Fate of the States: The New Geography of American Prosperity (4 page)

The dramatic increase in subprime mortgage lending did not cause the housing bust, but it was the classic canary in the coal mine. The reason: Over 75 percent of the new subprime mortgages underwritten were ARMs. With the steep yield curve drawing more banks into the mortgage business—specifically into ARMs—competition heated up. Banks and other lenders started moving down the credit spectrum in order to get more business and feed the securitization beast. Between 2001 and 2006, the interest-rate gap between prime and subprime mortgages narrowed dramatically, from 3.5 percentage points to 2 percentage points.
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This in turn made home loans more affordable—at least during the teaser-rate period—for people who would not have qualified for a home loan just a few years earlier. Not only were the teaser rates low, but banks started competing over loan terms too, allowing people of all credit stripes to get mortgages with no down payment or no monthly principal payments (the infamous “interest-only ARM”) during the teaser-rate period. There were also the infamous NINJA loans: no income, no job, no problem. If my grandfather had lived to see this, he would have been horrified.

Underwriting mortgages that homeowners could only temporarily afford was not only unethical, and in some instances illegal, but also terrible business. More than half of the largest originators from the second quarter of 2007 wound up either bankrupt or acquired in a distressed-situation deal.
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Wachovia was swallowed up by Wells Fargo. (Wachovia’s fate had been sealed in 2006 by its $25 billion acquisition of Golden West Financial, the largest thrift in the subprime mortgage capital of the world, California.
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) Washington Mutual, the nation’s largest S&L, went bankrupt and was eventually taken over by JPMorgan Chase.
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Colonial BancGroup was shuttered in 2009, its assets taken over by BB&T.
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And Countrywide was bought by Bank of America for $4.5 billion. (This price was a fraction of Countrywide’s onetime $26 billion stock-market valuation, yet buying Countrywide still proved crushingly expensive for BofA. Countrywide saddled it with $40 billion in real-estate losses. “The worst deal in the history of American finance,” is how Tony Plath, a finance professor at University of North Carolina at Charlotte, described the BofA-Countrywide deal to the
Wall Street Journal
.)
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While Greenspan’s rate cuts certainly encouraged the switch to more aggressive mortgages, changes in federal housing policy played a role too. In 1994 President Bill Clinton and Fannie Mae CEO Frank Raines—Clinton’s former budget director—embarked on a new push to increase the rate of homeownership in the United States. Clinton believed homeownership was “the realization of the American dream,” and his stated goal was “to develop a plan to boost homeownership in America to an all-time high by the end of this century.” The strategy was unveiled in a 1995 policy paper published by the U.S. Department of Housing and Urban Development and endorsed by the president himself in an introductory note. As Drexel University finance professor Joseph R. Mason pointed out in a 2008 report penned for Criterion Economics, the strategy put forward by the Clinton administration explicitly encouraged the kind of no-skin-in-the-game, borrow-now-pay-later mortgages that would ultimately sink the housing market. For example, the strategy paper praised the “great strides [that] have been made by the lending community in recent years to reduce down payment requirements, particularly for low- and moderate-income homebuyers.” It called for “financing strategies, fueled by the creativity of the private and public sectors,” that might make homeownership possible for “households [that] do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms.”
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In 1994 the Clinton administration pushed through revisions to the Community Reinvestment Act that incentivized loans to low-income borrowers by making such loan making a prerequisite for approval of bank mergers or acquisitions. Also in 1994 Fannie Mae reduced from 5 percent to 3 percent the minimum down payment required to qualify for a Fannie mortgage. Five years later, Fannie tiptoed further into subprime by easing income requirements for lower-income borrowers.

