The U.S Federal Reserve anticipates that in fiscal year 2009, the Unites States’ economy may shrink between 0.5% and 1.3%. By historical standards, this means that we are in a serious recession. This slowdown may be attributed to many factors – an increase in unemployment, a lack of consumer confidence, a lack of confidence in the investment community and an overall reduction of the amount of liquid assets in our banking system. Perhaps the biggest factor that has hurt the American economy (and the world economy as well) is what can only be called a collapse of the housing market in the United States. Many lenders have gone bankrupt, housing values have diminished and many homeowners are in trouble. Because the housing market is so big it affects every facet of the American economy and when the housing market is in trouble the entire financial foundation of the United States will be in trouble as well. How did we get here and what are the solutions?
Why is the housing market in the United State in trouble? A big part of the problem arises from a collapse of the so-called “subprime” mortgage market. Until just a few months ago, subprime lending – or lending to credit challenged borrowers was a big profit center for many banks and mortgage lenders. Subprime lending was so profitable that many lenders changed their business models to accommodate the demand for subprime credit. Subprime loans, or more accurately, pieces of subprime loans, were sold off by loan originators as securities in the stock market.
For many years, everyone involved in the subprime market was making money – mortgage brokers got paid for selling the loans, originators earned fees, underwriters got paid for “securitizing” the loans into investment vehicles, brokers got paid for selling the securities and middlemen of many stripes got paid for handling the loans or mortgage backed securities.
In my Atlanta area bankruptcy practice, I saw many indications of fundamental problems in the housing market. I can recall many discussions with clients who had incurred hundreds of thousands of dollars of debts despite modest incomes and average to below average credit. It was not uncommon for me to see a two income family earning $60,00o to $80,000 per year, servicing $50,000 in credit card debt and a $300,000 mortgage. Often the mortgages were adjustable rate loans with teaser rates or, worse, interest only loans. Often the homeowner could survive as long as there was no interruption in income or other hiccups. All it took was a missed credit card payment or short term layoff and the dominoes began to fall. The folks I was seeing often were families that had been hanging on, but who no longer had cash flow to keep everything afloat.
Unfortunately, all of the players in the subprime game failed to recognize that more and more subprime borrowers were people like my clients – honest and hardworking families who had succomed to the lure of easy credit and who who did not have enough cash flow to pay everything back. Homeowners looking for solutions to mortgage problems had few places to turn.
Many of these borrowers were poor credit risks because they did not have enough income to weather even minor changes in their budgets – a car wreck that caused insurance premiums to go up, a death in the family that required a $700 plan flight, a difficult pregnancy, an unexpected job layoff.
Despite what really were the best efforts of the borrower, and after all the slicing and dicing of the loans, the underlying loans frequently ended up in default. Some went into default quickly and some went into default after a few years, but a large enough percentage of these subprime loans went into default to convince investors, investment advisors and regulators that the values assigned to the securities derived from subprime loans was artificially high. Almost overnight, the subprime mortgage market collapsed.
Next – what was the effect of the subprime crash and what can be done to “fix” the problem.