Hi,

Can anyone from the Land of Plenty (USA) explain to me as a resident of what some have called a small offshore island (UK) what is going on in the world of finance currently? And how does this turmoil affect Joe Public?

Alan

It's complicated, but here is basically what is happening:

Over the years, the government saw that "minority" applicants for mortgages in the US ("minority" usually means black and Hispanic but sometimes just black) were approved for home mortgages 72% of the time, while whites were approved 89% of the time, and they decided that this was evidence of racial discrimination. (They ignored the fact that Asians here are approved for mortgages at a higher rate than whites are, because on average they have a higher net worth and better credit than whites, just as whites tend to have a higher net worth and credit rating than blacks.)

When the government decides that statistical differences are evidence of discrimination, they usually use some draconian measure to try to forcibly eliminate the statistical difference, and they often don't look at the possible consequences. In this case, the Congress passed laws forcing banks to lend money to minorities who would normally not be considered creditworthy. Of course, a bank cannot simply create a racially based lending policy, so they lowered the credit standards for everybody. They also had to use various creative financing techniques, such as giving out flexible-rate loans that looked really good while the interest rate was low, and "interest-only" loans, where the borrower would not have to pay the principle for several years.

It also became common to take out what are called "home equity loans", which are second mortgages on the portion of a house's value that was already paid up. Some seedier lenders (generally not banks) made these "home equity" loans for as much as 150% of the value of the house, which means the loans were based on nothing. The original idea was that these home equity loans could be used for improvements to the home, but many people used them (and were encouraged to use them) for ordinary consumer spending, because the interest on a mortgage is tax-deductible but not the interest on a credit card or ordinary consumer loan.

And most important, all of this allowed the banks to boost their racial numbers in lending, so that they could show the government they were "Equal Opportunity Lenders".

All this "easy" money being available had several results:

-- Many, many people (not just minorities) bought houses they couldn't afford, because the configuration of the loan payments made them think they could.
-- It created such a demand for houses that the prices skyrocketed, which of course made people take out even bigger surrealistic loans. It also caused a lot of speculation in real estate.
-- It caused a building boom in residential housing.

Interest rates don't stay the same forever, and when they went up a little, many people who had flexible-rate loans could no longer make their payments. With the "interest-only" loans, payments on the principle started coming due, and suddenly many people couldn't afford to make those payments either. The double whammy was when someone had a flexible-rate interest-only loan.

Many of these loans then had to be foreclosed on. The problem was that with all the foreclosures, the housing market began to shrink, and prices began to drop. People couldn't sell their houses for what they owed, and so many people just walked away from them. The banks then owned property that was not worth the loan amount. And remember, sometimes the loans were for as much as 150% of the value of the house, so there was no way to recover the money once the borrower defaulted.

Mortgages are sold back and forth by banks (my mortgage has belonged to two banks so far), and many banks and other financial institutions owned so many of these mortgages, or securities backed by these mortgages, that once a lot of people started to default, the banks and investment companies began to fail.

As to the question of how this situation affects Joe Average, the answer is pretty much not at all. If a person has not gotten up to his ears in debt, he sees the situation but is not affected by it. In fact, it can be beneficial to him, because the drop in housing values makes his own property tax rate go down. The last statistic I heard was that even in the worst-affected state, 93% of mortgage borrowers were still solvent, so most people are in good shape. The problem in some places comes when people want to move and need to sell their houses, because there are virtually no buyers. There are houses in my neighborhood that have been on the market for a year or more, which is unheard of.

Most people, though, see the effects but don't feel them. Over the past few years many blacks bought houses in my neighborhood, but over the past year more than half of them have disappeared and their houses are sitting empty. Some whites have disappeared also. Some of this is due to changes in local employment patterns, and some is due to defaults.

Another visible effect is that people who are solvent and like to invest in real estate and rehabilitate houses to sell them (so-called house flippers) are finding a lot of bargains.

There is a current attempt by some political factions to make people believe that the problem was created by the Reagan administration when it removed some bank regulations in the 1980s, but if that were true, the problem would have appeared 20 years earlier. It's really about banks being forced by Uncle Sam to lend to people with bad credit.

Here is one economist's explanation of what happened:
http://townhall.com/columnists/ThomasSowell/2008/07/22/bankrupt_exploiters


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