Taking stock of the U.S. real estate crisis

The rise and fall of mortgage lending

[Translated from GegenStandpunkt 4-12]

Five years after the crash of the housing market in the United States, the crisis has become somewhat permanent. Experts see in the conditions of this sector of the national economy either the worst crisis since the Great Depression or, when prices and sales figures temporarily rise again a bit, the famous light at the end of the tunnel. All the same, the general situation remains as summed up by the chairman of the Federal Reserve at the beginning of last year:

“The state of the housing sector has been a key impediment to a faster recovery. In the typical economic recovery, a resurgent housing sector helps fuel reemployment and rising incomes. But as you know all too well, that scenario has not played out this time… [H]omebuilding remains depressed in most areas, relative both to where it was before the downturn and to where it will need to be to meet the needs of a growing population in the longer term.” (Bernanke, speech to the National Association of Homebuilders, February 10, 2012)

Bernanke’s summary of the devastation that the mortgage crisis has caused homeowners, the financial world, and the U.S. economy in general is sustained by his concern for how long the downturn will continue or whether land is at last again in sight. He is also quite clear about the social and human costs of the crisis, namely, the growing number of those who are homeless or about to join them:

“According to the most recent estimate, about 1-3/4 million homes are currently unoccupied and for sale… Moreover, a very large number of additional homes are poised to come on the owner-occupied market. In each of the past few years, roughly 2 million homes have entered the foreclosure process, and many of these homes have been put up for sale, crowding out much of the need for new building. Looking ahead, the relatively high rate of foreclosures is likely to continue for a while, putting additional homes on the market and dislocating families and disrupting communities in the process.” (ibid.)

This may be bad for society, but necessary: banks must finally clean up their balance sheets and write off the bad loans which impair their willingness and ability to grant new mortgages. On the other hand, the widespread expropriations are economically harmful as well, because the houses put up for sale lead to a “drop in home values of historic proportions.” This hurts the construction industry, indeed the economy in general. After all, over-indebted homeowners show a remarkable aversion to spending money: “While estimates vary, homeowners are believed to spend somewhere between $3 and $5 per year less for every $100 of housing value lost.” This can be projected to a loss of national purchasing power of an immense 375 billion dollars:

“That reduction corresponds to lower living standards for many Americans. And, importantly, lower sales of goods and services also reduce the incentives of firms to invest and hire, thereby slowing the recovery.” (ibid.)

What the country lacks is not just houses and money to live on, but opportunities for business: the impoverishment of evicted and non-evicted homeowners hinders capital from selling them something, and that impairs what the country depends on first and foremost: the prospect of profit; without that, capital can’t use large parts of the working people, make them useful or let them earn something — and so on, in a crisis circle .

Bernanke is also aware of the reasons why the housing market is not getting back in gear again, although its prices must have fallen to an attractive level to buyers by now: everything depends on the banks. As long as their lending, which previously provided for the growth of this market, fails, nothing works. Finance capital has come this far with its expansive speculation on this sector of American economic life: the supply of the masses with housing stands and falls with the success of financial businesses in constructing and purchasing houses.

The business of lending for a home of one’s own and its government support

The nation has accustomed itself to the absurdity of the capitalistic property system, in which massive numbers of houses are for sale or go to ruin vacant right next to a growing number of Americans dwelling in mobile homes, tents, with relatives, or completely without shelter. The reason for this is also not only generally known, but acknowledged: the owners of the houses can no longer make payments on the principal and interest on the loans they have taken out to finance their residence. For this case, the banks have protected themselves with a mortgage on the house; in instances of payment default, they take hold of the collateral. The house is transferred to the bank and the residents land on the street.

According to a widespread view, this situation is at least partly due to the fact that people have borrowed money from the bank at a level they should never have been allowed to get in view of their low incomes. This denunciation of the breakdown in credit relations as a result of self-indulgent enthusiasts of home ownership and/or irresponsible bankers is revealing in two respects:

— First, this view assumes as a matter of course that a residence of one’s own is not possible without help from a financial institution. The elementary need for a place to live can hardly be satisfied in the US (except in big cities) other than by buying a house. However, this is out of reach of the buying power of an ordinary American. He must “finance” the inevitable purchase, take out a mortgage loan, and serve it from his income over a long time, often a lifetime.

