Misguided housing credit, the root cause of the global financial crisis

Analyzing the world financial crisis which marked the end of 2008, this article of January 2009 (published in "Urban World", March 2009, in "Urbanisme", Paris, May 2009, in URD, Beijing, 2009 and in PoSIbles, Buenos Aires, 4/2009) called for a serious debate on housing finance systems. This is still to happen….

A trillion dollars

On 7 September 2008 the two giants of American mortgage, Fannie Mae and Freddie Mac, have been de facto nationalised through the injection of USD 200 billion by the US Treasury. Together they had a credit portfolio of over USD 5 trillion but also a rapidly increasing debt and collapsing share values. Although the two institutions were already Government-sponsored enterprises (GSEs), their fall and forced nationalisation was the signal and beginning of the current world crisis. On 25 November 2008 the Federal Reserve announced that it will purchase up to USD 600 billion of their debt and troubled mortgage-backed securities. In February 2009 the Treasury announced a Financial Stability Plan of more than a trillion dollars and injected 200 new billions in Fannie Mae and Freddie Mac. These figures have been interestingly compared with the Official Development Assistance (ODA) to developing countries which, according to the OECD, amounted to USD 103.5 billion in 2007 (21.8 billion from the USA, 67 billion from Europe, 7.7 billion from Japan, 4 billion from Canada). Of course as stated by many politicians: “this is not the same money”…

Root-causes of the crisis

Among the many comments on the 2008 financial turmoil, the worst since 1929 and the first one of a truly global nature, too little attention has been paid to the starting point of that crisis, i.e. the complete failure of the US housing finance system. The present article is an attempt to analyse this failure, its causes and consequences, and by so doing to highlight the important relationship between the housing sector and the overall economy, as well as between the mortgage crisis in the USA and the global financial crisis.

Let’s try and summarize what has happened in the USA between 2001 and 2008, noting that similar events took place in other countries such as the U.K. and Spain.

The root-cause of the crisis is the manipulation of the housing credit system by the banking sector. This was done basically by playing on interest rates, on down-payments and on loan reimbursement periods. In simple terms the banks have provided low interest credit to middle-class borrowers, resulting in excessive indebtedness and drastic reduction of saving capacities (down to zero or even negative), while providing high interest credit to low-income families (the infamous sub-primes in which adjustable rates were used to hide actual rates, often above 10 %) combined with insufficient down-payments and overestimation of foreseen income growth, resulting in massive default repayment of these loans. Both actions were intended to promote the “ownership society” which has always been one of the core ideological value of the American nation (if you are not a home-owner you can’t be a good citizen, you have no roots). Artificially low-interest rates are the traditional American way to subsidize middle-class housing (and thus to limit official public subsidies) while the new high-interest strategy without serious guarantee of repayment appeared as a “miraculous” way to improve housing affordability to the poor. We will see below the underlying rationale of this expected miracle.

Errors or fatality?

The key questions are: why did the banks follow that risky track and why did the households fall in the trap?

For the households the response is relatively straightforward. During 2001-2006 housing prices were growing much faster (+ 60 % in 5 years) than the prices of other goods. Therefore buying a house was seen as a good investment (they could hopefully resell their properties at a higher price, provided the upward trend continues). The demand was high both from the middle-class (very happy with low interest rates) and from poorer segments of the society (betting on their improved future and finally accessing the ownership society, the American dream). But unfortunately housing prices cannot increase forever at a faster pace than inflation, simply because at a certain level the demand is saturated, it vanishes and a downward trend starts. This happened in 2007 when house prices went down by 9 % in the country (in 2008 they went down by more than 10 %).  And it happened simultaneously with an overall credit rationing, resulting in the vicious circle which brought about the financial crash of September-October 2008.

For the banking sector the response is more complex. Indeed bankers are supposed to be smart and intelligent people. Why should they lend to insolvent clients (between two and three million families) through sub-prime mortgages totalling roughly USD one trillion, out of a mortgage bond market of six trillion in 2007? On this issue one finds very few explanations in the world media. Apart from rather obscure considerations on the “securitisation” of sub-prime mortgages and on the contamination of “toxic” or “exotic” loans, it is hard to understand why financial institutions developed these particular instruments.

The starting point was that they had too much money and needed to lend as much as possible, even by taking exaggerated risks. The second point is that they found complicated and uncontrolled ways of sharing these risks among themselves. This was done by reselling packages of home loans, mixing these packages to dilute the risks, and taking a profit at every step. The loans were in fact sold in the form of mortgage bonds on the expanding mortgage bond market.

