The Mortgage Culprits In The Economic Meltdown

Sub-prime, Prime Mortgages, and the FED

Of the list of culprits of the past economic meltdown, Thomas Woods believes that too much blame has focused on the sub-prime loans. Besides the government's push for minority home-ownership, the Fed's increase in reserves for the banks allowed lending innovations such as 100 percent loans to become institutionalized features in the banking industry. After a decade, these lower lending standards for low- and middle-income borrowers became so normal that they eventually became standard for higher-income borrowers as well.

The easier access to financing, Woods writes, led to a surge in demand which had the unintended effect of attracting speculators into the market. These speculators also had easy access to financing. However, Woods reminds the reader that a "more significant factor in raising home prices was the artificially low interests rates brought about by the Fed."

Because the large increases in foreclosures occurred at the same time for both the sub-prime and prime loans, Woods rejects the common notion that the sub-prime loan problems somehow infected the prime loan market. In fact, from 2006 through 2007, the increase in foreclosures was much higher for prime loans than sub-prime loans (In total numbers, of course, there were more foreclosures of sub-prime loans, but that is normal and is why they carry higher interests rates).

Adjustable-rate Mortgages

The real culprit in foreclosures, Woods says, was not the sub-prime mortgages, but the adjustable-rate mortgages - "the ones Alan Greenspan had once urged people to use - whether prime or sub-prime." Adjustable-rate mortgages begin with an attractive rate called a teaser rate. After a set number of years, the rate adjusts based on different economic indices. Sometimes the rate will go up, and other times the rate will go down. This is useful in volatile economic conditions when the lender doesn't quite know what to expect in the future. The risk is then shared by the borrower.

Instead of the sub-prime mortgages having the larger percentage of adjustable rate mortgages, the prime mortgages had the larger percentage. In other words, the myth that the mortgage crises was caused by unscrupulous lenders preying on vulnerable people who couldn't understand their mortgage terms was just that: a myth. If it were true, then why did the the prime mortgage borrowers get "bamboozled" more than the sub-prime borrowers?

The speculation in the housing market explains the increase in foreclosures according to the available data. Speculators either "flipped" houses, that is, they bought a house and made various improvements and then resold it at a higher price, or they bought a house and waited a short period of time after it had appreciated. Both kinds of speculators were attracted to the adjustable rate mortgages because they expected to sell the house before the teaser rate expired. It has been estimated in recent years that speculators comprised of one fourth of homes purchasers.

When housing prices began to fall in 2006 (1.4 percent), foreclosures shot up dramatically - 43 percent in the last six months of 2006. This disproportionate rise, Woods explains, was caused by speculators who used the flexible, no-money-down mortgages to buy homes and then resell at a profit. Because the housing prices were no longer increasing, their chance of making a profit fizzled, and so many simply walked away. They hadn't lost much since they hadn't even made a down payment.

SEC Rating Agencies

The sudden collapse points to another culprit: the private rating agencies that judged the creditworthiness of the mortgages. According to economist Art Carden:

"SEC regulations hung over the rating agencies like the sword of Damocles, and the raters didn't want to attract undue regulatory attention by opposing a politically popular initiative."

These approved rating agencies are not free-market agencies, but a SEC-created cartel protected from competition by regulatory barriers. Liebowitz writes:

"Given that government-approved rating agencies were protected from free competition, it might be objected that these agencies would not want to create political waves by rocking the mortgage boat, endangering a potential loss of their protected profits."

The ratings agency cartel deserves all the blame that it has received, but Woods points out that the Federal Reserve's interventions into the economy distorts economic indicators. This makes it harder for everyone, including the rating agencies, to understand the true state of the economy.


Inspired by Meltdown by Thomas E. Woods Jr.

David Singhiser:

Orthodox Christian, Libertarian, World Traveler, Writer, Sovereign Individual, Sangría Drinker, Former Spanish Teacher, A Psychologically Unemployable Vagabond you can follow on his blog at: Libertas.ws, and watch his videos at: Libertas Videos.