— Second, it is taken just as self-evident that the right to occupancy becomes invalid as soon as payment of the interest due to the lender is not forthcoming. That means, at least, that the right of the bank to the payment on its lent money counts so absolutely that the need for a place to live must take a back seat as soon as the interests of the two parties come into conflict. If servicing the business concern of the bank, however, is the unavoidable precondition for a person needing a house getting one, then the bank’s concern is the valid social purpose to which someone must make himself subservient if he has no money on his own. The ordinary person gets the loan for the acquisition of this necessity only if the bank finds a way to make a reliable source of money for itself from this limited purchasing power. The rise and fall of the American real estate market is a nice object lesson in how comprehensively the bank defines the conditions of the lending act from beginning to end.

At first, banks and savings banks don’t do anything in this sphere of their business other than their usual: they enrich themselves on the deficient purchasing power of their customers by lending them money at interest. To this end, they examine the creditworthiness of customers; in the case of not-so-well-to-do customers, they assess whether and to what extent their financial resources promise to measure up to the additional burden of interest and repayment. And those who depend on wages are given a special risk consideration: loan servicing depends on whether the debtors manage to wring the interest rates – over a lifetime – from their scarce monthly wages whose payments are, moreover, unreliable because they depend on the calculations of an employer. The conditions for granting the loan (income statements, information about the applicant’s credit history and other payment obligations) testify to the troubles taken to ensure the suitability of these precarious debtors for the comparatively large credit transaction and to indemnify the bank with higher interest rates for the special risk they represent.

Moreover, the lender secures the mortgage with collateral, namely, the right of access to the real estate financed by it, in case the debtor can’t meet his obligations under the contractual relationship. The recourse to the value of the seized property is supposed to guarantee that at least the bank’s lent sum survives if the interest payments fail to materialize. This case is admittedly only intended as an exception to the rule that the granted sum is transformed into capital for the bank through the borrower’s interest payment. As a seizable asset, the real estate acquired with the loan performs a second service for the bank: it gives this kind of loan business its special security. The debtor is held accountable for this with his repayment of interest and principal and with his freshly acquired housing property. He must provide the debt payments out of current income to maintain his home ownership. Its monetary value therefore does not help him with that, but despite that is no less important: because it plays the role of “equity” for the bank, an equivalent, which justifies the granting of the loan, its amount and eligibility to serve as collateral decides on the conditions of the loan.

In this way, the owner who wants to live in his own home and not sell it depends on the market value of his real estate; he has, however, nothing to do with its coming about. This is decided by other economic actors among themselves with their businesses and calculations: municipal or private landowners as the suppliers of developable land and construction and/or real estate companies as demanders. They determine the price of land, the other major price component of real estate besides construction costs.

The might of right is the basis and reason for the fact that prices are generally asked and paid for a given piece of nature: the institution of private property permits a person to whom an area belongs to exclude others from using it. This opens the opportunity for the owner to demand money for its use or appropriation by others. He has not produced the land, in contrast to other commodities, no costs influence his price – surface development costs and possible buildings are charged extra. The landowner markets nothing but his power of ownership secured by law.

How much money the latter is worth, what price he can demand for the rent or sale of his land depends on the interestedness and ability-to-pay of the buyer who wants to use a certain piece of ground. Here the home buyer with his need for housing is still not in the game: public and private developers, real estate financiers, and others turn his need for a residence into an investment sphere, i.e., a sector for capital investment. For them, the price that the landowner demands for his land is not simply a sum that is paid and therefore gone, but part of a capital advance which must yield a return. The question of whether, and at what land price, an investment in a building project yields a profit arises for them out of a multiple comparison: first with the demanded prices for plots of land in similar locations and conditions; secondly with the prices they can expect to demand from the sale of houses of specific location and amenities; and finally the comparison to other prices which can be demanded by alternative, possibly commercial uses of the space. Against the proposed price of the investors, the seller proposes his own: in order to enforce as high a price as possible for his space, he refers to its special location and condition, but also to the economic trend, public development plans, etc. – nothing but the given or expected circumstances that make the use of his piece of land economically interesting.

Speculation on future development thus always enters into the determination of the price of land. What the one side charges and the other side is willing to pay is decided by expectations about how the use of specific plots of land will probably develop. And because the price itself is based purely on supply and demand, its amount has no upward or downward limit. That makes this sphere an ideal object of speculation and investment of credit. Banks climb on board with investors or act on their own as house builders: they pre-finance the development of properties and earn on the growth of the business they initiate with it. And at the same time they become active, as explained, as financiers of the prospective house buyers: they thus ensure that the demand that the construction companies count on with their investments materializes . Quite often one and the same bank is active on both sides of this business; in any case it’s always the same banking sector, and its yield expectations significantly determine this sphere’s course of business.

