Credit: Jean-Francois Martin
From the 1940s until very recently, U.S. housing policy consisted of two words: more homeowners. Everything from highway construction to taxation revolved around that goal. And the results were spectacular, as ownership rates went from 62.1 percent in 1960 to a peak of 69 percent in 2004. Equally spectacular—but with dire consequences—was how the “American Dream” mutated into “America’s Piggybank” and then “America’s Nightmare” within the last decade.
During this period of excess, buyers agreed to—or were duped into—home purchases their incomes couldn’t afford, and owners used those homes like ATMs to perpetuate more lavish lifestyles. Builders and developers interpreted demographic data—particularly about Hispanic buyers—in ludicrously optimistic ways to justify their expansion ambitions. Mortgage companies sank their underwriting standards to new depths. And, inevitably, investors pounced on opportunities to exploit a thriving market, even as they ignored the quicksand upon which that market had been constructed.
That few people expected home prices to ever come down, or gave much thought to what that descent could mean for the debt-inundated economy, speaks to how lawmakers, analysts, and the general public simply took housing and mortgage lending for granted. This “failure of imagination,” as Dean Johnson, chief economist of Comerica Bank in Dallas, calls the current housing and credit crises, led to a financial meltdown of global proportions. And America’s now-struggling housing industry—which one economist calls a “hapless participant” in the economy’s spiral—finds its pleas for help mostly falling on deaf ears of government officials, lenders, and investors who have convinced themselves that other sectors of the economy—financial institutions, auto makers, credit-card providers—are more worthy of rescuing.
That meltdown laid bare an economy that’s been manipulated by financial instruments whose complexities outran regulatory restraints. It also undermined confidence in free-market capitalism and the expertise of lenders, brokers, economists, the media, elected officials, and appointed regulators, who seemed clueless as they lurched from “solution” to “solution.” Restoring that confidence is critical to the economy’s recovery, but it won’t be easy in an environment of rising unemployment and tighter credit.
The following special report examines the root causes of the country’s malaise and offers suggestions about how it might play out. One scenario foresees a more cautious housing industry with as few as half the builders it has now (which to some observers is precisely what big builders want to happen). But what lessons will be learned from all this turmoil? That dramatic and potentially disastrous financial cycles are simply inevitable? Or that a better way might be conceivable through a responsible and coordinated application of planning, rules, and guidelines that isn’t motivated solely by self-interest.
Wall Street
Greed Isn’t So Good Securitizing mortgages separated the risk of lending from lenders.
Credit: Jean-Francois Martin
EFFECT: When the housing and credit markets collapsed, they took down Wall Street with them. Millions of working Americans watched helplessly as the value of equities in retirement plans dropped by $3.8 trillion, or 24 percent, during the 12-month period that ended Oct. 9, 2008, according to the Center for Retirement Research at Boston College. Those collapses undermined the credibility of the entire financial investment system and fomented a “psychological crisis” among consumers and bankers that brought the country’s economic growth to a screeching halt, observes Bill Hudnut, an Urban Land Institute fellow and the former mayor of Indianapolis. “What’s going on now is the consequence of a whole slew of government policies that incentivized people to act out of self interest,” says economist Bert Ely. And, as the government was forced to step in to bail out banks and brokerages, Wall Street became “a subsidiary of Pennsylvania Avenue and Capitol Hill,” says Irwin Stelzer, director of economic policy for the Hudson Institute.
RESPONSE: The credit crisis spread worldwide, and it’s been estimated that banks would write off up to $1.4 trillion in assets by the end of 2008. Distressed builders have charged off billions of dollars to cover massive impairments for land and homes that they liquidated at significant discounts. Stelzer foresees the emergence of a “new capitalism,” distinguished by a reduction in the willingness of individuals and politicians to accept risks inherent in a market-based system; a turning away from a bias that once favored deregulation; a refusal to accept without question the market’s verdict on how income and the fruits of economic growth are distributed; a rejection of the idea that the benefits of free trade are obvious; and the insistence that the balance between considerations of economic efficiency and equity be changed in favor of equity.
