House Prices - Economic MeltDown

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In the UK, the worldwide meltdown of 2007/8 was blamed by some on the US-led repackaging of bad debts. Others blamed it on the UK government, led by the economic mis-judgments of Labour politicians, who failed to advise/legislate the banking world so that their businesses would continue to succeed.

The banks treated housing as a commodity. They manipulated house prices by allowing bigger and easier mortgages. There was little incentive for house-builders to increase production - an increased supply would only lead to a fall in profit.

In the UK, house prices are currently showing increases similar to the increases just prior to 2007/8. The Conservative government is actively subsidising house price increases with its 'Help-2-Buy' scheme. But there is still no incentive for house-builders to increase supply.

The previous governor of the Bank of England was extremely critical of the behaviour of the banking industry, and his successor has today warned that rising house prices are threatening to generate a repeat of the events of 2007/8.

What is happening in the US?

Okay, here's my understanding and other people are of course free to disagree:

It was a market bubble, similar to tulip bulbs in Holland in the 1600s or whenever.

The crisis reached it's peak in Sept. 2008 with the failure of Lehman Brothers. Several others banks almost failed and were bailed out. President George Bush, and candidates Senator John McCain and Senator Barrack Obama all supported the bailout.

The big boy banks became interested in repackaging mortgages, and not the work-a-day business of qualifying the loans.

Now, some conservatives say it was because Freddie Mac and Fannie Mae was required by the federal government to grant loans to people who really couldn't afford them (and the banks followed these regulations to the letter, when they only kind of sort of follow pollution regulations?) In my mind, it may have been a minor contributing factor but it was not one of the major factors. It's just that conservatives have a hard time wrapping their mind around that markets sometimes fail.

And regardless of how we got into the mess, I think the take-home lesson is this:

This business of banks "too big to fail" is both a lousy and an unnecessary situation, and we shouldn't have to put up with it.

Thanks for the replies, guys. And I hope that most people would agree that the crisis of 2007/8 was mostly created by mis-judged commercial activities rather than by mistaken political decisions.

The important issue now is that, in the UK at least, there seems to be a serious possibility that the events of 2007/8 are about to be repeated.

This time around, the UK government is actively promoting a house price bubble with its 'Help-to-Buy' scheme.

Until recently, I would have included the governor of the Bank of England as being a member of the privileged classes. But Sir Mervyn King, and now Mark Carney, are beginning to establish themselves as potential game-changers.

Actually, we were in a bubble that was created by the Federal Reserve in an effort to counter the collapse of the Dot Com Bubble (and thus save the wealthy and influential from being bankrupted by their bad decisions when they bought into the bubble). Don't confuse the creation of the bubble with what pricked the bubble and caused it to collapse.

When you pour money into the system, you are going to see one of two things. If the distribution of money is very even, you will see inflation as more and more money chases goods of all kinds. If the money mainly goes to the privileged few, in this case Wall Street banks, they will generally invest the money in whatever is getting the best returns. And, of course, pouring more and more money into whatever is getting the best returns just keeps pushing the price higher and higher. In the case of the Housing Bubble, that money was going into mortgage financing and the cheap money was pushing the cost of the goods being bought with the borrowed money higher and higher.

The historical analysis of what happened in 2007/8 will continue for ever, but in the UK we are facing an imminent repetition of the collapse of the property market. Somebody, surely, has the power to prevent such an inevitable event. Unfortunately, the people with the power to prevent it are the same people who are immune from it's negative effects, and probably will only gain from yet more taxpayer bailouts.

Most ordinary people do not wish to connect with bubbles, monetary phenomena, or 'where the money is'. They just wanna a nice place to live.

For a few post WW2 decades, that seemed to be becoming a possibility. But the resistance to the Western way of the world is spreading across many many cultures.

I think it bears noting that there wasn't a single root cause of the crisis, but rather a confluence of mistake.

First, credit ratings weren't honestly undertaken. "Ninjas" (no income, no job, no assets) were getting "A" ratings, so that mortgage lenders would extend money to them. Who owned the credit rating agencies? The banks. The banks wanted to expand their business and the rating agencies provided the means by which that could happen.

Next, decision and risk got separated. Banks chopped up their mortgage assets and sold them off in packages of blended debt. In theory there's nothing wrong with this--but only in the risk is honestly disclosed. Lenders (for example, Northern Rock and Countrywide Financial) were issuing mortgages willy nilly, because they knew that they could sell them off at a discount, and then use to proceeds to issue the next mortgage.

Third, the Fed and the Bank of England followed a "light touch" regulatory environment. The thinking is, again, perfectly rational. Smart business people are likely to make deals that serve their best interests. People wouldn't buy these derivative instruments if they didn't believe that they were a good investment. Everybody was buying everyone else's "Mortgage backed securities" and "Asset backed commercial paper."

But then, people began to question their own balance sheets (largely because auditors were forcing them to). They couldn't figure out whether their assets were worth what they claimed they were.

And this is where the real disaster happened: If I can figure out whether my balance sheet is accurate, then how do I know that your balance sheet is accurate? And this destroyed confidence in the single, largest market in the world: the liquidity market--banks lending to other banks. We can actually pinpoint the day when capitalism came to a halt.

The dominos were falling. Northern Rock, the first, genuine, run on a British bank in over a century. The Bank of England staunched that one, but more started happening. BNP, Bear Stearns. And then Lehmans. And with Lehman's the Fed drew a line in the sand--and it was the wrong line. So, should regulators have prevented this? It's easy, in hindsight, to say, "yes." But there is a real question about whether they should have interfered, and why.

In the 2000's, the financial industry was providing 9% of all UK government revenue. Every reduction in business activity caused by regulatory interference would have had a direct and measurable impact on government revenue. In the United States, the Federal Reserve was ill equipped to regulate the subprime mortgage market.

Where prudential supervision did fail, both in the UK and the US, was in the derivatives market. The SEC and the FSA both relied too much on the wisdom of the market to protect itself. The crisis demonstrated to us, yet again, that markets are not wise. Markets are phenomenally good at finding fair value when everyone is playing with the same body of information; but the derivatives market in mortgage securities was anything but transparent, and the market was completely incapable of setting a fair value.

Not everyone came out of the crisis badly, though. Canada had a very different financial sector, caused by a few factors. First, 93% of the retail banking sector is controlled by six large banks. These banks are well positioned to weather downturns in the real estate market because they each hold broad portfolios which provide enough liquidity to write off underperforming debt. Second, every high ratio mortgage (> 80% of fair market value) in Canada must be insured with CMHC. This means that lenders are protected in situations where security interests fall. In the years since the financial crisis the Superintendent of Financial Institutions has further limited mortgage lending (getting rid of 95% mortgages, limiting high ratio financing on mortgages over $400,000 etc.) But these measures were intended to stem overheating in the real estate market; not to protect banks from their own folly.

The property market in some parts of Britain shows signs of overheating--but not all over Britain. But to the degree that the government and the Bank of England can tighten up on mortgage lending that will have a cooling effect on overinflated markets.