Let’s take an example. Brother Bank gives a loan of USD 200,000 to the Smith family, at 7 % over 30 years. In total the Smith will have to repay USD 480,000 or USD 16,000 per year. Then Brother sells that loan to Sister Bank (or to any investor) for USD 220,000. Brother gets a profit of USD 20,000 and moves away. Sister Bank may keep or resell the loan. If they resell it they may make a profit; if they keep it they take the risk of faulty repayment. That risk was to be reduced by not reselling loans one by one as in our example, but by regrouping many of them together (this is called securitisation, the process through which a company like Brother Bank bundles its home loans into securities or bonds and sells them to investors), de facto auctioned on the financial market, more precisely on the mortgage bond market. At this stage bankers were probably expecting both a miracle (good returns) and some losses. This is precisely the essence of capital investment in a market economy: taking controlled risks. They were of course expecting more returns, due to high enough interest rates, than foreclosure losses. Many banks jumped on the new tools developed by the gurus of Wall Street, those who had already imagined the junk bonds of the 80’s (culminating in the savings and loans crisis of 1987). And these banks discovered only in 2007 that the risks were much too high, that losses were getting out of control and outgrowing the returns. This was too late. More than one million American families (precise statistics are not available) were already facing the threat of eviction because they could no longer repay their mortgage. Fan and Fred were in deep trouble. They might have had in mind an automatic bail-out in case of difficulties… This is known as a “moral hazard” (abuse of the Treasury as lender of last resort), strongly criticized by the Wall Street Journal (in “Bailout for Billionaires”, 11 September 2008).

The sub-prime sub-sector collapsed in August 2007, announcing the general financial crisis which started a year later and which affects directly all American tax-payers and indirectly all human beings of the planet. The “securitisation miracle” did not happen. The former President of the Federal Reserve, Mr. Alan Greenspan, in a late flash of lucidity, declared:  “securitisation of home loans is the major cause of the crisis”. During the summer of 2008 inter-bank trust disappeared, credit became scarce (the so-called credit crunch) and expensive, the entire world entered into recession. The financial bubble burst. In October all bourses fell sharply, from Wall Street to Tokyo, from London to Shanghai, from Sao Paulo to Johannesburg. On that occasion many Governments declared that they needed to revise completely their economic and financial policies and instruments, that an in-depth review and reform of the international financial architecture was necessary, that capitalism had to be regulated. Public opinion was dubitative: the crisis was the result of a mix of conjectural and structural causes but it was difficult to draw the line between human errors and economic fatality.

The co-founder of the Bretton Woods Institutions, John Maynard Keynes, is back in force but the role of the housing finance system as the most frequent initiator of all recent financial crises does not seem to be fully understood yet (The Doha Declaration of 9 December 2008 on Financing for Development does not mention housing finance anywhere in its 90 paragraphs!). The fact that a house is generally the most valuable good (by far) that a household can purchase in its lifetime should give policy-makers and their economists a clue… The vicious cycle “housing bubble - financial crisis - economic recession” seems to repeat itself with a ten-year frequency (1987-1997-2007). It is time to break it by acting on its starting point.

Construction, engine of economic growth

Housing finance and subsidies - the core of any housing policy - should be the primary responsibility of Governments, as suggested in the Habitat Agenda, and not be left to speculators, traders and unaccountable corporations. In fact housing finance should become a kind of “public good” or “fictitious commodity”, placed under close public scrutiny. The present time of economic recession and retraction of real estate markets could offer opportunities for radical policy reform which may be politically popular in many countries. It should be founded at least on the following pillars: (i) leading role of the Government though proper institutional strengthening at all levels; (ii) rehabilitation and encouragement of household savings; (iii) regulated interest rates and down-payments; (iv) public incentives to the expansion of rental housing, particularly for low-income groups; (v) increased and well-targeted subsidies for lower middle-classes. Such a financial policy should go hand in hand with proper urban development policies aiming at making land affordable, reducing the cost of services by increasing density, combating spatial exclusion and improving the living environment.

So far both in the USA and in Europe, Governments have designed unfocused and hybrid reforms to address the crisis. They seem to lack a strategic vision. By injecting funds into banks and large corporations to save jobs, or by reducing taxes to boost consumption, they mostly deal with the consequences of the crisis. By lowering long-term interest rates they even take new risks. In spite of some welcomed attention to infrastructure investment in the US stimulus plan of February 2009 (seen as insufficient by the Nobel Economics Prize 2008, Paul Krugman), the construction sector is rarely placed at the centre of recovery policies. Instead of sprawling public money in all directions, it would be more effective to use infrastructure and housing investment as a driving force to leverage activities in other economic branches, create millions of jobs and strengthen intersectoral synergies (the well-known multiplier effect). Linking housing loans to savings, providing targeted incentives to households and developers, encouraging both rental housing and home ownership, investing in all types of environmental infrastructure, these could be the basic features of an ambitious revival strategy, modelled on what was successfully done in the 50’s and 60’s in Western Europe and more recently in China. In the USA the $ 75 billion Homeowner Stability Initiative launched on 18 February 2009 by President Obama to subsidize the monthly repayments of 3 to 4 million at-risk homeowners (particularly those who received subprime and exotic loans) should be accompanied by a complete overhaul of the housing finance system if a new bubble is to be avoided in the future.

After 25 years of neo-liberalism and deregulation, a serious discussion on infrastructure and housing finance might take place. In our global economy, this would be in the best interest of humankind for which the dream of “adequate shelter for all” becomes everyday more illusive.

January 2009