Analysis: What Happened to the Housing Market?

In October 2004, the Snohomish (WA) County Business Journal featured MILA, an innovative mortgage lending company, as one of the fastest growing companies in Washington state. They were completing a $5 million renovation on new offices, preparing for 800 employees and their first $1 billion year. In September 2007, a moving van emptied the building of furniture, personal computers, and boardroom furniture. This completed the action taken in April 2007, during which all of the employees were laid off. The particular case is just a small blip on the casualty list of the subprime-mortgage lending crisis that has rocked the markets, dried up the liquidity in the housing industry, and led to what may amount to 120,000 layoffs in the U.S. industry.

Its effects even reach down to the person on the street. Joe Morse bought a 40-foot motor home, intending to drive around the country after selling his house near Los Angeles, California. He is still waiting for his house to sell after months on the market, according to an Associated Press story by Eileen Alt Powell on September 23, 2007.

Just as the “dot com” bust had an impact across the economy, so the subprime-lending crisis is having and will have a broad impact. The comparison is intentional.

For example, “investment bank Merrill Lynch & Co. said Friday credit and mortgage woes will lead it to post a third-quarter loss, as it takes almost $5 billion in writedowns in the wake of a credit crunch that paralyzed Wall Street this summer,” according to an October 7, 2007 Associated Press article by Stephen Bernard.

“The $5 billion writedown essentially erases more than half of Merrill Lynch’s net income during the prior 12 months. The credit problems have not been limited to just Merrill Lynch though — the world’s largest financial institutions collectively lost well more than $20 billion this summer as investors pulled back from all but the safest propositions,” Bernard added.

What has gone wrong?

It is not surprising to find a complex connection of players involved in such a meltdown. While there was isolated fraud in places throughout the system, much of the problem is a classic ethics failure of greed and pushing the boundaries in many places in the system of players that make up this industry. It will likely be followed by increased regulations, some return to sanity, and then a repeat of the picture that until recently looked so good it was hard to resist.

The following summary has been gathered from many published and unpublished sources.

The Problem

Players in the housing sector include the home buyer, the builder, the appraisers, the mortgage bank, the full service bank, and those Wall Street institutions, including hedge-fund managers who purchase packages of loans as investment. To explain the problem, let’s focus on these three: the home buyer, the lender, and the purchaser of security packages.

There are three kinds of home buyers. Prime borrowers are those who have good credit, have cash for a down payment, and are making a purchase that fits within their ability to pay. This has always been the largest segment of borrowers who receive loans. Once the loan is completed, the mortgage company packages groups of loans together, often in $10 million bundles, and sells them to investors. This provides the cash to make the next round of loans, and the profits that support the mortgage lending business. In fact, until recently, Wall Street had an insatiable appetite for such packages when other investments seemed less likely to produce high returns, inspiring the mortgage lenders to seek more borrowers.

New Kinds of Loans

But not everyone has a great credit score or a steady income. So this led to innovation in the type of loans that were offered in order to increase the pool of borrowers. The adjustable rate mortgage (ARM) has been around for awhile. It is often a bit lower at the front end, leading to initially smaller payments. Then came the interest-only loans, where the borrower would make only the interest payments, making no progress on paying off the principal. But anyone who has borrowed for a 30-year mortgage knows you don’t make a great deal more than interest payments initially, so payments are still out of range for many buyers. This led to a new kind of adjustable-rate mortgage, allowing an even smaller payment, with the unpaid interest adding to the principal. A starter rate of, say, 2 percent would be in effect for three years, and then the loan would rachet up to market rate.

People may bet on an increasing income in order to make the higher future payments.

There is nothing fundamentally wrong with such loans in the hands of a qualified borrower. Researchers at Columbia and New York University, showed that these loans may even be the best, according to a recent article by Peter Coy in Business Week (September 24, 2007). “The key, according to professors Tomasz Piskorski of Columbia Business School and Alexei Tchistyi of New York University’s Stern School of Business, is that this kind of mortgage is optimal only in a perfect world — namely, one in which borrowers are fully rational and always do what’s in their own best interest,” Coy wrote.

We don’t live in that world.

Adding Lenders to the Pool

Even these loan adjustments do not broaden the pool enough, bringing in the so called “non-prime” borrower, with less credit and inadequate cash flow. The lenders created an opportunity for no-money-down loans. Then a new offering was created called a “stated income” loan. For those with an uneven income stream (consultants, commission sales people, etc.) their ability to pay was judged on the borrower’s own assessment, without verification, of their likely income. These have been dubbed “liar’s loans” by some in the industry for obvious reasons.

Finally, credit was extended to the “subprime” group, those who would not qualify otherwise but who some would lend to at a higher rate of interest because of their poor credit scores. Buyers would be enticed into the market with the pitch that “buying is better than renting.” The lender justified the loans on the basis of the higher rates that could be charged, boosting the potential value of the loan package. And with housing appreciating in value, even if the loan was foreclosed, the lender could often make a profit from the appreciated value of the home when it was sold. Hedge funds purchased these packages of loans without really knowing what was in the package.

