(For previous posts in this series, see here.)

As I discussed in the previous post, the instability caused by shareholder demands for steadily increasing rates of return infects every area of business for the worse. Furthermore, the law requires of management that businesses be run purely for the benefit of its stockholders. While this is meant to prevent management from acting negligently or even fraudulently to enrich themselves, it also has the effect that even an enlightened management has to be very careful about taking measures that are (say) motivated by concern for the environment or by the needs of its employees or the community in which the business is situated. Unless those actions can also be justified as leading to greater stockholder value, the stockholders have a legal right to accuse the management of acting illegally and to sue to demand changes.
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(For previous posts in this series, see here.)

The problem with the modern business world, as I see it, is that it is no longer enough that a company be successful in the traditional sense of steadily producing revenues in excess of expenditures. That model of a successful business is considered hopeless naïve these days. What investors want is not steady profits but a steadily increasing rate of return on investments and this is leading to chronic instability.

Let me give an example. Suppose I start a business that returns a 20% profit on my investment. That is a nice return, allowing me to provide good salary and benefits to employees, reinvest something in the company to improve the product, expand and improve the product, and so on. You would think that if I could continue to produce roughly 20% profits every year, I would be having a good company. After all, I am employing people, producing useful things, and making a reasonable amount of money. And as long as the company is privately owned by me, that might be true.
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(For previous posts in this series, see here.)

As is typical with bubbles, people involved at all levels of the subprime mortgage debacle seemed to deliberately shut their eyes to any negative information, as if they thought that wishing things were just peachy would make it so. As long as nobody looked too closely at the structure, no one would notice that it was a house of cards, and the good times would continue forever. But they never do. The house of cards always collapses.

(Some observers have pointed out that it may not be completely accurate to call the current subprime crisis a bubble. In classic bubbles, the prices of the commodity fall precipitously to their pre-bubble values or even below. This has not happened yet with home prices but the crisis is not yet over. The behavior of the principal characters in this drama, however, exhibit all the qualities of those involved in previous bubbles.)

Who is to blame for this situation? To be sure, there is enough blame to go around.

It is true that some of the homebuyers were outright dishonest, colluding with brokers to fake documents and income in order to pass a cursory scrutiny before getting the money to buy houses they could not afford. And it is true that some of these homebuyers acted with almost unbelievable ignorance and even stupidity about what they were getting into when they signed the papers to buy their homes. The Cleveland Plain Dealer had an excellent series on the foreclosure crisis by Phillip Morris and one story featured a man with a well-paying job who lost his home because he did not keep up with his $1,200 monthly mortgage payments. Meanwhile he was spending $40 a day on the lottery, hoping to strike it rich!

But apart from the criminal and the almost criminally stupid, it is true that many people buying homes in these go-go times should have suspected that things were too good to be true, that it was unlikely that many of them could actually afford the houses they bought. And yet, the dream of owning their very own home for the first time must have been powerful enough that they were willing to believe the promises of brokers and bankers, who were merely using them to enrich themselves. We also live in a time when people are told that living beyond their means, spending money they might not have ‘stimulates the economy’ and is thus a good thing.

We now see a backlash, with some policymakers blaming these buyers for the mess they find themselves in. But apart from those who willingly participated in fraud, such attacks are unfair. Buying a house is an enormously complicated affair, beyond the comprehension of most people. Although I am fairly literate and numerate and reasonably savvy regarding personal finance, I recall being overwhelmed by all the legalistic documents that we had to sign when we bought our house. I could understand the key points, but there were pages and pages of detailed jargon that we were assured were standard boilerplate language. I recall thinking how easy it would be to be swindled by the bankers and other people involved in the process. I had to trust that they were acting in good faith. Has it come to a point where we each have to have a lawyer and accountant with us when we enter into any reasonably major transaction?

Homebuyers are largely dependent on the honesty of the professionals who they think are acting on their behalf. As Duncan Black (aka blogger ‘Atrios’) says:

The inability of the Republican lizard brains to even fake the slightest bit of empathy or sympathy for those experience economic troubles, or in fact to even restrain from outright hostility, is rather fascinating.

That isn’t to say all of those in foreclosures are victims. But there were a lot of people ripped off by mortgage brokers they thought were acting in their interests who instead were pushing them into crappier loans for bigger commissions. When you hire someone whose job you think it is to get you the best loan possible, and their incentives are actually to get you the shittiest loan possible and you are unaware of that fact, there’s a wee bit of a problem in the system.

But there were also more sophisticated buyers who were well aware that their mortgage interest rates would soon go up but did not care. They were those who believed in the ‘greater fool‘ theory and saw themselves as smart investors who were planning to sell their property for a tidy profit before the rates rose. And as long as the prices kept going up and demand was high, that strategy would have worked. But as the subprime crisis unraveled and the number of foreclosed houses started shooting up, there was a glut in the market, buyers became more fearful and choosy, and prices started dropping and even the richer, more sophisticated buyers found themselves stuck with properties they did not want. It was cheaper for them to cut their losses and to walk away from their property than to sell it for a huge loss. This constitutes another wave of abandoned home foreclosures.