THE FUTURE: It could be quite a while before Wall Street finds its legs again, especially since it’s impossible to predict how long the financial markets will need propping up by the federal government. It’s also hard to predict what “Wall Street” will actually be comprised of, once the dust settles. The same is true about a housing sector whose products continue to define the relative wealth of its customers, for better or worse. “You could see a much diminished housing industry” as a result of the financial upheaval, says Ron Terwilliger, CEO of Trammell Crow Residential. But he doesn’t think the habits of surviving builders will change much. “Memories are never that long.”
Mortgage Lending
See No Evil Predatory lenders leave buyers holding the bag when home values plummet.
Credit: Jean-Francois Martin
EFFECT: The $700 billion federal bailout of the credit markets effectively blew up the country’s private investment banking system and left the FHA, for the time being at least, as the only consistent—if badly undermanned—source of mortgage capital. “Banks end up picking up the cost for the excessive practices of the few, and with IndyMac, that cost was nearly $9 billion,” laments James Chessen, chief economist of the American Bankers Association. The Office of Thrift Supervision estimated that the savings and loan industry lost $9.4 billion in the second and third quarters of 2008 and had allocated $7.9 billion in the third quarter for future loan losses. An avalanche of foreclosures—RealtyTrac estimates that 936,439 homes went into foreclosure from when the housing crisis first hit in August 2007 through October 2008; the Mortgage Bankers Association adds that foreclosure proceedings were initiated on 2.2 million homes in 2008—continues to destabilize home and mortgage values.
RESPONSE: The bailout’s Troubled Asset Relief Program, or TARP, through which the government agreed to buy mortgages and other assets from financial institutions, got banks to lend among themselves again. But it did little to unfreeze consumer credit markets or resolve how to renegotiate the estimated $2 trillion of toxic mortgages that were securitized. Since Congress okayed the bailout, the Treasury has altered it several times, first by injecting capital directly in banks in exchange for an ownership stake, and then by coming to the aid of companies that issue credit cards, make student loans, and finance auto purchases. Meanwhile, economists and regulators became more vocal in calling on lenders to maintain higher capital levels and on borrowers to make higher down payments. (Several sources contacted agree with former Treasury Secretary Paul O’Neill, who posits that no mortgage should be written without 20 percent down, regardless of how many buyers are pushed out of the market.)
Various programs designed to modify non-securitized loans emerged from banks, as well as Fannie Mae and Freddie Mac, which held or guaranteed more than two-fifths of the $12.1 trillion in residential mortgage debt outstanding through the second quarter of 2008. Most of these plans are modeled on FDIC’s loan-modification pilot program, which it developed as conservator of IndyMac. Despite the Treasury’s resistance to using bailout money to stem foreclosures, FDIC chairman Sheila Bair in mid-November pushed for a broader, $24.4 billion plan (see chart, left) that would reduce mortgage payments to 31 percent of an owner’s monthly income, set interest rates as low as 3 percent, and extend loan terms to 40 years. Bair estimated that the plan could help 2.2 million borrowers get new loans and keep 1.5 million homes out of foreclosure. But would any of these programs make a real dent when Moody’s Economy.com was projecting that 8.5 million homeowners might default on their mortgages between 2008 and 2010, and that roughly 5.2 million of them could lose their homes?
THE FUTURE: In late November, the government announced two more bailout programs that included $600 billion to buy debt and mortgage-backed securities from Fannie, Freddie, and Ginnie Mae. The government also drew from TARP to bail out Citigroup with a $20 billion loan and a guarantee to absorb up to 90 percent of the bank’s losses on toxic mortgages. Then, in early December, the Treasury reportedly was discussing with Fannie and Freddie a plan to drive down interest rates for new-home buyers to 4.5 percent. But Jerry Howard, CEO of the NAHB, observes that mortgage lending right now “can’t be left to the private sector.” He also says the housing finance system beyond Fannie and Freddie “is what needs to be fixed next.” But there are still more questions than answers about where mortgage banking is headed: What is the Treasury’s exit strategy from this mess? What will happen to the secondary mortgage market if, as some have proposed, the government-sponsored enterprises stop being public utilities? FHA requires borrowers to put down at least 3.5 percent to buy a house, but if home prices drop another 10 percent this year (as many housing watchers expect), won’t those mortgages be underwater?