The homeowner is thereby the dependent variable on all sides. What he must pay in order to buy a house is the result of bargaining between landowners and investors; what the loan necessary for it costs him results from the calculations of the bank; and what the house he is liable for with the loan is worth is – from the moment it is standing – the result of speculative demand for comparable properties. If the banks make mortgage loans available on a large scale and so ensure a growing demand for real estate, the price of land tends to rise; that increases the market value of the homes held as securities already posted in the banks’ balance sheets and allows the banks to grant a loan on the real estate a second time for an additional loan to the home owner and expand their business with it. If the banks reduce their real estate loans, that conversely generates a trend of falling prices; which by itself provides a reason to further restrict the mortgage loan business . The homeowners remain in all of this the hopeless figures that, after all, they simply are: rising prices help those who already have a house enlarge their creditworthiness and at the same time make things more expensive for those who need one; and vice versa. Thus the banks create with their own business the creditworthiness of the “hardworking Americans” that they need for their interest-earning business with them, and then take it from them – and thereby take away a place to stay from the many debtors who can no longer service their debt under harsher conditions.

This is the way it is in normal times; in the “Great Depression” of the 1930s, certainly, like today, the then already significant American mortgage market and housing construction completely collapsed and contributed its part to the contraction of the economy (a forty percent decline of industrial production compared with the pre-crisis level). The “New Deal” discovered not only the provision of the masses with affordable housing as a task of the welfare state, but took up the sphere because of its great consequence for banking and the economy: for President Roosevelt’s exemplary capitalism-compliant version of social policy, the fight against the housing shortage due to the Depression was from the start the same as the rescue of the lending business in the housing market, thus the rescue of the mortgage banks and, what’s more, the whole financial sector. For the poor masses, nothing different and nothing better was to be expected than state aid for the banks so that their business of making interest on the construction of private homes could succeed again.

In 1934, the Federal Housing Agency (FHA) was founded to insure mortgage loans that met certain quality standards against debtors’ insolvency. For these “conforming loans,” whose size did not exceed a fixed relation to the regular income of the debtors and to the value of the real estate (80%), the state took over the loan risk from the banks for a fee. This hedging of commercial calculations successfully aimed at the willingness of the banks to resume their real estate financing oriented to the mass market, and under conditions which permitted debt servicing from normal wage incomes.

By founding the Federal National Mortgage Association (Fannie Mae) in 1938, the federal government actively promoted the ability of the banks to grant mortgage loans. It’s task was

“to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.” (Wikipedia)

Fannie Mae still does this today by buying “conforming loans” from the banks insured by the FHA. Banks can transform these mortgage loans at any time into liquid funds by selling them to the government agency, making them availble for expanding business as well as for payment obligations. This increases the incentive and ability of private banks to expand this type of lending business. When the latter leads to great prosperity, its then for a different reason.

The career of the home loan as material for the capital market

Fannie Mae does not use government funds to manage the refinancing of the banks’ mortgage lending business, it borrows it. For this, it uses its disposal over the purchased mortgage loans and the interest and repayments accruing from them. It establishes a new credit business on the claims it owns and the inflows that it expects from them by – on the basis of these sources of income – promising investment-seeking money owners future interest yields on the money they are investing. The investors buy themselves the increase of their invested money by the issuer, thus transforming it into a piece of money capital.

Like in every other security business, this procedure’s achievement is twofold: it equips the issuer Fannie Mae with the financial means to carry out and expand the purchase of mortgage loans, and at the same time creates new capital assets in the hands of investors. The equation maintained in a security – of speculatively anticipated yields with real, current property – is confirmed in the act of purchase, thus it is based on the investors’ trust in the ability of the issuer to fulfill the given promise of yield, that is to say, in the issuer’s creditworthiness. The role of guaranteeing this befits the latter’s assets, in the given case the pool of mortgage loans bought by Fannie Mae. The state’s guarantee that it will take responsibility for any of the possible obligations of the agency it has created with funds from its budget, however, bestows a decisive new quality to this business: the securities issued by Fannie Mae count – in comparison to competing offers – as exceptionally secure, and so find an abundant demand and allow the agency to expand its refinancing ever more.

This is how the growing securities business fulfilled the political mandate to increase the rate of home ownership. Its success allowed the government to transform Fannie Mae in 1968 and its sister organization Freddie Mac in 1970 into “government-sponsored enterprises” (GSE), privately calculating, partly state-owned corporations. Their special status as initially still monopolistic buyers of FHA insured mortgage loans was able and supposed to be translated by the financial institutions doing business with them into an implicitly continuing state guarantee, without that being formally written down.

