The Revenge of the Invisible Hand

Let's go back about a decade.

Wall Street was finally feeling the inevitable fallout that was the result of venture capitalists with dollar signs in their eyes loaning billions of dollars out to any twenty-something with a cool website capable of writing a business plan. The internet bubble had burst, dozens of scrappy dot coms went under, putting a sizable number of people out of the job, and Wall Street lost a decent chunk of change after what had promised to be the business model of the future had proved to be a pipe dream for all but a few corporations. Now, usually, when this sort of thing happens, we have some pretty substantial economic woes. But in this case, Wall Street had an ace up its sleeve - the mortgage industry.

See, someone (probably several someones) figured a giant loop-hole in our economic system - if people don't have enough money from their jobs to pay for things, you loan them money at interest to pay for it. The company still gets the sale, the consumer get their product, and the lending bank gets a nice little profit in the form of interest. Which is all well and good, except for when the consumer can't or won't pay the bill, especially if they file bankruptcy and you can't get your money back. But there was a solution - loan against people's property. It is a solid asset, and since, at the time, home prices were continually going up, the company could always foreclose on the property, sell it, and make their money back. Brilliant!

Even better, encourage people to refinance their homes, pay off those unsecured credit cards (which pretty much all belong to the very same banks offering mortgages) and now the bank has traded an unsecured loan for a secured loan, just like that. Which isn't to say the borrower is the victim here.

In a perfect world, everyone wins. When I was working in the industry - the perfect loan scenerio looked something like this:
John Doe calls us about getting a loan. He's got mediocre credit, way too many credit cards at high interest rates, but a decent amount of equity because the houses have been busy going up in value at a crazy pace (especially in areas frequented by those same dot com people I mentioned earlier). So, John gets a loan that will pay off all his credit cards, and since he had a bunch of equity and interest rates are lower for mortgages than for credit cards, he ends up with a total payment lower than what he was paying before. If he really wanted to get that payment down, he opted for an adjustable rate loan, which would have a really low interest rate for two years.

Now, in our perfect scenerio, John paid off all his credit cards, and used the money he saved with the lower payment to get a decent IRA account, maybe do some investing, fix up the house, whatever - the point is, something fiscally responsible that would improve his financial standing over the next two years. Then, he would call up our firm two years later with an A credit rating and we'd refinance that adjustable to a fixed rate loan with a nice low interest rate and John was set for life, pretty much.

So, have you spotted the problem with this scenerio yet?

First and foremost, the main problem is human nature - people are, for the most part, greedy and short-sighted. The is not helped by a consumerist culture that holds up ownership as an ideal - the idea that every person should own a home and one car per adult, as well as a large smattering of consumer electronics drove multiple industries during the last decade. And we had quite a bit of posterity there for awhile. But no one asked the important question - where was the money coming from?

It wasn't coming from actual income, becuase if you look at the record, incomes really haven't increased that much since the mid-90s, even as inflation has been spiraling out of control. The answer is that the money was coming from credit - more than a little of it from home loans. I know, becuase I saw it happen again and again and again. John rarely spent that money from his home loan to pay off his credit cards - he spent it on vacations and cars and big screen T.V.s, or just to live on because his real income wasn't keeping him up with the Jones.

I lost count of the number of phone calls I took as an escrow officer, demanding to know where the money was, or asking if we could not pay off all the credit cards, or wondering if there was any way the borrower could raise the loan amount at the last minute because they just realized that they really needed a few more thousand. And 9 times out of 10 this was competely the borrowers idea, not the loan officer's. I think the most outrageous call I ever got was from a client that was supposedly getting the loan to pay down some credit cards and finish building a painting studio in his home (the client was a professional artist). But when the loan officer had to tell the client that we (escrow) had discovered a tax lien (that the client had lied about) that we had to pay I immediately got a call from the client - from Las Vegas. The client demanded we not pay the tax lien (which, legally, we absolutely had to), because... they had already spent all the money they had in Vegas and needed the money from the loan to pay for thier hotel room and some myserious "private lender" they didn't really want talk about. I can only guess. (We ended up paying the lien and getting the client just enough to pay thier debts, but I can't say anyone was happy when all was said and done.) Not every client was this blatant, but I can tell you this was far from the exception.