So far, the various programs to keep people in their homes have been only modestly effective. HUD’s outgoing secretary, Steve Preston, noted in November that the Hope for Homeowners program had received only 111 applications for assistance since its introduction on Oct. 1, and the FHASecure program had helped only 4,000 delinquent borrowers. The federal government’s Hope Now Alliance reported that, despite increased loan modification efforts, 180,000 more homes entered the foreclosure process in October. There’s also a growing consensus that regulatory reform of the banking system “needs to bring more companies under the federal umbrella and regulate them based on product type, regardless of charter,” says Scott Polakoff, COO of the Office of Thrift Supervision. Martin Regalia, chief economist with the U.S. Chamber of Commerce, adds that reform must ensure that all transactions are backed by more capital resources; seamless regulation “that doesn’t have gaps in it”; more transparency among lenders and borrowers, and data sharing among regulators; and “a recognition that the [banking] system is worldwide.”
Federal Reserve and Treasury Department
Who’s Minding the Store? The Fed’s light oversight let financial institutions run amok.
CAUSE: Former Federal Reserve chairman Alan Greenspan’s mea culpa for his unrequited trust in the self-regulating powers of capitalism only confirmed the bumbling image of the Fed that its critics have long held. “A cheerleader for imprudence,” is what James Grant, the publisher of the influential Grant’s Interest Rate Observer, called Greenspan. “A source of instability” is economist Bert Ely’s take on the Fed. By lowering the federal fund rate 13 times, from 6.5 percent to 1 percent between January 2001 and June 2003, the Fed provided the impetus that drove lenders to sell as many mortgages as possible that could be packaged for resale to investors searching for the next big score after the dotcom meltdown. “The central bank has lurched from one mistake to another,” Martin Hutchinson of BreakingViews.com wrote in TheNew York Times. He blames the Fed’s “dual, and structurally contradictory, mandate: Fight inflation and preserve full employment.”
EFFECT: The Fed and the Treasury Department, acting in tandem, reacted to a viral credit crisis frenetically. They aggressively provided liquidity to prop up certain financial entities, such as the giant insurer AIG, and encouraged consolidation of the banking and financial services industries. But their decision to let Lehman Brothers fail is generally seen by economists as a major mistake that further eroded confidence about and within the global financial system. To stave off their own demise, bastions of free enterprise such as Goldman Sachs, Morgan Stanley, and American Express agreed to change their identities to bank holding companies and submit their operations and practices to the Fed’s presumably tougher regulatory scrutiny in exchange for gaining access to the Fed’s borrowing programs. For Goldman and Morgan, that transformation required them to beef up their debt-to-capital ratios to 10 to 1, from 24 to 1 when they fell under the umbrella of the Securities and Exchange Commission.
RESPONSE: The Fed and Treasury bit the bullet last September and proposed an $850 billion emergency rescue package (which included the loans to AIG). That plan increased the assets on the federal government’s books—as defined by its “reserve bank credit”—136 percent to $2.198 trillion for the week ended Nov. 12, or the equivalent of 15.4 percent of total gross domestic product (GDP) in the second quarter of 2008. But the bailout, which the Treasury and the Fed sold to Congress as a way to stabilize the financial sector by using $700 billion to purchase toxic mortgage-based securities, quickly changed stripes and became a plan to recapitalize banks to free up credit. (The Treasury at first purchased $125 billion in stock from nine banks, and then, in late November, distributed $33.56 billion more to 21 other lenders.) Critics justifiably wondered if Treasury Secretary Henry Paulson knew what he was doing when he admitted that buying mortgage assets was not the most effective way to use government money, and in mid-November redirected the bailout again to spur consumer spending. His maneuvers rankled builders, who felt more abandoned than rescued as Paulson made it clear the Treasury wouldn’t use bailout money to prevent foreclosures.
