Something Had To Give

[This is a slide from an article at Afferent Input about the growing income disparity in America. Combine that trend with our recent adventures in bad financial policy, and you have a recipe for a home mortgage meltdown.]

Recently, I've written that I'm not an economist. I don't have any particular expertise in the area. What I am is an engineer. That makes me an amateur economist. I'm used to thinking of prices in terms of their effect on a budget, much as housewives and househusbands are used to thinking about food and utility prices in terms of a family budget. I look at manufactured items and wonder how much they cost relative to incomes at the time those things were made, as well as the cost of making them relative to the budgets of the companies that produce them.

Call me an idiot savant economist.

I haven't followed the housing market all that closely. Yet it's seemed to me for years that the current financial meltdown, fueled as it was by bad mortgages and resulting inflated housing prices, was in some ways inevitable. I knew that, sooner or later, something had to give.

To illustrate why I felt the way I did, let's look at a bit of demographic data from the last census. For my city, Federal Way, Washington, the median household income was about $50,000 in 1999. It hasn't risen a whole lot since then. I live in a small three-bedroom, two bathroom house. It's a good house for a single person, a couple with no children, or a small family. Houses like that go on the market now for upwards of $220,000. Mind you, this is now, after real estate prices have been falling for several months.

Now, let's recall that years ago, in the 1990s, for instance, the financial advice on mortgages is that they shouldn't be more than three times your household income. If your household is making the median income in Federal Way, which, incidently, is close to the median income in the Christian Science Monitor's Patchwork Nation version of Federal Way, that would be about $150,000. You need to come up with another $70K to make that threshold, which is a lot for a young family to come up with. Let's also recall the definition of median average. It means that half the households earn that much or less, and half earn that much or more. In short, at least half of the people who live here couldn't afford to buy a house here.

The Patchwork Nation link estimates that 30 percent of the country is like Federal Way. Even if this example is only true of this sort of community, that's quite a bit of the country. The reality, though, is that this is true in much of America.

That's the problem. It's the reason why the mortgage industry is collapsing. They either needed to find ever riskier ways of selling mortgages, or they needed to resign themselves to a smaller market. Needless to say, most mortgage businesses weren't in favor of Plan B. Here's a site, for instance, that says up to eight times your household income might be acceptable.

As we are all too aware, one of the riskier ways of selling mortgages was adjustable rate mortgages (ARMs). These mortgages offered easy early payments in return for riskier future payments. I first heard about these mortgages while I was house-hunting back in the '90s. I thought they were a terrible idea from the borrowers' standpoint.

What I didn't realize at the time was how risky they would end up being for the banks.

The question that ought to come to mind at this point, assuming you think my calculations make sense, is why did prices get to be so high? We can yammer all day about things like the elasticity of demand and other things that affect price, but the bottom line is that the price will be whatever the market is willing to bear. Why was the market willing to bear prices that clearly left many potential customers unable to afford it? One possible answer is that the prices were artificially high.

Why were ARMs risky for the banks, and why did they serve to raise housing prices? Here's what a site about mortgages has to say about ARMs:

An adjustable rate mortgage, called an ARM for short, is a mortgage with an interest rate that is linked to an economic index. The interest rate, and your payments, are periodically adjusted up or down as the index changes.

Facts About ARMs, Adjustable Rate Mortgages

In other words, the consumer takes the risk that inflation won't make his later payments even higher. In classical fixed rate mortgages, the lenders assumed that risk. While the interest they were paid would mean that they earned some money from the loan, the opportunity cost would mean that they weren't making the best use of their money if inflation worsened. Lower risk to the banks means easier finance terms.

Back in 1992, economists Richard A. Phillips and James. H. Vanderhoff performed a study of their effect on demand for housing. Their conclusion, as expressed in the paper's abstract, was:

This article investigates the impact of ARM initial rate (teaser) discounts on mortgage choice and housing demand. Because discounted ARM loans may reduce expected user costs, theoretical models predict a positive impact on housing expenditures. To test the hypothesis, a simultaneous model of housing expenditures conditioned upon mortgage instrument choice is estimated using a national sample of transactions for the 1986 to 1988 period. The results indicate that overall housing demand would have been reduced by approximately 13 percent during the period in the absence of ARM loans.

Abstract: Adjustable Rate Mortgages and Housing Demand: The Impact of Initial Rate Discounts

Over time, thanks to the growing income disparity in America, this demand undoubtedly became more inflated. That was bound to have an even greater effect on prices.

In short, for the past thirty years, we've been making it possible for people to buy more expensive houses than they could really afford, and house prices inflated way beyond what they should have as a result.

Why was this risky for the banks? To answer that question, recall how loans are secured. The bank risks that its borrowers will repay the mortgages as they agreed. If they don't, the lender has the option of repossessing the homes and reselling them. That's what collateral is. The problem, as this Wall Street Journal article explains, is that the value of the collateral has fallen well below the value of the loans:

Lower home prices threaten the economy's growth by making consumers feel less wealthy and thus less willing to spend. They also curtail homeowners' ability to borrow against the value of their homes to finance other purchases. In addition, lower housing prices erode the value of banks' collateral, prompting them to tighten their lending standards, which further damps economic growth.

Decline in Home Prices Accelerates

When the price a bank can obtain for a house is less than the value of the money the bank lent to the borrower, the bank will lose money.

Now multiply that by millions of homes and you'll see why this situation was untenable.

Of course, as an idiot savant is wont to do, I've oversimplified. This difference between the money risked and the current value of homes is only part of the problem. As NPR explains, part of this has to do with how that risk is distributed between the world's banks:

There are about 51 million first mortgages in the United States right now — but only about 1.4 million of them are either referred for foreclosure or in foreclosure, said Mortgage Bankers Association chief economist Jay Brinkmann. In other words, fewer than 3 percent of American homes with mortgages are in foreclosure.

The problem is this: Those bad loans are having an outsize impact on the financial world. They are mixed with good loans in securities that are crippling investment banks. No one wants the securities, even though not all of the loans are bad.

Bad Mortgages Taking Down Good Loans, Too

Nevertheless, the bottom line is the same - the banks will lose on these bad loans no matter what course they take. The only question is whether it's enough loss to make the system collapse.

The sad fact is that none of this was unpredictable. (That link is from 2005.) It was, as I've demonstrated, blindingly obvious that this day would come. Yet we persisted in this folly for the better part of three decades. What's more, we deliberately pursued economic policies that would concentrate wealth into the hands of very few people, making it harder for the average American to afford a home. If we continue down the path of creating more income disparity, more risk for borrowers, and less risk for the people who run the financial sector, we'll be revisiting this situation in a few years.

Maybe it's time for a new course?

UPDATE (Feb. 25, 2009): Finally noticed the problem with the third paragraph. Before, I seemed to be saying that the meltdown would continue. It now says what I meant it to say when I started writing that sentence.