By Steve Freidell
Land Line contributor
Many of you are probably familiar with this situation: You’re cruising along some tollway when all of a sudden you hit a big pothole. You curse and shake your head.
Weeks later, as you warily approach the pothole again, you notice that it has been repaved with new asphalt. You’re initially relieved, but then you reach the tollbooth and find that the toll has been increased to pay to fix the potholes. You curse and shake your head.
People ask me all the time, “Steve, how did our economy collapse so quickly?” Well, like that pothole, it didn’t happen quickly, but rather was the result of damage accumulated over time. Let me explain.
Back in the 1990s, our government wanted to offer those people who had previously stumbled and made mistakes the opportunity to own a home. They encouraged Fannie Mae and Freddie Mac to create special lending programs for those persons who were credit-challenged.
After several years of these programs doing what they were supposed to do, government leaders walked away and took their eyes off the ball. In 2000, the tech bubble burst and the economy began to falter. The Fed lowered interest rates to 40-year lows, and by 2001, mortgage companies discovered the panacea created by these relaxed credit standards.
These banks and mortgage companies began to aggressively solicit customers to take out low-interest loans.
Homebuyers, seeing an unbelievable opportunity, began to purchase homes they never dreamed they were capable of buying before the low interest rates and relaxed credit standards made it a reality.
Homebuilders dramatically increased production to meet the demand, but quickly found prices rising faster than they could build homes. Home prices rose so fast during 2001 through 2006 that many homebuyers were lured into a false sense of security that home prices would never decline.
Mortgage brokers created special “interest only” loans, “adjustable rate” loans – which had artificially low rates the first year or two that increased significantly thereafter – and loans that did not require proof of incomes.
With interest rates so low, large brokerage companies began to purchase these mortgages and to repackage them into bundled securities, which paid higher rates than other similar investment securities. As such, the demand for these securities soared, further increasing the demand for the mortgages, making money easier to get, and bringing more unreliable buyers into the real estate market. It was all one massive house of cards.
In August of 2007, a financial instrument called a CDO or collateralized debt obligation, which was a financing tool used by the large brokerages to purchase and finance these mortgage securities, began to falter. When money became tight for these programs, brokerage firms stopped buying the CDOs.
Finally, investors began to take a look at these mortgage-backed securities and discovered that they were essentially built on a pile of bad credit. As a result, the markets began to topple. Home prices quickly followed, and borrowers were soon faced with skyrocketing mortgage payments as those adjustable rate mortgages increased with other interest rates.
In many cases, homeowners owed more than their homes were worth, and their only choice was to default on their loans. The house of cards had collapsed.
After this short explanation, I am usually asked, “Well, Steve, then who was at fault?” My answer is everybody, just like the pothole was created by everybody who drove over it. We all are at fault.
We borrowed too much; we overspent our means; we thought the good times of home ownership had only one direction, and that was up.
Greedy mortgage companies preyed on this weakness by creating complex instruments that generated large profits while hiding the weak foundation they were built upon.
Brokerage companies, large banks, even foreign banks and governments failed to detect the structural issues, turning the other cheek in favor of huge profits and a false sense of security.
Finally, our government officials who helped create these programs never looked back to see if their house was still standing. Too many of their constituents were benefiting from the easy credit and they didn’t want to upset voters.
So, have we learned from this? Well, consumers have steadily decreased their debt over the past 18 months by billions of dollars.
Reducing debt is the best way to prevent this from happening in the future. Reduced debt causes all of us to spend within our means, and it takes away the incentive from greedy lenders to prey upon our need for debt. The result is increased savings, which will offer you substantial capabilities to weather the inevitable financial storms in the future.
Paying down your debts now will be the only way to reduce that increased toll coming in the future when inflation, interest rates, and taxes will soar to very high levels. That pothole will seem small in comparison to the crater you will come across if you fail to prepare adequately. LL
This material has been prepared for informational purposes only; it is not intended to provide and should not be relied upon for accounting, legal or tax advice.
Steve Freidell has assisted clients in their cash management, trading, and portfolio management of fixed income securities since 1975. Steve started his career at the First National Bank of Kansas City and later served as first vice president with Commerce Bank, where he served his clients for 25 years. In 2006, he joined the DeWaay organization, the financial management company used by OOIDA. Steve Freidell may be reached at email@example.com.