THE FUTURE: The Fed was still putting out fires in November and December, when it infused AIG with another $37.8 billion; bailed out Citigroup by injecting $20 billion into that bank and guaranteeing $306 billion of its troubled loans from losses; and lent $200 billion to investors holding small-business and consumer loans. As November ended, the government had guaranteed nearly $8 trillion in investments, deposits, and loans, and had spent $1.4 trillion, according to estimates by TheNew York Times. Fed chairman Ben Bernanke called for newer, less risky forms of government-sponsored underwriting. Others talked about reducing regulatory overlap (banks now answer to the Fed, FDIC, and the Comptroller of the Currency). Indeed, the housing and credit crises could serve as opportunities for the next president to rethink the Fed’s future role. Alice Rivlin of the Brookings Institution believes the Fed “need[s] to be more creative about curbing asset bubbles.” Grant wants the Fed to fight inflation and dollar depreciation, period. But former Fed chief Paul Volcker, one of President-elect Barack Obama’s economic advisors, wants the government to pump more money into infrastructure. What shouldn’t happen, says James Chessen, the American Bankers Association’s economist, is for turmoil to lead to “inundating” all banks with more regulation in the name of safeguarding the economy.
AD&C Loans
Snapping the Credit Line Banks lose faith in builders as partners, and vice versa.
Credit: Jean-Francois Martin
EFFECT: The deterioration in the credit markets fractured long-time relationships between builders and banks as lenders effectively shut off access to AD&C loans and in several cases discontinued credit lines even to builders that were current on payments. In late November, the NAHB complained that builders were being forced to halt construction and were losing sales as a result of failed banks being taken over by FDIC. The Florida HBA held a statewide news conference to decry what it saw as draconian measures by lenders that were driving builders to the brink of bankruptcy or liquidation. Trammell Crow Residential’s CEO Ron Terwilliger says his company is being asked to put up 35 percent equity for its rental projects. “The borrowing spreads also have widened to 300 basis points” from 150 points before the meltdown. In many cases, the banks have had little choice. “Some of our members are feeling pressure from bank assessors [to clean up their balance sheets], especially on construction and real estate loans,” says Ann Grochala, vice president of lending and accounting policy for the Independent Community Bankers of America. This lack of credit left many builders wondering if they could get through the winter months intact.
RESPONSE: There was growing evidence that more banks were pulling away from offering AD&C loans. For example, Dallas-based Comerica reduced its portfolio with California builders to $625 million as of Sept. 30, 2008 from $925 million on Dec. 31, 2007. “Right now, I don’t have the capital or risk-return opportunities that I had a year ago,” says R. Bird Anderson, a senior vice president with Wachovia, which itself needed a life raft to stay afloat by being acquired by Wells Fargo. Anderson noted in November that while banks’ exposure to AD&C loans was down 20 percent from the peak in 2007, the housing market itself was down 40 percent to 50 percent, so reducing that exposure further “could have a ways to go.” Any project loans Wachovia did transact were structured to require more equity and to weigh risk more carefully. Some builders looked to tap into new cash streams, recognizing that private equity money has more strings attached to it.
THE FUTURE: “It is incumbent on borrowers to realize that the way loans were written 12 to 24 months ago is never going to return,” warns Scott Polakoff, COO of the Office of Thrift Supervision. Still, he recommends that builders maintain “an open dialogue” with banks, even if they’ve been cut off, because “this will turn around.” But don’t expect banks to start writing checks any time soon, says Dana Johnson, Comerica’s chief economist. “Time has to pass, and markets have to clear. Our lending standards will stay high until we see evidence that the economy is getting better.”
Consumption vs. Savings
Beyond Their Means Debt gives Americans a false sense of prosperity.
