The Origins of The Crisis: The Housing Bubble

First off, it’s essential to state that the underlying causes of the current state of the economy are complex and are not universally agreed on or even completely understood by economists and intellectuals; so I will not be able to supply a completely correct and objective answer. What I hope to do here is to provide a basic overview of some of the most important reasons that America and the world has reached the point where it is today, and the interesting and important information about these reasons.

The first and perhaps most important thing to understand is that house prices lie at the heart of the problem. American house prices rose by incredible amount throughout the late 1990’s and early 2000’s, with house values tripling in some places in less than 15 years, with the majority of this occurring after 2002. Understanding why this happened is essential to understanding everything that has followed.

Most things in the economy follow a pattern of boom and bust. As more people want to own a home, due to income rises and increases in population, prices will rise. This increases the incentive for builders to build more new homes, as they can now sell them for more. Over the long run this leads to an oversupply of houses on the market, which decreases the price. Buyers stop buying, waiting for prices to drop, further decreasing demand, which causes builders to stop building. (This is where we are now in America) Eventually this decreases the supply of houses on the market, first stopping the price-slide and then eventually increasing prices, and the cycle begins anew. In the real world things are immensely more complicated, but understanding that this cycle exists is a good starting point.

When this boom cycle began, U.S. economic growth was high and prosperity was widespread. Average U.S. household incomes grew throughout much of the 1990’s, increasing the percentage of families who could afford to buy homes. People were living longer and more of the elderly were remaining in their homes or moving to retirement communities where they owned property. An increasing number of people, having reached the middle class, were buying vacation homes. Immigration was high, as strong economic growth drew a wide variety of people to America. Highly skilled professionals flocked to Silicon Valley and other high-tech centers. The unskilled were employed in hotels, restaurants, and as itinerant farm workers, keeping prices low and freeing up the American labor force to move into middle class service industry positions. All of this led to a sustained and widespread increase in demand, particularly in places with large vacation and retirement communities (Florida, Nevada, and California).

People who buy houses generally don’t do so by writing a check. They save up enough money to pay for 15 to 20% of it, and then ask a bank to pay for the rest. In return, they agree to pay the bank back over a set time period, generally 30 years. The bank makes money by charging the home owner interest on the debt. This interest rate is set at a certain level, based on the market, which is generally a few points higher than Federal Reserve’s benchmark interest rate. Banks do not just give out loans to anybody, however. They check to make sure that the prospective buyer will be able to pay back their loan, looking at their credit history, annual salary, etc. If a prospective buyer is risky the bank will seek a way to minimize that risk to them. They can do that by charging higher interest rates (in this way they trade increased risk for increased profit potential). In America, two very large institutions known as Fannie Mae and Freddie Mac have been created to help people who are relatively poor or young. These people, who in general would be seen as too risky by banks due to their lack of credit history and assets, are able to buy houses because Fannie and Freddie buy their mortgages from banks and thus eliminate the risk to the bank. If for some reason a buyer does default on their loan down the road, the bank will generally repossess the house and then sell it to someone else in order to recoup the money they are owed. As always, this is a simplistic overview, but it gets at the most important points.

So why did this housing boom turn into a bubble? First, the Chairman of the Federal Reserve at the time, Alan Greenspan, had lowered the interest rate coming out of the 1992 recession which swept Bill Clinton into office in 1993. However, he did not really raise it much in the economic boom which followed in the late 1990’s on the back of technology and the internet boom. The Federal Reserve is very concerned with inflation, which it wishes to remain in the low single digits, and Greenspan believed that if he raised interest rates then inflation would fall to zero. He looked at the increasingly globalized economy, and the flood of cheap labor from the former Soviet countries and China, as well as the cheap goods which were being imported for American consumers from factories throughout the developing world, and his concern for these deflationary pressures kept him from raising rates quickly. After dropping them to 3% in 1992, he had increased them to 6% in 1995. As the economy grew fairly regularly over the next few years, he held them more or less steady, lowering and raising them by small amounts.

The technology boom turned to bust suddenly, and many I.T. companies collapsed, causing the economy to slow and fears of recession to arise. This was exacerbated by the events of September 11th, 2001, and it appeared likely that the country would slip into a downturn. In response to these events, Greeenspan quickly began dropping interest rates, bringing them below 2% in July, 2002, and reaching a low of only 1% in 2003. Most people now think he made some mistakes; first by keeping interest rates too low during the 1990’s, exacerbating that boom, and then by lowering them too far in the early years of the decade, and keeping them extremely low for too long. The incredibly low interest rates during this second period, lasting from summer 2002 to summer 2004, overlapped with house prices rocketing up at an incredibly fast pace. As explained before, interest rates for house mortgages are based off the Fed rate, so by keeping this too low people had an increased incentive to buy new and more expensive homes, as they would be able to afford them due to the low interest rates.