The fact that the state no longer explicitly guaranteed the obligations of the GSEs did not detract from their business. They started to take advantage in a new way of the other pillar of their creditworthiness, their disposal over a gigantic portfolio of mortgage loans, by inventing “mortgage backed securities” (MBS), securities “backed” with claims from mortgage loans. Their special reliability was underpinned by a legally codified relation to an agreed part of the mortgage portfolio of the GSE on which its holder could fall back as security if the issuer should default on interest and principal. The mortgage debts which the GSE owned not only guaranteed here in general the ability of the issuer to take responsibility for promised yields; the direct relation to them as a legal pledge created the papers’ own creditworthiness, which permited them to separate from the creditworthiness of their issuer.

The combination of the GSEs’ still present state background and the stock of mortgage loans, multiply insured and collateralized against default, which served as collateral for the security of the MBS, registered ratings for the issues of the half-state agencies not inferior to virtually failsafe US Treasury Bonds. They thereby meet the needs of various participants in the capital markets: institutional investors, such as insurance companies and pension funds, hedged their long-term payment obligations with MBSs. Banks and other capital market participants bought MBSs as liquid assets that, on account of their security and their great commercial volume, were considered as especially money-like. Funds invested in such securities in order to market shares, with reference to the purchased source of profit, etc. From their growing business with MBSs, i.e., from the difference between the interest brought in by the mortgages in their possession and what they as absolutely creditworthy institutions had to offer for the marketing of their debts, many billions of dollars were generated for the GSEs.

It is therefore not long before their partners in the securities industry, the banks, no longer operated only as buyers in the MBS market, but also as suppliers. The big investment banks got into the business of securitizing mortgage loans by buying up such loans themselves and issuing their own MBSs on this basis. In the interest of an expanding use of this market, they soon emancipated themselves from the barriers to the business which the GSEs had imposed on themselves to make their securities especially secure, but also low yielding. The banks expanded the range of their “securities” backed by mortgage loans, from “non-conforming loans” right up to those which later come into disrepute under the name “subprime.” Resourceful financial specialists used this “material” with greater risk of default to construct a new class of securities that they equiped with varying degrees of risk and that they offered to investors according to their appetite for risk or need for security: even unreliable mortgage loans could be transformed into halfway first-class investments by bundling them into a pool that the various tranches of a collateralized debt obligation (CDO) were based on: the low-interest senior tranche incurred the last of possible payment defaults from the pool and was therefore rated AAA, the wide mezzanine had to bear incurred losses before that, and even before that – up to their total loss – there was the highly speculative junior tranche, in which primarily hedge funds invested in search of higher yields. So the banks generated “synthetic products” entirely according to their customers’ “demand” for the relation between risk and yield. The speculative risk was provided with a price in the form of conditions and interest rates, thus remaining present at every processing stage. The grouping, linking and dispersion of risks was supposed to mitigate them and relativize them to each other; actually, they were distributed to many investors and sold to them according to the risk they thought they were able to afford. This expanded on the whole the ability of the financial world to be able to take on risks, and thereby the field of its enrichment possibilities; however, this practice had the downside that the risks were then also generalized and that losses occuring would affect this entire world.

Hedge funds and investment banks used such papers not simply as investments, which they put in their portfolios in anticipation of the promised interest and/or liquidated if necessary: they used their disposal over such papers once again as the basis for a new type of business, for which the German bank IKB (which loans to middle-sized companies) and its special purpose vehicle (“conduit”) “Rhineland Funding” became infamous (selling 6 Million dollars of a commercial paper generated from Goldman Sachs CDOs to the City of Oakland: [1]

“It is the task of the conduit in the market to buy loans and asset-backed securities and to refinance them via issuance of short-term securities (asset backed commercial paper, ABCP). Obviously, to give the Rhineland a good credit score as issuer, the IKB has granted it a credit line. The profit the conduits make is usually payed via advisory and other fees to the bank that ultimately stands behind the conduit. IKB has estimated the consulting fee of Rhineland at around 54 million euros … According to the IKB spokesman, Rhineland has invested 12.7 billion euros in loans and loan securitizations, thereby also in ‘subprime’ securities.” (Frankfurter Allgemeine Zeitung, or FAZ, July 31, 2007)

The papers of such “vehicles” [2] enjoyed the trust of potential investors because a potent bankthat provides them a line of credit stood behind them. For the bank, “outsourcing” this business into a “conduit” had an unbeatable advantage: the “conduit” operated completely without the need for its own equity because it financed its procurement of sources of interest completely by issuing its own debt papers. The funding source cost the bank no advance in equity capital; while yields from zero advance may have been limited in absolute numbers, as yields on capital they tended to infinity.