The Housing Boom: The Ownership Society and Securitization

Unprecedented access to home loans opened up possibilities that had never existed before for many Americans. During the housing boom, eighteen million new homeowners were created and $8 trillion in additional mortgage capital was injected into the economy.
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This made the impossible possible. More homes were built. More furniture and appliances were purchased. Home-equity lines of credit were tapped for vacations and other discretionary spending. The impact on the job market was massive. According to the Bureau of Labor Statistics, the housing bubble created 1.2 million real estate–related jobs between 2002 and 2005. Unemployment dropped to its lowest level on record. Best of all, jobs in home building and construction couldn’t be outsourced or offshored. The work had to be done locally, which had an incredible multiplier effect on local economies.
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However, in the same ways America’s manufacturing boom in the post–World War II era was not shared equally by all Americans, the economic boom of the last twenty-five years was not experienced equally among all Americans either. The real-estate boom shifted economic power from industrial states like Michigan, Ohio, and Indiana—where real-estate markets were softer—to states like California, Arizona, Florida, and Nevada. The country shifted in one generation from a manufacturing-based economy to an economy whose growth came from housing, consumer leverage, and, to a lesser extent, technology.

The homeownership rate climbed from 64 percent to close to 70 percent in just twelve years.
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The problem was, the unprecedented demand for homes stimulated an equally unprecedented rise in home prices. What followed was a period of hyperinflation of real-estate assets, leading to a period marked by cash-out refinancings, peak homeownership, go-go securitization, and eventually the piercing of the housing bubble and the onset of the Great Recession. The housing-related riches that had accrued to states like California, Arizona, and Nevada in the West and to Florida, North Carolina, and Connecticut in the East simply vanished.

From 1994 to 2006, average home prices in California and Florida increased 482 percent and 463 percent respectively, which was more than 2.4 times and 2.3 times the national average. Sure, housing prices rose 199 percent nationally during that time, but the gains were disproportionately weighted to coastal and Sun Belt states.
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Homeownership rates in these states soared by 12 percentage points. The economies in these states thrived. More than 5.1 million jobs were created during that period, 21 percent of all job creation in the country, and the overall contribution of these states to total U.S. GDP stood at 20 percent by 2006, the peak year in housing. The good times seemed like they would never end.
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Not coincidentally, consumers started to borrow more as the values of their homes appreciated. This was a variation on the stock-market wealth effect. But with real estate, unlike with stocks, consumers tapped their winnings by borrowing rather than by selling. Consumers piled on debt, further boosting the economy in the short term, though not all consumers piled on debt equally. In California, Nevada, Florida, Arizona, New Jersey, and New York, debt per capita ballooned by over 100 percent in just one decade. Feeling flush from their real-estate gains, American consumers grew addicted to their credit cards as a cash-flow-management vehicle. This access to credit allowed consumers to continuously spend beyond their means and gave small businesses the ability to hire more people. Most of the debt pile was tied to real estate. In California 88 percent of consumer debt per capita was related to the value of homes. In Nevada the figure was 85 percent; in New Jersey, Florida, and Arizona, 83 percent, 85 percent, and 78 percent respectively.
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Politicians in these boom states had never had it so good. There was more money to go around, and the notion that home prices could ever decline seemed absurd. Few things are more dangerous in government than an elected official with an open checkbook, and too many elected officials chose to solidify their political bases by directing surplus tax dollars wherever they pleased. The school system in Montgomery County, Maryland, for instance, chose to spend a $32 million budget surplus not on reducing class sizes but on increasing take-home pay for teachers.
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In Nevada state spending almost doubled over the past decade. Arizona was close behind, with spending growing 93 percent. Spending in California grew 70 percent from already-high levels. The problem was, the rising standard of living in places like Las Vegas and Phoenix was grounded not in something truly sustainable like wage growth but in one-time withdrawals of home equity.
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People literally started using their homes like ATMs. The prevailing mind-set: “The value of my house is up ten thousand dollars. Well, then, there’s no harm in taking out a ten-thousand-dollar home-equity loan. Even if I can’t afford to repay, I can always just sell the house and still turn a profit. Right?”

