Tuesday, January 27, 2015

2008 Housing Bubble: The Law, Speculation, and Rating Agencies

After identifying the role of GSEs such as Fannie Mae and Freddie Mac in the 2008 housing bubble, in this article we will see three more culprits: the law, speculation, and rating agencies.

The particular law we want to identify is the one made during Carter's time and revived under Clinton's administration. It is the Community Reinvestment Act.

This law coupled with political pressure from special interest groups, bankers were forced to lower lending requirements to provide easy access to housing loan for low-income borrowers. "Racial discrimination" was the favorite rallying cry during those years. As a result, lenders afraid to go against a popular political tide and legal threat were forced to conform to pressure and thereby loosened lending requirements. 

Stan Liebowitz expressed an interesting observation about the absence of the most vital information in housing literature from 1990 to 2006. It was the connection of weaker lending standards to housing defaults. 

And so the banks simply followed what the law mandated them to do. But when the housing bubble burst, the role of the CRA was denied. 

Henry Cisneros served as the the best example of a public bureacrat who applied this weaker credit standard, and even used it in his private investment. In fact, he built around "428 homes for low-income buyers" (p. 19).

A chain of responses followed. Due to easy credit terms, the demand for housing increased. This provided the environment for speculators to flock into housing market. The price of houses artificially appreciated. This multiplied speculators, not only from low-income buyers, but also to higher-income borrowers. Speculation became viral. The two most notorious examples of this were house-flippers and market-timers. 

Private rating agencies were also have their share of responsibility in the housing bubble. They failed to do their duty due to SEC regulations. Like the bankers, they were also afraid to go against a popular political propaganda that caused them not to do their job. 

Personal Response

Reading this section of the book causes me to reflect on the stock market in the coming months. I suspect that as an outcome of the decision of the European Central Bank to inject $1.3 trillion into global economy until the end of 2016, this will motivate speculative stock trading. I think that this new money supply will find its way into stock market. This is advantageous for those who do both stock trading and investing, but detrimental to savers and those who depend on fixed salary. 

At the moment, I am seeing an unusual price appreciation in consumer products, in banking sector, and other related sectors of the economy. This happened during the first round of QEs from the Federal Reserve, and it appears that is is now being repeated in 2015 as a result of ECB announcement. Is this another bubble in the making?

As for rating agencies. I wonder how many stock brokers would give a "buy" rating on firms and yet would do otherwise in the their actual transactions. I saw company reports from 2006 to 2015 of one firm rated as "buy" in August 2007 and in the succeeding months, but after a year and 3 months, its price per share sunk down from 62.50 to 11.25. Even if you will use averaging I wonder how could "experts" advice their clients to invest long-term when the latter's equity lost 80% of its total value after investing for three years. 

Guide Questions:

1. Why were bankers forced to lower their lending regulations?

2. What was the observation of Stan Liebowitz on housing literature from 1990 to 2006?

3. How did Henry Cisneros implemented this lower lending standard in his private investment?

4. Describe the spread of speculation as a result of government easy credit. Give two examples of speculators. Define each of them.

5. Why private rating agencies failed to do their job?

6. What do you think would be the impact of the $1.3 trillion stimulus package from the ECB? How would it influence the stock market?

7. How about stock brokers' rating? Do you trust them? 

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc.