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Wednesday, March 19, 2008

A concise explanation of the credit crunch

David Leonhardt of The NYT has a clear article explaining the credit crunch: Can't Grasp Credit Crisis? Join the Club
It really started in 1998, when large numbers of people decided that real estate, which still hadn't recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she's going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia's boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates - even if they're disguised by low initial rates - and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.'s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody's Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people - by "people," I'm referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners - decided that the usual rules didn't apply because home prices nationwide had never fallen before.
And that's a faulty premise if there ever was one.

Home prices nationwide collapsed during the Great Depression.

Unfortunately only a few people know that: Some, because they remember their parents and grandparents talking about what happened then, others because they live in areas of the rust belt where housing prices never recovered after the steel industry left town.

When I lived in Convent Station housing prices plummeted when several of the major employers in the area (ATT, Henckles, Exxon, Allied Corporation) had major layoffs. Several homeowners defaulted on their mortagages.

I was working in real estate at the time, and several of my coworkers used to be amazed that I didn't "make" my customers overstretch themselves to the max. A lot of my coworkers' clients had overstretched themselves to the point where, once they closed on the houses they bought, they had zero money left to furnish the place.

Then those homeowners got laid off. Their houses (which had furniture only in the bedrooms, a table and chair in the kitchen, and a sofa and TV in the family room), when shown to prospective sellers, spelled one word in big neon letters:
D-E-S-P-E-R-A-T-I-O-N

They sold at a loss. Some of them defaulted.

But, as the article says, many people live under the illussion that house prices don't come down:
Based on that idea, prices rose ever higher - so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn't spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. That's why a hedge fund associated with the prestigious Carlyle Group collapsed last week.
After seeing what happened in Morris County in the late 1980s, here's what I would advise anyone buying a house:
Don't think of your home as a speculative instrument; instead think of it as a secure roof over your head.

Since it's not a speculative instrument, get a traditional mortgage. If you get a fixed-rate 15 yr mortgage and live in the house for only 5 years because you need to relocate, you have not subjected yourself to mortgage rate fluctuations and you are not dependent on real estate values appreciating in order to recover your investment. If you live 15 years in that house, you own the house free and clear. Real estate values may fluctuate but you won't be losing your house.

The Husband and I have been extremely conservative and have bought the houses we have lived in where the mortgage payments could be met by only one salary - the lesser salary. This is because throughout the course of our carreers we have been laid off and we didn't want to have to worry about "where is the mortgage money" coming from if one employer went bust.

Your job is secure, you say? Then think about the effect the loss of your spouse's income, or a devastating illness (on yourself) would have on your ability to pay those bills.

As to thinking that real estate prices can not come down, or that big profits do not come from big risks, reality's biting now.
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3 Comments:

At 5:12 PM, Blogger Dale B said...

I'm with you on this. A house is a place to live. If you want to play with investment property, go ahead but do it with something other than where you live.

People tell me "You must be thrilled that your house is now worth $300k when you only paid $60k." It doesn't matter what it's worth now. If I sold it I'd still have to live somewhere and if I bought a similar house it would cost just as much as I received for my current house.

If I downsize in the future and buy a cheaper house I'll gladly take the gain. Until that happens the paper gain is just that, paper.

That's why a sensible person does not include the equity (let alone the market value) of their house in their net worth calculations. You have to live somewhere and wherever that is, it will cost money.

 
At 5:27 PM, Blogger Fausta said...

Until that happens the paper gain is just that, paper
And until the gain is realized, not even worth the paper it's written on.

 
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