Sadly, the end is not yet near for this crisis. 2008 will be another year in which many initially low-interest teaser adjustable mortgage rates will rise, leading to another wave of foreclosures due to people’s monthly payments rising above what they can afford. About 1.6 million homes were foreclosed last year and this year is expected to bring a similar number. The government and a consortium of six major banks involved in the subprime market announced a plan called Project Lifeline to give homeowners facing foreclosure thirty days more to try and refinance their homes so that they can afford them, but it is not clear if this will work. There are strong fears that this is inadequate.

Next: How did things get this way?

POST SCRIPT: Hype in sports

David Mitchell (one partner of That Mitchell and Webb Look) makes fun of the nonstop breathless hype by sports announcers, where every upcoming game is made to sound momentous. Here he is talking about English football (‘soccer’ in the US).

(For previous posts in this series, see here.)

Up to now, I have been looking somewhat generally at the problems created by the collapse of the subprime mortgage market: how the problem was created and the scale of the problem. But to really appreciate how it worked and its impact on actual people, one can look at two case studies, in Stockton, CA and Cleveland, OH.

CBS’s 60 Minutes had a report on the community in Stockton that showed how the pyramid scheme worked:

Most of the mortgages issued in Stockton, and half of those now in default or foreclosure, were something called subprime loans, meaning less than prime quality. The borrowers often had sketchy credit, were financially strapped or lacked sufficient income to qualify for a standard mortgage. After a year of artificially low payments, the interest rates on subprime loans jumped all the way to ten or 11 percent.

And yet, these loans were marketed aggressively. As Jim Grant, a leading expert on credit markets said: “When you opened your mailbox in 2004, 2005, you could barely — people were pressing on you, if you were not institutionalized, all matters of schemes in which to expand your personal debt and mortgage debt. You could, and people did, borrow more than 100 percent of the price of a house with the most fragile of financial bonafides.” Little or no attempt was made to verify ability to pay.

Grant calls it an invitation to fraud. “You apply to a bank, or a mortgage broker for a loan. And you would fill out a form. And you would say, ‘I have an income of, oh, $400,000 a year.’ They say, ‘You do? Fine. Just sign right there.’ And they would nod, and because they were being paid, not by the veracity of the information, but by the consummation of the deal. The lending office would say, ‘Ah. You have verified this?’ ‘Why, yes, we have.’ And the lending officer would say, ‘Great. So do I,'”

Almost all of the people involved in the transactions made good money, then passed the risk onto someone else. Instead of keeping the dicey loans in their own portfolios, the big banks and giant mortgage companies that originally underwrote them, resold the mortgages to big New York investment houses.

Firms like Bear Stearns and Merrill Lynch sliced the loans into little pieces and packaged them up with other investments, then sold them to their best customers around the world as high-yield mortgage-backed securities, turning sows’ ears into silk purses, all with the blessing of rating agencies like Standard & Poor’s.

“At every step in the way, somebody has his or her hand out, getting paid. And everyone, for the time, is happy. The broker got paid. He or she was happy. The lending officer, ditto. The rating agencies got paid for passing judgment on these securities. They, too, were pleased, and their stockholders were happy. And on and on. And it would never end, except that it did,” Grant says.

It was all predicated on the idea that real estate prices would keep going up, and up and up, and for a long time they did. But by the summer of 2005, speculators flipping houses in Stockton had helped drive the price of that four-bedroom house to more than $400,000 and the market began to soften, then to tumble.

All of a sudden those subprime borrowers who had taken the free money found themselves upside down, owing more on their new house than it was worth.

Some unsophisticated buyers actually wanted to live in the houses they bought but did not realize that after a year or two the monthly payments would skyrocket out of their range. They consist one group of defaulters, and these people are overwhelmingly low-income or middle class. Cleveland’s Mount Union neighborhood was one such community hard hit by these dreams destroyed, as this news report describes:

The streets are empty. Trash rustles down the road past rusted barbecues, abandoned furniture, sagging homes and gardens turned to weed.

This is Mount Pleasant, a neighborhood in southeastern Cleveland ravaged by the subprime mortgage crisis roiling the United States.

Faded “for sale” signs sit in front of deserted houses. The residents are gone, most after being evicted for missing their mortgage payments.
…
For county treasurer Jim Rokakis, the greed of the banks is to blame for this man-made disaster.

“All you needed was a pulse to buy a house. Some loans were written with no money down, no proof of buyer’s incomes. They did not even check what people were saying. Most of those folks were jobless,” he said in an interview.

The Mount Pleasant community, he said, “was the perfect storm: poor folks, unemployed and a desire to get a piece of the American Dream.”