System Failure

But about two years ago, the default rates started to increase, particularly on the subprime loans. Adjustable rate mortgages started to adjust upward. Stated incomes didn’t meet expectation. And the housing prices stopped climbing. Wall Street decided these loan packages were no longer the hot item and stopped buying. The liquidity in the system just stopped. In fact, it “backed up.” The lending institutions could no longer sell their loans, and ran into cash-flow problems. Firms large and small went bankrupt. Others had huge layoffs.

Countrywide is one example. In an Associated Press article by Alex Veiga (September 15, 2007), the plight was described this way:

“Countrywide Financial Corp. grew from a two-man startup in 1969 to become the nation’s leading mortgage lender by deftly riding out housing boom-and-bust cycles. This time around, however, the ride has been a lot rougher, leaving the company in a scramble to regain its footing as the housing market has turned from boom to bust.

“To survive, it’s been forced to borrow billions of dollars, announce thousands of job cuts and dramatically restructure its lending practices to nearly eliminate risky subprime loans to borrowers with shaky credit that have led to massive foreclosures and defaults wracking the housing market.

“In a recent letter to employees announcing as many as 12,000 layoffs, he characterized the current housing market cycle as “the most severe in the contemporary history of our industry,”

Of course, there are still loans for people with good credit and down payments. But unless they are first-time buyers, they would have to sell their house before buying the next one. Government-backed loans through Fannie Mae and Freddie Mac are still available, but they are limited to $417,000. And there are full-service banks where they have access to the balances of checking account customers who don’t draw interest, so there is still capital in the system. The challenge is, with less capital available, fewer lenders working, the whole system is tightening to the point there is much less liquidity in the market.

The pressure for those in real estate and those building homes is also intense today.

The picture is very clear in hindsight. But interestingly, even Alan Greenspan, former U.S. Federal Reserve chairman for many years, acknowledged he didn’t see the problem coming. “While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I really didn’t get it until very late in 2005 and 2006,” he said in an article by Ann Davies, September 18, 2007 in the Sydney Morning Herald.

Finding Fault

Many can participate in the blame game. Wall Street aggressively bought loan packages without properly scrutinizing what was in them. Lenders pushed too hard for the extra dollars that would come from getting additional loans. Even conservative banks did not want to get left out of the “gold rush” and bought subprime lending institutions. Buyers pushed beyond their means or lied about their income, while lending institutions did not verify. Appraisers overstated the values of homes, sometimes in collusion with lenders, to justify a bigger loan. Speculators entered the market looking for a killing. Several sources mentioned condo sales in Florida made to buyers from New York who made their purchases over the phone without seeing the property. Pure speculation.

Roger Eigsti, retired chairman and CEO of SAFECO financial services, said, “Wall Street analysts overreacted as they often do, touting those companies with large real estate holdings one day, and then calling for a sell on these same companies the next.”

Next Steps

It is not as if we have never been here before, Eigsti said. The temptation is very strong on the up cycle, and people seem to forget that what goes up also comes down. “Now institutions will tighten credit standards, lay off employees, and increase their reserves for credit losses. Over the long run, this is a positive step economically for the banking industry, because they had become too lax. In the short run, many people and companies are hurt. I can almost guarantee that this cycle will repeat itself,” Eigsti said.

A wealth manager at a local brokerage firm said the whole scenario reminded him of the story that circulates in their industry:

A fish buyer buys the last case of canned sardines from a boat in the New York harbor for $50. An owner of a pizza parlor with a popular sardine pizza decides this box of sardines is so valuable he pays the first buyer $100 for the box. But then a gourmet restaurant owner buys the box for $200 for his menu leading “sardine salad.” Finally a wealthy society leader decides he needs sardines for his next party and pays $500 for the box.

When he prepares for the party and opens the first can of sardines he finds they are badly spoiled. He complains to the restaurant owner who complains to the pizza owner who complains to the fish buyer. But the fish buyer said, “You don’t understand. These weren’t eating sardines. These were trading sardines!”

Barry Horn, CEO of Liberty Financial Group, had this comment on the expected outcome: “There is going to be more regulation both from the state and the federal government. Some of the loans we have done in the past like ‘stated’ will probably be eliminated some day. There will certainly be more restrictions on our industry. This is a good thing and is certainly needed.”

Some states such as Nevada are in discussion over outlawing “stated income” loans. Froma Harrop, syndicated columnist from the Providence Journal called for “the federal government to tighten up consumer protection on home loans and to do away with overly confusing or abusive mortgages.” And then she reminded us to “enjoy a few years of thinking about our homes as homes” rather than financial instruments.

Unfortunately, another predictable next step is starting to emerge. Scams from organizations offering to “assist” people caught in pending foreclosures on their homes are just beginning to be reported.


This is all about housing. But it is also about greed and self discipline that can play itself out in any business. We need the right level of regulation, but this alone is not the answer since there will always be loopholes. It’s about having a purpose bigger than making money. And it is also about remembering a home is a place to live, not just a trading instrument.

Paulson Talks Tough on Housing, Subprime Bailout

Investors who made a bet on the subprime market and lost must deal with the consequences of their actions, Treasury Secretary Henry Paulson said Tuesday. In a speech at Georgetown University in Washington, Paulson said he has “no interest in bailing out lenders or property speculators. The ongoing housing correction is not ending as quickly as it might have appeared late last year, and it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet.” (RTTNews, October 16, 2007)