Credit: Jean-Francois Martin
EFFECT: People stopped buying; companies laid off workers. The U.S. lost 1.9 million jobs in 2008 through November, when the unemployment rate rose to 6.7 percent. The four-week average for first-time claims for unemployment insurance rose to 524,500 during the week of Nov. 22, the highest number in 26 years, according to Labor Department estimates. The fear of losing one’s job further froze consumer spending to the point where home builders simply could not induce buyers to come off the sidelines with pricing that, in several markets, had fallen below construction costs. And businesses directly impacted by the housing and credit crises—such as Circuit City, Linens ’n Things, and Stock Building Supply—faltered. Auto makers that, in recent years, had become symbols of America’s declines in unionism, manufacturing, and innovation, teetered on the brink of bankruptcy and were begging for a federal handout.
RESPONSE: The federal government’s attempt to jump-start the economy by giving 130 million taxpayers $120 billion in rebates last spring did little to halt the downturn. Even home-purchase borrowing rates dropping below 5 percent in early December provided little stimulus. Consumer spending wouldn’t get cheaper, though, as the credit-card companies raised their interest rates and lowered consumers’ spending limits. Treasury Secretary Henry Paulson shifted the emphasis of the federal bailout toward consumers on Nov. 12, when he stated that his department was turning away from purchasing mortgage-backed securities and toward helping nonbank financial institutions and consumer finance companies. By the end of the month, the government had invested $200 billion more into its Term Asset-Backed Loan Facility, which lends money to investors holding securities backed by consumer- and small-business debt, hoping they’d reopen their spigot.
THE FUTURE: Is the age of conspicuous consumption finally coming to an end? At the least, Americans will need to make do with less, as banks—which might need to write off as much as 10 percent of their credit-card debt in 2009, according to estimates by the research firm Inovest Strategic Value Advisors—lick their wounds and tighten their credit requirements. Home values will eventually settle at levels substantially below what the same houses were worth only a few years ago. In October, consumer spending fell by 1 percent, the largest decline since 2001. But will consumers see the long-term virtue in saving? Home builders can only hope so, because coming up with a down payment “is still the largest barrier to homeownership,” says the NAHB chief executive Jerry Howard. And a financial behaviors index, which the financial services firm First Command Financial started publishing last February and bases on its polling of 1,000 households, found an unexpected rise in consumer thrift in September, where a typical family had saved $901 and paid down $1,010 in debt that month. “Americans are realizing that a long-term view is necessary,” says First Command’s CEO Scott Spiker.
Tax Policy
Tapped Out Cash-strapped states can’t rely on housing-related revenue as they once did.
Credit: Jean-Francois Martin
EFFECT: As president, Barack Obama must craft a tax policy that grapples with a $10.3 trillion debt (nearly $3 trillion of which is owed to foreign investors and banks), and a budget deficit in 2009 that is projected to exceed $1 trillion, substantially more than double last year’s deficit. The federal government is also likely to be called upon to provide more assistance to state governments, at least 41 of which will struggle with budget deficits this fiscal year or next, according to the Center for Budget & Tax Priorities. The budget gap in New York alone for fiscal 2009–2010 is projected to hit $11.2 billion without revenue gains or spending cuts. In early December, California’s Gov. Arnold Schwarzenegger declared a fiscal emergency for his state to close a budget gap projected to grow to $28 billion over the next 18 months. Tax credits for affordable housing projects are also drying up in places such as New York City.
RESPONSE: As of late November, President-elect Obama’s economic team reportedly was putting together a stimulus package that contains more than $500 billion in federal spending and tax cuts over the next two years, with the primary goal of creating 2.5 million jobs during that period. But Obama has also laid out an ambitious—and potentially expensive—agenda for his first term that includes expanding health care and spending $15 billion per year on developing alternative energy sources. Obama sees massive investment in infrastructure construction and repair as the clearest path toward creating new jobs at a time when the U.S. unemployment rate is marching toward 8.5 percent sometime in 2009. During his first press conference as president-elect, he called on Congress to pass a second stimulus package, which he said was “long overdue.” Obama spoke then about helping families avoid foreclosure but spent as much time talking about saving the gasping automotive industry.