So finance capital organized for itself and all investors whom it is in a position to involve in these business dealings a constant multiplication of assets. They all derived from securitization of debts, which conversely meant: the many asset titles were nothing other than the obligations of others; every debt relation was guaranteed by the fact that the debtor himself owned others’ debts, i.e., yield-producing claims against an upstream entity. The intrinsic value of each such financial title stood and fell with the trust in the ability of the debtor to assume liabilities, thus depending on the quality of the claims which he could present on his part. Referring back to the original mortgage and its value thereby fulfilled the function of ultimate provider of trust. The original mortgage loan got its prominent role in this detached activity from the fact that it was the first stage of the structure of demands and obligations referring to each other and piled on top of one another. The assessment of the original mortgage loan was always included in the growth of this gigantic concoction: its interest service, redemption, and failure rate got the new, additional function as an indicator for the functioning of the entire credit superstructure based on it.

As long as the participants were convinced of the evidential value of these indicators, the need for more such contractual obligations emerged from the lucrative marketing of mortgage loans. The securitization of loans, which began as an instrument for refinancing, became the real purpose of the operation, and the acquisition of mortgage debts the means for it. Now, the need for housing – more exactly, the willingness and ability of citizens to borrow for a home – no longer generated the demand for housing loans; rather, the need for debts as commercial objects generated the interest of the banks in more and more mortgage loans. In order to procure material for their credit trade, they enmeshed more and more customers in more and more generous funding and made sure all the necessary sums were available for it. The longer this went on, the more they forewent their usual loan-to-value ratio and debt-to-income ratio in financing housing with new customers, and the more the examination of other collaterals became more generous and in the end even got by without an amortization rate.

When bank capital with its credit power plunged into this sphere and provided (almost) everyone who wanted to have a home with the necessary ability to pay for it, then that opened new prospects for the housing market and for home owners at the same time. With the growing number of financed buyers, not only did prices increase for new buildings; the creditworthiness of those who already purchased a house also improved: on the basis of their self-generated boom, the banks treated their debtors as owners of increasingly valuable properties and again granted further loans against their revalued real estate with home equity loans. They thereby expanded not only the business with their old debtors, enlarged their legal claims to interest payments, and again procured new material for securitizations; they also secured in this way their first mortgage loans by enabling their customers to fulfill payment obligations from old contracts with newly taken-out loans. By this, they made their business more independent of the limits of the debt that had to be served out of the available income of their debtors, which by no means grew along with it. As a byproduct of the credit boom, the average breadwinner temporarily profited by joining in speculating on himself: on credit, he could afford a standard of living and perhaps a college education for his children that was not at all possible on his wages. As long as this worked, no one cared – except for a few know-it-alls who worriedly compared the annually increasing indebtedness ratios of the American consumer with their rather declining wage levels.

In the decades-long upswing in America’s housing market, the full capability of finance capital manifested itself: it not only allowed creditworthy private individuals to go into debt for the purchase of a place to live and of course at interest, and it not only turned good debts into financial products of a higher kind. The interest of finance capital in its own accumulation provided borrowers, indeed created the good borrowers that it needed by immediately increasing the value of the securities that made these debts good ones along with its own growth. It is not just that the interest payments of customers caused the profitability and growth of the bank’s capital and restricted it at the same time; the other way around, its growth supported – indeed produced – not only the creditworthiness of the borrowers, but also their ability to service their debts; in the interest of growing capital banks temporarily considered even interest and principal to be expendable.

All this was achieved by marketing the debts that the banks owned. They turned the securities they sold to money owners around the world as investments into supports for and guarantees of the value quality of their debts. By buying, holding, and using these papers as means of business for financial operations, investors confirmed them as money capital; by using them, they gave the issuers credit, and by purchasing their debts, promoted their creditworthiness. The more business partners involved in the whole contraption, the more durable it became; all the more then those who are tarred with the same brush and harm themselves when they call into question the intrinsic value of the tower of debt. The interdependence of debt relations provided a stability and security that reduced the first debtor’s reliable interest payment to an aspect that “the market” at one time considered important, at other times ignored due to of its interest in material for further business in the capital market. But then the same applied the other way around: the more business partners involved in these credit connections, the more credit collapsed when doubts really arose in its sustainability and investors withdrew en masse from investments, thereby devaluing them. The crisis has revealed how global the “socialization” of credit relations have become in the meantime and what the whole world has participated in when believing their money to be safe and invested in durable value: namely, in a chain of debt relations that are money capital as long as, but also only as long as, the parties are willing and able to use them for the growth of their assets. [3]

