purchase process, then make a little more when they sell the loan.

Just think of yourself as a bank president. You are free to make home loans, even if they are a bit risky and the home purchaser is going to be squeezed making the monthly payments. You are pretty comfortable with this because you don't have to take the risk. You will be selling the loan to Freddie Mac or Fannie Mae pretty soon and those organizations will take the risk. But what of those organizations, aren't they taking a big risk? No because the federal government guarantees they will take tax payers money to prop up Fannie Mae and Freddie Mac should anything happen. It did happen and the federal government poured billions of dollars into propping them up. Your money, to pay for bad loans, sold by banks that were encouraged to lower their credit standards, which were then picked up by Freddie Mac and Fannie Mae. Let's bring this down to a personal example.

You loan money to a cousin who is known not to be good with their finances. But the federal government encouraged you to make the loan because it would be good for your cousin and, even though he is a credit risk, the government wants to help him along. But the feds don't want you to bear any risk either so they set up a bank who will buy that risky loan from you. You get to keep the down payment your cousin gave you at the start of the loan, and the feds will actually give you a little cash when they take over the loan from you. If your cousin doesn't pay then the feds will give money to the bank they set up. Everybody wins right? Well your cousin's situation didn't change much; he's still bad with money. The bank is good because they really can't lose. You made out with a little profit and you really didn't have to take any risks. It's the tax payers who get the shaft but hey it's for the good of the country.

Now in the middle of all of this some good does come out of it. Homes are built, furniture is purchased, drapes and rugs are manufactured and bought, landscaping employs many. Jobs are created. Well maybe. None of this changed the rate of population growth in America. The population of the country would grow at a similar rate with or without housing controls. If people couldn't afford to buy homes they would rent. They would still buy furniture, landlords would still buy curtains and carpets. So some job impact would have increased but you have to be careful with those figures.

Have you heard of Credit Default Swaps (CDS). In the early days of the economic crash that term was heard over the air and on the internet often. What was that all about. Well when a loan was being carried a bank or Freddie and Fannie they could buy insurance in case the home buyer couldn't pay the loan back. That insurance is called Credit Default insurance. A Credit Default Swap is when a third party takes the risk away from the bank "swapping' the risk for payments. To make things even more abstract those CDSs could be sold, which isn't too bad, or the entity playing insurance company for the bank could themselves take out more insurance. The story is if an insurance company is someday going to have to pay off a loan they are very unlikely to have widespread loan losses and will make a lot of money. The only way they would lose is if there is a widespread mortgage loan system failure (sound familiar).

Credit Default Swaps were pretty much unregulated. There was a lot of money to be made as long as the mortgage industry was holding together. Banks took risky loans, sold them to Freddie Mac and Fannie Mae who really didn't know how bad the loans were, then the CDS groups guaranteed those loans. One really bad thing about CDSs is they produce nothing; no product and few jobs. They weren't illegal, and still aren't.

Sure some banks that were selling loans to home buyers were pushing the limits. Some were even knowingly blowing through the regulations. That's why the banks are being blamed for the mess. But those banks that were honest and sticking to the regulations were still selling loans to risky home buyers because they were being encouraged to do so. In fact they were even being forced to do so based on the proof that low income people were being redlined not to get loans. So the federal government actually made regulations about how many low income (read risky) loans a bank had to make.

Let's not leave out one more entity in this mess. The home buyer. I'll give them a lot of slack because the vast majority didn't see the risks in the system and were going along with the crowd. Most Realtors certainly weren't going to push buyers away by telling them there was too much risk in them taking these loans. Gratefully there are some Realtors out there who do work for the best for their clients. But most just want the sale and the check that goes with it. Escrow companies are not at all tasked with making sure the borrower can afford the loan. The banks aren't going to spend too much time telling their customers not to take the loan. The poor home buyer is being dragged along unknowingly adding to the risk of an economic collapse.

There used to be a general rule about how much family income could be applied to mortgage payments. It was something along the lines of 30 to 35% of the income, above that banks would tend not to make the loan. Then the credit rules were relaxed and people could apply 50% of their income to the home mortgage payments. From the 1940's up to today a major shift occurred. That being a shift from a single income per family to dual income. Wives went to work. Now the risk was dramatically increased but that factor was ignored too. If one member lost their job the second income rarely could cover the cost of living including that high mortgage payment.

A downward spiral began. Banks were in trouble, the federal government was pouring billions of dollars into banks, Freddie and Fannie, and trying to prop up the economy with stimulus money. Everyone was nervous. People stopped spending as much as they were before. People were laid off, salaries were cut, homes were lost, banks were in more trouble, the federal government tried even harder to prop things up. Federal debt and defect soared. The country was in economic crash territory.

Some believe that the price of a new home is set by the underlying costs plus some profit for the builder. That is simply not true. The cost of the land under the house is established by the value to the purchaser, the price for living in that area. The cost of the home on the land is what people are willing to pay for it. It has very little to do with the cost of the materials or labor to build the house.

In 2007 the house adjacent to ours went on the market for near $1M. The cost of the materials and labor to rebuild that house that day, should the house burn to the ground, would have been closer to $400,000. The house was valued way beyond the replacement cost because someone wanted to live there, and banks were willing to loan the money for them to buy it. Today that house can be purchased for under $350,000, less than the replacement cost.

It is important to judge the value of a home based on it's replacement cost. If replacement cost is higher than the asking price it may very well be a good investment, depending on the direction of the economy. If the home is priced at 2 or 3 or 4 times the replacement cost you would do well to consider passing it up. The bubble can only last so long.

Who's to blame? The federal government, banks, home buyers, Realtors, Credit Default Swaps, risk takers at all levels, and certainly some who were clearly doing illegal things for their own gain. Who's to blame? Pretty much everybody.

How do we recover? Well I have my ideas but we haven't recovered yet and under the current situation we aren't likely to recover any time soon, several decades at least. In my estimation we will have to lower our standard of living, and I do believe we will have to suffer through deflation before we can recover. I expect our decades long attempts at social engineering will completely backfire and millions will be jobless in spite of all of the efforts to the contrary. A long period similar to the great depression is ahead in America. Sad but I believe it to be true.

Do a quick check on the internet. Search for "Banks relax mortgage requirements" and you'll see as recent as the end of 2013 this is still going on. Have we learned anything yet?

How can you protect yourself? Live well below your means. Downsize if need be. Pay off your mortgage if you can. Be prudent about your investments. Consider having a portion of your portfolio invested overseas. Stay away from precious metals like gold that just won't be the protection that gold sellers want you to think they will be. Don't go into debt if you can help it. Keep the old car longer. Make sure your children have a good education. One of the best ways you can help the overall economy is to buy stock in American companies so they can grow and compete. Federal bonds don't pay enough today. Soon they will start to pay more and you can use them as investments but eventually the U.S. bond rating will fall and you should get out of federal investing of any kind.

Check out these references:

·        - 1933 under President Franklin D. Roosevelt the Home Owner's Loan Corporation was established.

·       -   Under President Jimmy CArter The Community Reinvestment Act (CRA, Pub.L. 95–128, title VIII of the Housing and Community Development Act of 1977 was established

·         

      - The effort to reduce mortgage lending standards was led by the Department of Housing and Urban Development through the 1994 National Homeownership Strategy, published at the request of President Clinton.

·         - Fannie Mae — the Federal National Mortgage Association — was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac, which does pretty much the same thing, now finance most of the home loans being made in America.