THE FUTURE: In November, the housing industry pitched Congress on a $268 million stimulus package that includes a tax credit up to $22,000 for all home buyers and a steep buydown of mortgage interest rates. Public builders would also like to be able to write off current losses against past profits further back than two years. But in the market of diminished resources, the industry’s priorities are a much harder sell, especially when some critics question once again how lawmakers can justify the $100 billion in annual mortgage interest deductions that the IRS allows homeowners. That deduction—which the NAHB’s CEO Jerry Howard calls “the holy grail” and “one of the reasons America is the best-housed nation in the world”—is also seen as symbolic of how “tax policy grossly favors homeownership,” says economist Bert Ely. Ron Terwilliger, of Trammell Crow Residential, calls the mortgage deduction allowed for second homes “a disgrace” and the deduction on all homes up to $1 million “ridiculous.” The NAHB might sanction a tax credit over the deduction, says Howard, as long as it didn’t translate into reduced benefits for homeowners.
Food For Thought
There has been no shortage of opinions about what the U.S. needs to do to pull its economy out of the fire it’s in right now. And the government’s response to this crisis has been surprisingly—if often alarmingly—freewheeling, as if it is willing to try just about anything that might work. The following are ideas (some fanciful) that might actually benefit home builders and their customers.
Barry Zigas, director of housing policy for the Consumer Federation of America, thinks that giving judges the authority to modify loans—which was pulled from the federal bailout at the last minute—should be reinstated, in part because he believes that adjudicating modifications would remove two major obstacles: the threat that investors will sue if the terms of the mortgage are altered to their detriment, and the problem of trying to unravel a mortgage that’s been securitized and resold.
Bert Ely, a Virginia-based economist, thinks the premise of mortgage securitization itself “has it backwards.” He advocates a more efficient system that would move large amounts of capital directly to originators. Like several other sources, Ely also favors covered bonds as an investment instrument because their risk remains on lenders’ books and must be backed by a solid mortgage.
Scott Polakoff of the Office of Thrift Supervision (OTS) thinks a solution to keeping more homes out of foreclosure could be a negative equity certificate, which OTS proposed about a year ago. Loans that have been securitized would be modified to the point where the borrowers can actually pay them. But the lowered principal would not be forgiven, and a portion of a resale would go back to the lender. Polakoff says the problem with FHA’s version of this is that it splits the proceeds of a resale with the agency, not the servicers “that [consequently] need to be motivated to participate.”
The International Monetary Fund identifies real estate in Australia as being among the world’s priciest, and that country’s housing market is certainly bubbly. But homeowners there are a lot less likely to walk away from underwater mortgages because loans in that country are full recourse, meaning that if borrowers default and their property value doesn’t cover the debt, they are on the hook for the shortfall and the laws favor lenders that go after them. Consequently, Australians are more careful borrowers than Americans.
Peter Cramton and Larry Ausubel, two economics professors at the University of Maryland, have a solution to get toxic mortgages off of the books of financial institutions: a “reverse auction,” with one buyer (the federal government) and many sellers (the lenders). Each seller would offer a “bid” price that would generally reflect how badly they want to sell. The government would have to figure out which price to accept that protects taxpayers’ interests but isn’t so low that it breaks the banks. Plus, there are literally thousands of types of mortgage-based securities. But Cramton and Ausubel think such an auction could be an efficient way to set the prices for these troubled assets and transact their sale.
The federal government for decades has paid farmers not to grow crops to control supply, demand, and prices. Why not subsidize builders temporarily when the supply of unsold homes exceeds 10 months? Most experts, of course, would say such a plan would be impractical and wildly expensive: Even at November’s paltry annualized rate of 625,000 housing starts, if all those new homes sold at the median price of $218,000, the industry’s revenue would equal $136 billion. But if builders curtailed that production to, say, one-tenth of current levels for two or three years to flush out the overhang and foreclosures, how much would they need to stay in business and keep some employees working?