This kind of myopic thinking would prove painful not only for homeowners but also for the communities in which they lived—communities whose economies had grown dependent upon the housing boom. The pockets of highest unemployment and slowest economic growth began shifting from historically poor Southern states like Mississippi and Louisiana to the nouveau riche–turned–
nouveau
pauvre
states like Arizona, Nevada, and Florida—those most affected by the housing bust. In 2006 those three states had below-average unemployment as well as the highest GDP growth in the nation, at 6.6 percent, 7 percent, and 6.7 percent respectively, according to the U.S. Bureau of Economic Analysis. Just four years later, Arizona, Nevada, and Florida ranked forty-eighth, forty-ninth, and fortieth in GDP growth, while Nevada had the highest unemployment rate in the country at 14 percent. (California was second worst at 12 percent.)
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The Housing Bust

In 2006 home prices in America peaked, and the rest is history. That very same year, subprime mortgage lenders began to go out of business due to rising losses. By 2007 more than twenty-five subprime lenders had declared bankruptcy.
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By 2008 the tidal wave of losses was no longer limited to subprime. Iconic firms like Bear Stearns and Lehman Brothers collapsed under the weight of the housing-bust carnage. From their peak, home prices declined over 30 percent in the top ten cities across the country. In Las Vegas home prices dropped 60 percent. In Phoenix home prices declined 49 percent. Miami, Tampa, Los Angeles, and Chicago were all hit with their own crippling declines.
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Today home prices have rebounded slightly off the bottom, but given the sorry state of the economy, it’s far-fetched to think prices will quickly rebound to break-even levels for those homeowners who bought at or near the peak of the market.

While the housing market appears to have stabilized and pockets are improving, or stabilizing, off the bottom, prices are still way off their peaks. In many states, such as California, Florida, Arizona, and Nevada, home prices would have to more than double just to get back to even.
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Making normalization of the housing market even more challenging is the completely dysfunctional condition of the current mortgage market. We still have no U.S. housing policy. The Federal Reserve has distorted mortgage pricing to such an extent that the entire market is effectively mispriced. Most mortgage activity today relates more to refinancing activity than to new home sales, so those that have good credit are paying less for it and those with less-than-good credit are renting, unable to buy homes. For many want-to-be homeowners, low rates have almost nothing to do with being able to buy a home if they can’t access a loan in the first place.

In the near term, the economic gap between the have and have-not states cannot be closed without rapid reinflation of the housing market, and that seems unlikely given the current state of mortgage finance in the United States. Lenders are much more cautious about underwriting non-GSE-backed mortgages, which hurts affordability. Since the U.S. mortgage-backed-securities (MBS) market collapsed in 2008, lenders have begun to raise down-payment requirements and mortgage fees again, as the option to churn mortgages into MBS has all but disappeared. In other words, with banks’ ability to unload credit risk and generate revenue via MBS securitization now cut off, borrowers are faced with a more expensive mortgage product at a time when home loans are already harder to obtain. This is perhaps why Federal Reserve chairman Ben Bernanke shares my housing-market caution. Said Bernanke in November 2012: “Overly tight lending standards may now be preventing creditworthy borrowers from buying homes, thereby slowing the revival in housing and impeding the economy recovery.”
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It’s going to be a difficult cycle to break. States and municipalities are strained financially by weak tax receipts resulting from declining home prices. They respond by raising taxes, cutting programs, or both. Higher taxes and reduced social services create new downward pressure on home values, which in turn takes another bite out of property-tax revenues. Of course, scenarios like this have played out before in the United States, and the afflicted cities and states did recover within a few years. But in prior cycles, the holes they were digging out from were not nearly so deep. Consider what happened to New Hampshire in the early 1990s. New Hampshire was arguably the state hardest hit by the savings-and-loan crisis. Seven of the state’s seven largest banks went belly up, New Hampshire’s unemployment rate reached 8 percent, and average home prices fell 20 percent.
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Yet not a single New Hampshire municipality filed for bankruptcy. Why not? New Hampshire’s state and local spending as a percentage of state GDP was 17 percent in 1992 versus a national average of 18 percent. In 2009 the national average was 21 percent, and four of the country’s most populous states—California, Michigan, New York, and Ohio—topped 23 percent. Whatever policy mistakes New Hampshire politicians made back then, overspending was not one of them.
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