*

The American state, incidentally, had no objection to this sort of wealth creation; it promoted the boom with all its power – not only with its GSEs. With the might of right, it backed each new scheme for turning legal claims to future yields into current means of business. Every president pursued a “housing policy” — whether under the slogan “Home Ownership Strategy” (Clinton 1996) or “Blueprint for the American Dream” (Bush 2002), with ever new regulations and deregulations, with rules, authorizations, and subsidies [4] — in order to increase the attractiveness of the housing business to financial capital. The boom accompanying the private investors’ entry into the MBS market then managed the miracle: in 2004, the proportion of happy homeowners in the United States reached, according to the U.S. Census Bureau, the historic record high of sixty-nine percent of all American families. [5]

The system, and specifically its financial sector, earned a lot of praise for the fact that finance capital helped people get a house of their own that, according to all the standards of the market economy, they do not really deserve. In hindsight, however, the success story was regarded as an improper exaggeration – and indeed one that is no longer revocable:

“In the view of some economists and political leaders, Americans have over-invested in the housing market and should learn to live with a lower level of home ownership. This view has much to recommend it; however, the nation has become committed over many decades to the housing market as a key source of economic growth. To reverse that definition would also take decades and could cause damage to an entire generation of individuals and the nation.” (Los Angeles Times)

The financial crisis and the collapse of the housing market

The crash in the market for mortgage loan securitizations came about exactly like its upswing. The banks, which had turned mortgage loans into debt relations marketable to suppliers, paid attention to all the detailed developments of their basic business: the failure rate of the mortgages, the price trend of real estate, the interest rate. All factors were taken note of as indicators for the stability of their basic market, and entered into the pricing of ABSs, MBSs, etc as “market data.” At the same time, an assessment of how “the market” might take and value them entered the evaluation of the data – the value of one’s own property title ultimately depended on the behavior of others in the capital market. This meant variously: unsold houses, for instance, are part of the normal course of business, so whether growing vacancy rates were just a glitch in the recovery or the beginning of its end – that’s what needed to be tracked down. On the one hand, it was clear that the market couldn;t continue to grow forever; on the other hand, it does not mean that it couldn’t continue to appreciate for another year or maybe more. At what point one gets out needs to be carefully considered; best just in time, but in no case too early.

Such doubts had what it takes for generalizing. It sufficed that a bigger number of investors took data on the housing market at the same time for a reason to sell MBSs and to move into other investments without enough new buyers being found for the papers thrown on the market. When investors wanted to turn debt claims into money on a large scale, it revealed that that the claims were not money – and it showed that they were money capital only by the investors’ trust in the promise of yields:

“The real estate crisis in America during the past few days has triggered a crisis in the credit markets. In this context, even the recoverable value of AAA securities, which are backed by subprime loans, are doubtful, which has led to price losses … Experts say that it is an open question whether the subprime securities with good credit scores will in fact suffer capital losses at all. There is a lot to suggest that these papers were actually well shielded against mortgage defaults. Then the current write-offs of these papers could be followed by increases and book profits.” (FAZ, July 31, 2007)

It did not come to this, as is well known, and not even because the shielding of the audaciously constructed AAA securities would have failed. Hardly anybody really cared to put it to a test because the depreciated papers had long ago been made the basis for further securities creations, which escalated the mistrust of investors, who then denied the various special purpose vehicles refinancing of their loan portfolios. Because of doubts about the reliability of their “asset backed securities,” even the conduits themselves as issuers of debt securities were doubted. “Against this background, it was difficult for Rhineland to find new buyers for their ABCPs.” (ibid.) A conduit could no longer pay back its debts because it could no longer procure the money by marketing debts based on these “assets.” Once the parent bank then became liable for the line of credit that was never really used, but was only supposed to provide a guarantee for the creditworthiness of its conduit, it became itself overextended. Doubts about the soundness of the big banks’ business capacity finally plunged the whole sector into crisis. For it turns out that the capital and reserves of the banks, funds, and insurance companies consisted of nothing other than these and similar debt securities.

The crash of the capital market business also struck back on the real estate financing and housing prices which it had previously spurred on. Distrust in the stability of the MBS market weakened the ability and interest of financial institutions in expanding their mortgage business. For business professionals, the expectation of impeded real estate financing translated directly into the expectation of falling, or at least stagnating, housing prices; the caution growing all the more for that reason made that expectation a “self-fulfilling prophecy”: prices fell across the board. Massive numbers of home owners were consequently over-indebted because the value of their real estate fell below the amount they owed on the mortgage. The bank customers, who were owners of respectable collateral yesterday became again poor people whose debt was disproportionate to their income. In a first step, the bank therefore refused to continue refinancing their debts and insisted on clearing interest and principal. More than a few homeowners promptly proved unable to make payments on their outstanding loans because they could previously only do so by new borrowing.