I have shown this clip by comedians John Bird and John Fortune on the subprime mortgage crisis some months before, but it is worth seeing again because it captures precisely the way the crisis occurred, the cavalier attitude of the banking and financial sectors to the way they used other people’s money, and how the whole house of cards was built on illusion and hype.

Next: Assigning blame

POST SCRIPT: Causing and taking offense

Bill Maher explains why he is not afraid of offending religious sensibilities.

(For previous posts in this series, see here.)

The real estate boom fueled by the easy availability of subprime mortgages was a classic pyramid phenomenon, entirely dependent like all such phenomena on an endless stream of new buyers coming along willing to pay the inflated prices. When the crash came, as it inevitably does with all schemes that are based on expectations of permanent and rapid price increases, it turned out to be financially advantageous for many people who had taken these loans to declare bankruptcy and simply abandon their homes and walk away, since the money they owed was often more than the house was worth. Some became homeless as a result, but others who had bought these properties more as investment vehicles did not fare too badly. Many had put no money of their own as down payment so they had essentially rented the houses for a few years, often at below market rates.
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(For previous posts in this series, see here.)

The current so-called subprime mortgage crisis is a result of a real estate boom fueled by a combination by ignorance, greed, lax standards and oversight, and outright criminality.

Unlike art or precious stones, in the case of a house, the value can be determined within a fairly narrow range. Knowing the neighborhood, the size and state of repair of the house, historical pricing patterns, etc., one can assess the value of a house fairly accurately. Barring sudden unforeseen events such as finding oil on the property or the discovery that some major new construction is going to occur nearby, or that the house has been built on a toxic waste site, the price of property tends to be fairly stable and predictable.

When it used to be the case that the banks that loaned you the money to buy a house held on to the mortgage themselves, there were built-in checks and balances to prevent the unrealistic pricing of homes. After all, foreclosing and selling a house is a costly and tedious business that banks would like to avoid, so it was in their own interest to ensure that the buyer could afford the house so that default was highly unlikely. It was also in the bank’s interest that the house was being bought at a reasonable price, with a down payment, so that the bank was lending substantially less money than the house was worth so that they could sell it easily in the unlikely event of a default. That was indeed the case when we bought our own house nearly twenty years ago. There were careful checks of the title to make sure the ownership was not challenged, a valuation of the home by an independent appraiser to make sure we were not paying too much, and we had to demonstrate, using tax returns and the like, that we had the steady income that we claimed we had and that it was sufficient to pay the mortgage. The fixed-rate mortgage payments themselves were high enough so that they covered the interest and also part of the principal, so that the money we owed the bank steadily decreased over the time of the loan.

But those days are long gone. Now the banks that loan you the money to buy your house resell your mortgage within days in the secondary market. Since the banks that initially provide the money for the house purchase do not hold on to the mortgage but quickly sell them, this does not require them to look too carefully into what they are financing. Indeed it is better not to do so at all, since the banks make their money at the point of transaction, so that the more mortgages that pass through their hands, the more money they make. This lack of close scrutiny also encourages the emergence of unscrupulous mortgage brokers who make their living on the basis of the number and value of the mortgages they broker between buyer and bank. Hence it is in their interest to obtain as many mortgages as possible for as high a value as possible. This encourages them to inflate the prices of the houses being bought and sold (in which they are aided by appraiser accomplices) and to inflate the incomes of the buyers so that they become eligible.

In order to make even more buyers eligible, buyers with poor credit histories (i.e., those labeled ‘subprime’) were also offered adjustable rate mortgages with no down payment and low teaser interest rates for the first few years so that they could afford the payments, at least initially. Furthermore, they were offered mortgage deals in which the monthly payments were interest only (in which case the money owed never decreased) or, incredibly, did not cover even the interest, so that as time went by the borrower owed more money, not less. The net result of the latter practice was that the value of the mortgage often exceeded the value of the house by substantial amounts.

Why would buyers accept such terms? These practices enabled them to afford to live in a more expensive house than was otherwise possible for the few years during the initial low-interest period and they thought they could sell and move on before the higher rates kicked it. Those who hoped to make the house their permanent home could hope that they would be either earning more money in the future to make the higher payments affordable or were told that they could refinance to a fixed rate mortgage at better rates in a year or two, before the low initial interest rates ended.

As a result of all these dubious lending practices, more people became ‘eligible’ to buy more expensive homes and home prices naturally started going up as a result of the increased demand for them. As long as the real estate market was booming and prices were rising, overextended buyers felt they always had the option of selling the home at a higher price than what they bought it for, thus paying off the mortgage loan with a tidy profit left over. Everyone would be happy. As a result, no one was looking very closely at the underlying value of the properties. There was no incentive to do so, and in fact it was discouraged. Why do that and destroy the dream?

Next: The end of the dream

POST SCRIPT: Lewis Black gives TV executives some good advice