Now, there are alot of people out there who would say that we should have just refused to give these people loans, but the fact is that if someone qualifies for the loan, it's really not our place to tell them what to do with their money. In fact, its a good way to get sued.

And really, the fact of the matter is that, at the time, most of America benefitted from all this fake income and money squandering. Those same ill spent dollars funded a thousand industries, from those ubiquitious coffee chains to hybrid cars. And because getting a home loan had become so easy, they could buy bigger and better homes, which drove home prices up, which made refinancing even easier, which drove the home loan industry, which made it easier to buy houses, etc. etc. etc. And so the real estate industry had figured out a way to provide a seemingly endless supply of "free" money to the people, and the rest of the business world was more than willing to provide them with stuff to spend thier dubiously aquired money on, and so we had an economic boom.

The only problem is, how do you sustain that? Because eventually, you run out of people to sell homes to or someone screws themselves up so much they really do go into foreclosure. But that was okay because the fiancial gurus had a fix for that too - creative financing. Can't afford to buy a house - sure you can! Thanks to credit only loans, and 100% financing. About to go into foreclosure? Let's provide "Foreclosure" loans - loans specifically designed to give people one last shot to save thier house. But these were all temporary fixes at best. The investors had gotten greedy, the real estate sales people had gotten greedy, people looking to sell thier homes for nearly twice what they paid for it in the 90s had gotten greedy - everyone had, really. Home prices started slowing down, investors were getting more picky about thier loans. We saw the handwritting on the wall two years ago, and started the process of shuttering our own brokerage, knowing that the break point was just around the bend...

And then one day, the Feds shut down New Century, and all hell broke loose. A downward spiral started that we are currently still struggling with. The dominos look something like this -

New Century goes down, word spreads like wildfire through the mortgage industry
Other companies that had very similiar practices to New Century started taking serious measures to clean up thier books before the Feds could get to them, too. But I think ultimately this was a bad call.
Because nearly overnight, the sub-prime market stopped. All those special creative financing loans just upped and vanished. That means that a whole lot of people that should have had yet another round of disposable income or been bailed out of foreclosure, weren't.
And then all the bad press came out, and the mortgage industry tightened up its belts even more. So, even more people couldn't get loans now.
And the worst part is a vast majority of public was lead to believe this was a good thing. And it probably was, but I don't think enough people thought about the long term consequences of encouraging that kind of lending reform - I know they didn't, because if they had, no one would have been surprised at the mess we are in now at all.
It's all very simple - the credit availablity for the average person dried up, and people were forced to actually live on thier incomes, in addition to a major industry disappearing virtually overnight, putting thousands upon thousands of people who had been earning obscene amounts of money out of the job. All of which amounts to people spending less money. Which means less money was going to every other industry across the board.
It's all very basic economics - no more loan officers were buying BMWs and Land Rovers, so now those car dealerships were making less money, so they put sales people out of the job, then those people had less money to spend, so places they used to frequent made less money, so THEY let people go, and on and on down the food chain, until now you have a whole mess of people out of work, and an economic downward spiral showing no signs of slowing.

But it isn't mysterious why it happened - less money in the system = economic downturn, plain and simple. But how its going to get fixed is impossible to tell. We've already demonized easy credit to the point that its no longer a viable option. You can pump free money into the market (which seems to be the current plan), but eventually the money is going to have to come from somewhere. Or... you could let the invisible hand to its work, and just let the market fall. Eventually inflation would reverse itself, prices would come down, and someone will come up with the next big industry.

But that's not a very popular suggestion. It certainly won't win anyone the election if someone actually stands up and says, you know what? We're going to have a recession, it's going to difficult, but we can all keep our heads down and work through this together, we'll be in a much better place economically a few years from now.

But it is true. (Probably - this would, of course, require that everyone stop trying to "fix" things, which is not likely to happen anytime soon.)