This transformed mortgage loans as the bank’s functioning means of business into unredeemable claims. The bank’s step of halting credit relations to defaulting debtors across the board, expropriating them to at least recoup the remaining value of their real estate, did the rest: carrying out massive numbers of foreclosures threw more and more homes on the market and brought to light that their values indended as collateral were the result of the speculation on their growth, thus were destroyed by the attempt to realize them. The further decline in housing prices put even more mortgage debtors “underwater,” leading them to worse credit terms, a strict insistence of the bank on punctual debt service and, in the event of default, led to more foreclosures and an even worse decline in housing prices, and so on. Not a few banks, most recently Bank of America, came to the conclusion that they should sell off or liquidate the entire department. In this way, the collapse of the speculative superstructure reached those whose debts and homes had functioned as the base for a whole epoch of credit growth. They got the bill for finance capital having learned to appreciate their debts as its means of growth: first in their own home, which they really could not afford, then in the form of expropriation and homelessness.

The state’s crisis management
The social catastrophe – a case for the rule of law

The devastating effects of the credit crisis on the lives of millions called the state into action – in its capacity as rule of law. In the “land of the free,” the loss of a home is a private matter, bad luck, tough times that must be coped with privately. At most, an aggrieved person could expect consideration for the basic need for housing when he could demonstrate that the bank which expropriated him was not allowed to and broke the law. Those affected grasped at this straw and went to court en masse. Under the heading “foreclosure gate,” [6] the American nation was outraged about everything that the legal system and the media found illegal or even only unfair in the banks’ homelessness-generating behavior. This affected a lot; only – not the main thing.

The seizure of over-indebted homes was attacked by expropriated residents with the fact that, in view of the unlawful resale of their loans by the mortgage bank and its use in a pool of hundreds and thousands of other debt agreements as collateral for securities derivatives (MBSs, ABSs, CDOs), it was no longer clear at all to whom the debtor was now actually indebted, who was thus entitled to the lien on his real estate. The holders of the defaulted real estate derivative saw this the other way around, demanding the right – for which they owned a guarantee – to the property of the last borrower, even if the paper they owned – perhaps in the second and third processing stage – only represented a lien on perhaps a thousandth of the value of a particular house. The matter is not simple: apparently, when “asset backed securities” were being constructed, it had not been considered how a right to assert a claim on collaterals that were mixed, chopped to pieces and split up among countless securities would be sorted out again if the derivative’s issuer went bankrupt; the rewinding of the tangle of loans up to the bitter end was not foreseen. The case will keep the courts busy for a while.

Easier to regulate is another scandal. The banks, which no longer terminated one or another non-performing mortgage but cut back or dissolved their entire home-financing departments, made use of the same form of automatic business transactions they had been practicing in the boom. Back then, this was in the interest of the applicant and not complained about. However, the mortgage law now required careful examination of the circumstances and creditworthiness of the individual case and consideration of alternatives to eviction. The banks avoided the costly efforts needed for it by deploying assistants as human “robo-signers” of eviction notices. Many critical Americans could be outraged about this because it confirmed their view that the whole crisis was only attributable to the illegal practices of greedy bankers. And they actually are legally vulnerable. Lawyers share with local and state advice centers and mediation bodies the market arising for legal aid in which those facing eviction can get free help and advice. The civil servants take pains to produce something like a level playing field between the banks and their helpless customers so that people are not unduly taken to the cleaners. [7] Foreclosures should only happen when they are legally flawless, and those affected should – if at all – be ruined no more than necessary.

The big demand, in view of the catastrophic collision of the banks’ property rights with their poor customers’ need for housing, was generally justice in the sense of American “fair play.” So a practice of underwater homeowners that was legal in some states and illegal in others [8] found growing social acceptence. It is popularly called “walkaway” or “jingle mail,” “strategic default” in legalese, and consists in the debtor defaulting on his loan and simply leaving his house to the bank. He quits making payments before he runs completely out of money and preempts the foreclosure. A legal professor from Arizona, Brent White, made a national name for himself with an article recommending this tactic to homeowners and based it on its legal, but above all moral, admissibility.

