Who is to Blame for the Credit Crunch?

There are many lenders currently under investigation for fraud, perhaps most notably the nation’s largest mortgage lender, Countrywide Financial. Even if Countrywide is found to be guilty of fraud, one company alone (even if it is responsible for 20% of the mortgages in the U.S.) cannot be to blame for the woes of the credit and housing markets. If anything is to blame, it is the market itself.

As mortgage rates began to fall towards all-time lows early in 2004, real estate prices skyrocketed. Thus began an insatiable appetite for home ownership, and lenders began to offer all kinds of mortgage products that would allow consumers to finance as much as possible for as low a monthly payment as possible. It was a snowball effect that caused a housing bubble that eventually popped.

Unfortunately, a lot of time and money will now be spent with investigating lenders. Time and effort will also go into the development of new regulations to prevent such a calamity in the future. At this point there is little that can be done to rectify the problem, other than to simply let the markets take their course. The reality is that the banks have already paid the penalty with the increasing number of defaults they are experiencing. Most of the new regulations will probably be unnecessary, as the banks have learned their lesson and have become very restrictive with their lending practices in light of what is taking place in the real estate market and lending market.

If you still insist that someone should be to blame, you could point the finger at the Board of Governors of the Federal Reserve and former chairman Alan Greenspan. Although mortgages do not directly follow the Federal Funds Rate, they do tend to trend along with the Federal Funds Rate when it experiences rapid and drastic changes. From January of 2001 to June of 2003, the Fed Funds Rate dropped from 6.5% all the way down to 1%. They remained at 1% for a year, until the Fed began raising rates again in June of 2004. There are others that also share my view that Greenspan is partially to blame for the credit crunch.

Not only did the Fed’s monetary policy help fuel the fire for the spike in home prices, but remarks by the Fed chairman did as well:

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

I think it is outrageous for the Fed chairman to make such remarks when fixed rate mortgages are at an all-time low (that remark was made on February 23, 2004). Certainly the banks were more than glad to oblige him, and they offered all sorts of exotic products to allow borrowers the highest mortgage balance possible for the lowest monthly payment. If you combine a high mortgage balance, an interest rate that is adjusting upwards, and little (or negative) home equity, you have a high probability that a default will take place.

Not only will a homeowner have a difficult time with the higher monthly payment on an adjusting rate, but with little or negative home equity, they may not be able to refinance into a fixed rate mortgage. Even if a borrower somehow manages to pass the strict requirements that lenders now have, the new fixed rate is very likely to be higher than the rate they had previously. The new payments are likely to be higher because of the higher rate as well as the principal component, which may have not been present in their prior mortgage if they had an interest-only loan.

The Fed may have prevented a recession in 2001, but the housing and lending markets are paying for it now. Now the Fed is lowering the Fed Funds Rate again, in hopes to prevent a recession from taking place. Sound familiar? Fortunately, this time there won’t be another housing bubble since the last one is still deflating. I think this time the actions of the Fed will result in the cheapening of our currency. It has already begun to happen, and is likely to get worse. Because the U.S. economy depends so much on foreign exports, the current actions of the Fed will most likely result in inflation.

Adding insult to injury, the bursting of the housing bubble has also contributed to the decline of the dollar. Foreign investors hold trillions of dollars in mortgage-backed securities. The problems with the housing and lending markets have led to a huge sell-off in these securities, lowering the demand for the U.S. dollar. If it wasn’t for foreign monetary policy, the decline of the dollar would probably have been much worse than it has been.

I think some moderate inflation will be necessary to allow household incomes to catch up with home prices. Even with the deflation of the housing bubble, home prices are still very high relative to incomes. If one is to purchase a home today with a traditional fixed rate mortgage, either their income needs to rise, the price of real estate must fall further, mortgage rates need to come down, or some combination of the three. Rising incomes will also help to lessen the blow of the problems with foreclosures and defaults. Lower foreclosures and defaults will improve the problems with the secondary mortgage markets, which will restore some confidence with foreign investors in that market. Eventually when things settle down the U.S. dollar should stabilize as well. It will certainly be interesting to see how things play out.

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