Why do those who cannot afford their mortgages have the potential to bring down the entire economy?
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Why isn't the crisis just limited to the borrowers, banks and those associated with the real estate market?
The answer to these questions is two-fold: a crisis on Main Street and another much larger crisis on Wall Street. Not since the savings and loan debacle of the 1980s has unregulated capitalism had so much potential for economic chaos.
On the surface, the lending crisis is due to easy credit. Lenders were too lenient on loan qualifications and borrowers too willing to accept escalating loan payments. It all started when easy credit fostered a boom in the real estate market.
In some communities, housing prices were increasing 50 percent a year. Soon the overheated markets became clear when it became cheaper to rent than buy. But even these excesses could be wrung out with a normal market correction. Unfortunately the crisis ran much deeper - the result of deliberate and accelerated lending to sub-prime borrowers. These marginal borrowers were used to prolong the housing boom.
Sub-prime loans represented only 1 percent of the market in the 1990s. By 2001 sub-prime loans had increased to 10 percent and by 2005 were 40 percent of the mortgage market. A perfect storm was in the making as the whole notion of affordability was overlooked and other routine economic factors worked against the housing market.
Federal interest rates were increased to primarily combat inflation and to attract foreign capital. The rate hikes, however, also increased the costs of all mortgages and the overheated market began to stall on many fronts. Many new home owners found that they could no longer afford their homes - especially those with variable interest loans. Today, nearly three-quarters of a million homeowners have filed pre-foreclosures. Housing starts are at a 14-year low and repossessed homes add to the glut of homes for sale.
On Main Street, the trickle down effect is straight forward. There is a lower demand for all those making their living from real estate, for example, home builders, suppliers, architects, interior designers, furniture makers, bankers, real estate agents, insurance agents, etc. Since these folks make less money, their spending in retail trade and services is reduced. In turn, lower incomes in retail trade and services further depresses overall consumer spending.
Lower incomes throughout the economy mean lower tax revenues and fewer public services. Nevertheless, if the credit crisis were limited to Main Street, house prices would fall by about 10 to 15 percent and become flat for years to come. But the credit crisis does not end on Main Street.
The real crisis is on Wall Street, and that contagion has shot across the world, from mortgage companies in Los Angeles to banks in Seattle, from hedge funds in Australia to the European Central Bank. Why? Because many financial institutions purchase and use home mortgages to borrow additional money, called mortgage-backed securities. This is a long-standing practice with normally acceptable risks.
This time, however, the underlying assets were laced with sub-prime mortgages. The risky borrowing could only be sustained if Main Street kept paying their mortgages. But, they did not. Consequently, billions of dollars in mortgaged-based securities became worthless almost overnight. In a downward spiral, stock markets around the world lost $3 trillion in value in just one month. The panic spread to other Wall Street borrowing not involved with sub-prime loans - the so-called "liquidity crisis."
But again, how did we get here?
The current crisis was not due to deregulation like the saving and loan debacle. No, my theory is that easy credit worked because it made Main Street feel good. It was our economic crack cocaine to finance two wars and simultaneously provide tax cuts for the wealthy. How else could we ignore record federal and trade deficits, and a steeply falling U.S. dollar? So now, even if we decide to inflate our way out of this mess, the next two generations can expect a lower standard of living to pay for their share of our easy credit. That is how we got here!
Joe Mehrkens is a retired resource economist and resident of Auke Bay.