Friday, August 12, 2011

Strong-ARMed by the Subprime Bubble

Thanks to another econ site we follow around here, I became aware of the superb services rendered to data mavens by the St. Louis Federal Reserve Bank’s FRED program (FRED stands for Federal Reserve Economic Data); the site is accessible here. More specifically, Modeled Behavior, the econ blog, alerted me to construction data on FRED in this interesting post, featuring expenditures on churches; check out the downward slide. That in turn led me to see if I could find data on residential construction. Yes. I found them. That led to more investigations into the roots of our current economic problems—and FRED once again obliged. The three graphics presented below come from that site—and shown, although re-graphed by me using Excel, in the same style used by the St. Louis Federal Reserve.

My subject is the Subprime Bubble. It is—if not a singular then an instructive—indicator of what happens when greed, vanity, and ambition align with flagging oversight in a hot, free economy to produce a great storm that ravages the innocent and guilty alike for years on end.

The roots of the Great Recession where “innovations” in real estate practices. The first of these was the introduction of adjustable rate mortgages (ARMs). You borrow at a low rate—thus you can realize your “dream” (a God-word of our times) before you can really afford it. The rate is adjustable upward, if interest rates rise; but ARMs were not (and could not be) designed to raise your income automatically as well—therefore, if rates spiked, you could lose your house. ARMs allowed more people to buy homes—read increased demand.

The next innovation was subprime lending. But what does subprime mean? The word is deceptive because sub means below. If you are careless, you might assume that subprime refers to the interest rate and means lower than then prime rate. It means the exact opposite. Subprime lending means lending at higher rates to people who are sub—thus less qualified to borrow. Those with adequate assets and income qualify for the lower prime rate; its prime, desirable, because it’s lower. Subprime borrowers can only get mortgages at higher interest rates.

Subprime lending was much touted as a service to the young, the needy, and those who had been discriminated against for lack of qualifications. As subprime lending took hold—guess what? more people came into the market, demand increased—and pushed up prices. The first graphic shows what happened as a consequence:

Home prices began a precipitous climb. The graph shows Standard & Poor’s 10-city home price index, which goes back to 1987 and is the best-known measure of home pricing. S&P’s 20-city index is slightly lower but shows the same pattern; it doesn’t go back as far. Rapidly, indeed dramatically appreciating real-estate values, triggered by these “innovations,” also fuelled it. With property values reliably rising, people thought they could easily refinance if they got in trouble—the underlying asset, after all, had appreciated. The bubble peaked in May of 2006 and soon came a precipitous drop in home prices. This, of course, chilled the market and resulted in…

…a steep rise in delinquencies. They stood at 1.53 percent of all mortgages in the second quarter of 2006, peaked at 11.36 percent in the first quarter of 2010, and were still at 10.52 percent of mortgages a year later in the first quarter of 2011. Add this another “innovation,” namely the securitization of mortgage debt. I’ve posted on that complex subject here on the old LaMarotte under the title of “Let’s Build a Pyramid.” What securitization did was to spread the liabilities of subprime lending into the financial system. All manner of instruments were sliced, diced, tranched, and sold—secured by questionable mortgages. When the nature of those mortgages became clear, the finance system began to quiver and shake. Not surprisingly, all this resulted in—recession. A Great Recession. And recessions have consequences. One of these, most closely associated with real estate is …

… a sharp down-turn in residential construction. That began in April of 2006, right on time, and foreshadowed the recession that would begin a year later. Such curves mean loss of jobs. And when we consider that housing, as an industry, is a fundamental support of economic well-being, the drop you see here signals radiations which we feel now and expect to feel for some years to come.

The Hidden Hand? Well, it can also slap you, and real hard. But this didn’t have to happen. It happened because, for that Hand to be Hidden, the Eye has to be Closed.

1 comment:

  1. Most interesting.

    Thanks too for the links. By the way, in this format or template you are using, the links you imbed don't show in any way... differnet color or font strength or anything so, when one goes back up in the text to find that link, it is hard to find. Just an FYI.