Lessons Learned from the Financial Crisis: The Housing Bubble and Its Ramifications

September 11, 2011

Presenter Julie Stackhouse takes a deeper dive into the housing boom and the roles played by the growth of private-label mortgage securitization, increased subprime mortgage lending and homeowners using their homes as mechanisms for generating cash.

Presentation (PDF)


Julie Stackhouse: Okay. So that's where we started. Now it wasn't all as simple as that. I mean, back in the days of the 1980s, you might remember back in the late 1980s something called a Savings and Loan Crisis. Anybody remember that? Raise your hand. Okay. So that seems a long time ago, right? But here's what it kind of looked like. Is back in those days Sally Roth from Regions Bank is here, and I don't know how many mortgages Regions made, because they were mostly in savings and loans. But Regions may have made a mortgage, a 30-year fixed-rate mortgage, probably not a lot of them because mostly they were done in savings and loans. And what happened is the savings and loans made these mortgages. They held them on their books. They were actually loans to the savings and loan. And then all of a sudden something changed and interest rates on deposits, the restrictions were lifted. And now investors demanded that these institutions pay the same rate of interest that they could get elsewhere in the market or they were out of there.

And so all of a sudden savings and loans were paying more for their deposits than they were earning on their mortgages. That turned the balance sheet upside down and that created a crisis that had to be worked through and obviously was very, very difficult in the latter part of the '80s. Do you have a question?

Audience Participant: If I'm not mistaken, it was a regulatory crisis, was it not? I mean, the deregulation of the liability side of the balance sheet, it didn't happen in a vacuum.

Julie Stackhouse: Yeah. So not to get too far afield, but thank you for raising that. There's something called Regulation Q. It's one of the many letters that we put on regulations. And up until that point in time it had certain limits on the rates that could be paid on deposits. What was happening though is an industry called money market mutual funds was developing. And so all of a sudden banks and savings and loans were saying we can't compete with them because they can offer rates that are much higher. We need more flexibility.

So in the simplest sense, Regulation Q was lifted, and while that helped for those that could compete with those money market mutual funds, it really hurt those that had lots of these long-term assets on their balance sheet. So that was basically the story in the simple version.

What happened though is financial institutions realized there was another choice. And that was something called a security. So how it works today, I know we've refinanced not too long ago. I think our mortgage was sold to Fannie Mae. It was either Fannie Mae or Freddie Mac. And probably most of you, if you're refinanced, and you probably have if you still have a mortgage, because interest rates are so low, more likely than not a good share of the mortgages have been sold to Fannie Mae and Freddie Mac. So what happens is that you go into your lending institution, they say, oh, you know, we'll give you a mortgage, and you'll see some paperwork that says the mortgage is actually going to this mortgage giant, Fannie or Freddie, or for those with a little less income it may be the FHA, and someone will take care of collecting your payments and all is good.

When the mortgages get to Fannie Mae and Freddie Mac, Fannie Mae and Freddie Mac take those mortgages, they bundle them, and they create something called a security. It is a financial instrument. It is something sold to investors. Why do investors like securities? Because they can be bought and sold. So unlike a mortgage that if I make it, I have to hold on my balance sheet for 30 years, an investor can buy this instrument that's a part of a mortgage, hold it, and then sell it again if they need the money. And that's how financial markets work.

So in a sense it was a very elegant design when it worked well, and when losses on mortgages were very low. But coincidental with this sub-prime mortgage market was creation of a new security, and often these were called private label mortgage securities. So these were not Fannie Mae and Freddie Mac securities. These were securities that went from mortgage companies, banks, other lenders into large investment companies like Goldman Sachs, Lehman Brothers. And there they were put into pieces, financial instruments called securities, and they were sold not just to investors in the United States, they were sold to investors across the world because the U.S. housing market is a great place to be investing. The securities typically earned more money than certainly U.S. Treasury securities. And, my goodness, these large rating agencies said they're AAA rated, even when the securities were of the nature we talked about, highly risky sub-prime mortgages.

Investors, who are sophisticated in theory, were reading their prospectuses and making these choices and all should be well. For financial markets, if you have sophisticated investors who make decisions knowing what they're doing, then if something goes wrong they just absorb the loss and they move on. But, of course, we can look back today and see that that was not the case.

It's important to understand though that the mortgages, and when we hear about things like refinance programs and why do borrowers not, cannot refinance under these programs, that we have very complex legal documents that surround these mortgages, and they put limits on what the companies that collect payments can do. So while it would be nice to have it like the days of the savings and loan, when the mortgages sit on the books and you can deal with the customer, today's environment is very different. And so that was the process that occurred.

Okay, the other thing that was occurring, and I promised to show you this slide, was the cash coming out. And I think this too was one of the things that as we look back maybe should have been more obvious. But today it’s almost a little bit of a surprise. The home, probably the biggest asset on most people's balance sheet, was being used as a mechanism to generate cash. And, of course, when values go up that works well. When values go down it's a whole different story. And, again, we'll talk about that in a little bit.

So here's a look at what housing prices were doing. And what we did is, first of all, there's lots of different housing price data. So you can pick your favorite, but I think you're largely going to find the trends to be pretty much the same. And what we did for those that like to do graphs and charts is we took housing prices at the beginning of each of these three decades and we said that housing prices are equal to one. Okay? And then we said each year how much have housing prices changed? And from there we've looked at the difference, and then we've plotted that difference. And it's a pretty amazing story, isn't it?

When you take a look at the decades of the 1980s and the 1990s, housing prices increased at a very moderate rate. Not too fast, not too exciting, very moderate. Take a look at what happened in the decade of the 2000s. We did, in fact, have rapid acceleration in housing prices. So a couple of things were going on. We had more credit available. We had more ways to get that credit because we were creating securities that investors across the world wanted. We were also fueling demand for housing that caused prices to increase at a very rapid pace.

That was important not just from the standpoint of the owner of the house, you felt good when it was going up. It was also important for banking organizations, and I’ll get to that in just a minute.

I might offer though that as this bubble started to occur, that's when investors came into the market. And certainly you probably each have a story if you have a condo in Florida or you know someone that has some type of property or an investor went in, bought it with the idea "I'm going to sell it in one or two years, and I'm going to make a lot of money." And, of course, that also fueled the increase in prices.

So here's sort of the bank side of it. This is the tough story that I have to deal with pretty much every day in my job. As the demand for housing grew, banks, the little banks actually didn't buy very many of these securities that I mentioned, these financial instruments. Most of the little banks made loans to real estate developers to develop land to build houses. And this is the tough part of the story. There was so much demand for housing, and it seemed like it was going to continue indefinitely, that a lot of bank credit was made available for real estate development – purchase of land, clearing of land, construction of houses.

And as we take a look in this case we've got, we picked Chicago banks, because Chicago has really suffered in the past few years. And then we also picked all banks in the United States. And we took a look at what happened to their construction loans as percent of the total loans that they make. And, again, you can see where banks were going. They were following the housing boom. And as banks followed the housing boom they were later in the game, because financing the development of land takes a long time. It can take several years. And so they were already in when the housing bubble began to collapse.

And this shows us what happened as housing prices began to fall. And it occurred very quickly. As we take a look at what happened since really 2007, we can see that housing prices nationally are some 16 percent overall off their peak, with a lot of differences, both geographically and in neighborhoods. St. Louis off on average about 10 percent. Now you may say, "that’s not my house." And it might not be your house. Again, these represent what's happening collectively in the market. And that's how quickly it occurred.

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