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The Housing Bubble: Making of a Banking Crisis?The housing market has buoyed the economy in recent times. But this growth has been spurred in part by increasingly risky loans. What happens when the bubble bursts?by Darrel KeiselThe American economy has grown without a major recession for a long time. The booming housing market is a big part of why it has done so well. When the Federal Reserve dropped its lending rate from 6 percent to 1 percent in one year, it started a frenzy of home building and buying. Banks have made a vast number of loans and have done well financially. Banks, like other businesses, are never satisfied with how much they make. Pressure from management to make more the next quarter than they did the last is always present. Banks must keep their mortgage rates competitive. They also must decide which loans are good risks and which aren't. The more liberal lenders have been the most successful in recent years. If we would have had a hard recession along the way, banks would have tightened their lending practices. But without a recession, banks have become more lenient about whom they loan to and more creative in their logic in justifying loans. In a recent Wall Street Journal survey, about 20 percent of leading economists surveyed said a possible housing burst is their biggest worry for the economy. Let's look at what the banking business has done. No money down: The precarious status of Fannie Mae and Freddie Mac In the 1970s and '80s, home buyers needed a 20 percent down payment. If the bank had to take a house back, the bankers were quite sure they could get at least 80 percent back from reselling it. Now, due to the ever-rising real estate market, they feel they can recover the full value. So today they allow some first-time home buyers to buy a home with no money down. Some banks, in bigger cities, will lend 120 percent of the value of a house. This enables the purchaser to furnish the house as well. Banks reason that the value of the house will increase faster than the value of the furniture will depreciate. And, of course, banks make more interest. Many first-time home loans and low-income loans, which are higher risk, are sold to Fannie Mae or Freddie Mac, federally chartered mortgage companies holding about $1.5 trillion worth of low-income and first-time home buyers' loans. This frees up the banks to make more loans. Just about every time Alan Greenspan, outgoing chairman of the Federal Reserve, gives a speech on the state of the economy, he mentions "the precarious financial status of Fannie Mae and Freddie Mac." Their accounting practices have been suspect. They have had a lot of bad loans, in spite of the strong economy, and they have not set aside enough money to cover these bad debts. Greenspan said, "Because it is a highly leveraged operation and because it requires sophisticated hedging of interest rate risk, it is imparting a significant risk to the American financial system." If Fannie Mae and Freddie Mac should go belly up, they are too big a factor in the U.S. economy to not save them. Yet, for the government to bail them out would be catastrophically damaging to the value of the American dollar. Most of the money Fannie Mae and Freddie Mac uses comes from bonds purchased by people, companies and other nations. China is one of the biggest contributors to these agencies, a factor that adds to their possible instability. "Interest-only" loans In order for banks to keep home mortgage monthly payments lower for the customers purchasing homes, banks now sell "interest-only" loans, usually for a 30-year term. The Wall Street Journal of July 20, 2005, says in some cases borrowers can even pay less than that, allowing interest to pile up and be repaid later. This seems to promise a lot more money for the banks. The logic for justifying these loans is that as time goes by, these homes will be worth more money, and when the house sells, the bank can get the principal back. Though this concept only started in 2001, nearly 20 percent of new mortgages are now of this type! 40-year and adjustable loans Another way to lower monthly payments is to extend the length of the loan (thus greatly increasing the total amount to be paid). Some people are getting 40-year loans. Imagine a recent college graduate buying a house but just getting it paid off in time to retire! Adjustable Rate Mortgages (ARMs) have always been a little lower than the fixed rate, but they are available only for short periods. Almost 40 percent of mortgages today are ARMs. The borrowers typically think they will be able to afford the fixed rate when the ARM expires, but that is a gamble if they are overreaching their budget. Layoffs, less in reserves Banks make money by borrowing from big lending agencies on short-term notes at lower interest than they charge mortgage holders on long-term notes. The difference between short-term and long-term rates has traditionally been between 1 percent and .75 percent. Now we are in a very unusual trend. The difference between these rates is getting smaller all the time. As of this writing, it's down to .25 percent, meaning the profit margin is about one third of what it usually is. To cover this deficit in profits, some banks are laying off employees. The Aug. 9, 2005, issue of the Wall Street Journal stated, "Others are setting aside less in reserves to cover bad loans, a practice with which they feel increasingly comfortable because corporate and consumer bankruptcies remain at historic lows. The strategy could backfire, however if credit quality begins to deteriorate." Lenders reason that home values will continue to increase. However, economic forecasts show that we may be in a housing bubble, which means house values may drop suddenly. Home prices rose 13.4 percent in the second quarter of this year (April through June 2005), the largest quarterly jump in over 25 years. Normally, when short-term and long-term rates converge, we have economic downturns. In the current economy, the amount banks have lent and the liberal terms for qualifying for these loans are at record levels. The Federal Deposit Insurance Corporation can handle a certain amount of banking debt, but whether it can handle the potential housing crash is questionable. How secure the securities? Mortgages are bundled together and sold to big investors such as insurance companies, hedge funds and foreign investors. The rate of return is better than any treasury bill and so far the risk has not been bad. For example, if 20 mortgages are put together to form what is called a security, and two of the mortgages go bad, there remain 18 good loans to soak up the losses. At the end of 2004, 6 percent of U.S. mortgage securities were held by foreigners. This number is up 26 percent over 2003 and continues to bound ahead in 2005 (Wall Street Journal, Aug. 24, 2005). Zhu Kai, a manager of dollar investments at the Bank of China, and other Chinese investors reason that "U.S. authorities will prevent a bust." The question is, "How?" If the dominoes start falling, how do you stop them? And what's to keep foreign investors from pulling out and moving to Europe for more stability? The root of the problem How can professional bankers and businesspeople take such great risks? The answer is shortsightedness fueled by greed. The ancient wisdom of the Bible has much to say about this topic. Solomon said in Ecclesiastes 5:13-14: "There is a severe evil which I have seen under the sun: Riches kept for their owner to his hurt. But those riches perish through misfortune." The riches could quickly be lost. Solomon also pointed out, "He who loves silver will not be satisfied with silver; nor he who loves abundance with increase. This also is vanity [that is, a chasing after wind]" (Ecclesiastes 5:10). While this has been true throughout history, the Bible pinpoints an increase in greed as a sign of the end time: "But know this, that in the last days perilous times will come: For men will be lovers of themselves, lovers of money" (2 Timothy 3:1-2). The greed of the banking industry plays on the greed of the public, which is buying what it cannot afford, and for a while it seems like no one is hurt. But modern financial gimmicks are only postponing the suffering that is sure to come. Greed will get worse and worse until it devours us. Results of disobedience to God The greed and lack of wisdom in this impending crisis, which threatens the stability of the world's largest economy, is a symptom of the malaise God warned of in Deuteronomy 28. God had promised great material blessings to the people who became the United States and the British peoples (Deuteronomy 28:12-13; see our booklet . Both are free and can be requested or downloaded from our Web site at www.wnponline.org. WNP | |||||||||||||||||||||
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Keywords: real estate Fannie Mae Freddie Mac greed
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