It is necessary to look further into the increase in demand for homes. In addition to the reasons mentioned above, we must look at how much easier it became to purchase homes. In the 1990’s, Democratic government strongly supported Fannie and Freddie, and passed legislation making it easier for them to take on loans from risky borrowers, as this helped poorer families qualify for buying homes. Upon his election, George Bush encouraged the continuation of this trend, calling for what he termed the “…ownership society.” Thus both Democratic and Republican governments encouraged a continually increasing pool of lower-middle class families to buy homes at interest rates which underestimated the risk of their defaulting. Banks also played a part in increasing demand. Whereas historically most banks did not lend to risky borrows, as previously mentioned, they increasingly began to utilize different forms of loans to attract these poorer buyers. Subprime lending refers to lending to people who do not qualify for prime rate loans, because they are perceived as higher risk. Due to the aforementioned low interest rates, subprime lending became a popular way for banks to give loans to high risk people, by charging them a higher (subprime) rate. There has been much criticism over the way lenders gave these loans out, and there is no doubt that some practiced deceptive techniques, not fully informing their customers of the fees which came with these mortgages. For example, many of them reset at higher interest rates after two years, or a like period of time; others involved hidden fees which did not become clear until after the loan had been taken out. Not everyone who took out these loans were being taken advantage of, however, as many were simply real estate speculators who hoped to flip the house for a profit before the higher rates kicked in, or were simply families buying homes they could not afford. Regardless of the reasons why people used subprime loans to buy houses, however, there is no doubt that they vastly increased demand and pushed house prices ever higher through the early years of this decade.

The final piece of the puzzle is to understand why banks were suddenly so eager to engage in this high-risk lending, and why they were able to, but that is too much information to put in here...

Sarah Palin and the Debate

I have to admit, when McCain first announced Sara Palin as his running mate part of me was excited. She was a fresh face, she was exciting, she was young and full of energy. It seemed clear from the minute he picked her that the dynamics of the race had changed. No longer did Barack Obama have singular ownership of claims on vitality, youth, and crowd-pleasing rhetoric. Perhaps she was just what the Republican party and McCain needed. That has worn off over the last few weeks, as I mentioned in my last post. Her lack of knowledge about vital situations essential to someone a breath away from the presidency is stunning, not to mention her fundamentalist views and odd associations with Alaskan Independence parties and a church which banishes demons from her and professes that Alaska is the Land of Refuge, to which we of the lower 48 states will thankfully flee in the (imminent) end times.

I will attempt here to briefly sum up a few instances in which Governor Palin has said something which causes me concern, specifically within the context of the interviews over the last few weeks with various members of the media. The first sign was her interview with Charlie Gibson of ABC, in which she was completely unaware of what the Bush Doctrine meant. It was completely clear that she had never heard this phrase before, which has been the central tenet of U.S. foreign policy in the years since the September 11th attacks (although it could be argued that it has quickly faded as a paradigm). After this interview I was concerned; how could someone with no knowledge of current foreign policy be expected to take the reigns in the middle of an undoubtedly challenging and demanding international situation for the U.S., in the middle of two wars, with a resurgent Russia, a rising China, and an unstable Middle East.

I resolved to hold off on my verdict for the time-being, and waited for Katie Couric's interview, to see if she would handle herself better with another week of study and prepping. She instead showed herself more unprepared, if possible. She began with incoherent statements about Vladimir Putin floating into Alaskan airspace, and then continued by failing to name a single Supreme Court case besides Roe v. Wade which she disagreed with. After this performance she had lost all credibility with me, and I awaited the vice-presidential debate with interest, half-expecting her to self-destruct on stage.

The debate itself was rather disappointing in its mundaneness. Senator Biden, fearful of saying anything which could be interpreted as "bullying" Mrs. Palin, ignored her the entire time, directing his attacks on Senator McCain, and only indirectly acknowledging that she shared the stage with him. Boring as he was, though, it was clear he had a grasp of every issue, and his competence was never questioned. Given that a large portion of the country shared my expectation of Mrs. Palin coming into the debate, all she had to do was not dissolve into incoherent babble and she would come out alright. She managed this handily, by relying on a set memorized responses of around twenty talking points, which matched up loosely with the questions asked. Early in the debate she cannily explained to those watching that she would not be answering the questions as posed, because she would rather speak "directly" to the American people. She threw in some of her folksy charm,winking at the audience and giving a "shout-out" to third-graders back in Wasilla.

After it was over, it was clear that Biden had won the debate if one measured it through the rubric of having and explaining policy differences, or through being qualified to run the country. Given the incredibly low expectations set for Mrs. Palin, however, it seemed that she came out of the debate as having done "better than expected," which perhaps will allow her to reclaim some of her momentum and status as an outsider. This debate seems likely to be looked at overall as a draw, much as last Friday's presidential debate was. This is good news for Senator Obama, as he has decent lead in most swing states and the overall polls, and without a dramatic event (such as the original, but temporary, boost to the McCain ticket when Mrs.Palin entered the race) things look grim for Senator McCain. Sarah Palin, however, lives to fight another day, and if she can manage to remain governor for a few more years, or even grab a Senate seat (depending on circumstances) she could be a force to be reckoned with in the coming years, just based in Anchorage, not Washington.