“The housing collapse left 10.7 million families owing more than their homes are worth. So some of them are making a calculated decision to hang onto their money and let their homes go. Is this irresponsible?… President Obama has urged that homeowners follow the “responsible” course. Indeed, HUD-approved housing counselors are supposed to counsel people against foreclosure. In many cases, this means counseling people to throw away money… There are two reasons why so-called strategic defaults have been considered antisocial and perhaps amoral. One is that foreclosures depress the neighborhood and drive down prices. But in a market society, since when are people responsible for the economic effects of their actions? Every oil speculator helps to drive up gasoline prices. Every hedge fund that speculated against a bank by purchasing credit-default swaps on its bonds signaled skepticism about the bank’s creditworthiness and helped to make it more costly for the bank to borrow, and thus to issue loans. … The government should encourage borrowers to default when it’s in their economic interest. This would correct a prevailing imbalance: homeowners operate under a “powerful moral constraint” while lenders are busily trying to maximize profits. More important, it might get the system unstuck. If lenders feared an avalanche of strategic defaults, they would have an incentive to renegotiate loan terms. In theory, this could produce a wave of loan modifications — the very goal the Treasury has been pursuing to end the crisis.” (New York Times, January 7, 2010)

The plea for justice and a nationally useful level playing field with greedy bankers is in a class of its own: vacating the house is recommended as liberation! Freedom – just another word for nothing left to lose!

The state’s struggle to rescue and renew mortgage loans

The state, meanwhile, had more serious problems. It had to save the collapsing national financial system in general and mortgage financing in particular. The recovery of this sector was widely regarded as the key to overcoming the entire economic crisis.

The government made full use of – what else? – its monetary power. On behalf of the government and with new state loans, Freddie Mac and Fannie Mae bought up bad mortgage loans from the banks to prevent their bankruptcy and stop the ongoing collapse of the real estate market. The guarantees of the GSEs were used on a broad scale; the rescued banks nevertheless did not go back to financing real estate as they previously had. The funds of the state agencies did not function as they formerly did, as the basis for a growing private business, but as a lifeline and substitute for its failure. The fact that banks did not return to a more generous granting of mortgage loans nicely shows the interest they had in this business during the upswing. They could use it well as a foundation for their credit securitizations. Now that it depended on the demand of customers who could carry out and afford the building of a house in the recession, it remained paltry.

The takeover by the GSEs of rotten mortgages ensured some cleanup of the banks’ balance sheets; but at the price that the agencies accumulated losses in their budgets. In the course of 2008, it became known that their market interventions entailed enormous capital requirements for which no financiers were to be found on the capital markets. [9] However, because the GSEs absolutely had to remain solvent guarantors for the U.S. housing market and the ABS market, the state took over management of the two companies and responsibility for their payment obligations. [10] This burdened its budget with totals in the hundreds of billions until 2011 alone.

Because all this did not stop the collapse of the housing market, the government thenalso designed programs to assist homeowners facing the threat of termination of their loans. HARP (Home Affordable Refinance Program) and HAMP (Home Affordable Modification Program) provided support for some of those who were insolvent. At a certain level of their over-indebtedness, the government sorted them into bad debtors and good ones who were somehow financially impeded and offered to relieve the latter of their debt payments or subsidizes banks that were willing to modify contracts. A right to participate in the program or a duty of the banks to offer participation to their borrowers was not provided. Both programs were taken up to a negligible extent; and the multiple amendments to their terms changed little in this. The banks charged such high fees for participation in the programs that they were unattractive to the debtors. They documented for a second time that they were not interested in this segment of the loan business for the time being.

The Obama administration was miffed about that. The banks were happy to help themselves to state aid to unload their bad loans, but refused to assume their responsibilities as lenders and to grant relief to their overextended customers and instead continued their practice of foreclosures. The government was now focusing on the nonperforming, systemically too-big-to-fail financial industry as an obstacle to crisis management and even as a law breaker. With the help of the law, it intended to force the banks to at least limit the damage they caused. Taken to court by the partly nationalized agencies Freddie Mac and Fannie Mae, the banks had to take back mortgages that they sold to them too expensively, namely with a falsely declared quality. A similarly justified, much larger lawsuit was filed by the federal government against a variety of American, as well as international, banks.

On the issue of foreclosures, however, the Obama administration brought the legal dispute with the banks over the distribution of the costs of the crisis to a certain conclusion. In February, 2012, it reached a “foreclosure settlement” with the largest institutions in the country:

“This round of relief will reach about two million former and current homeowners. Under the agreement, banks will grant some $10 billion worth of principal reduction, $3 billion in refinancings and $7 billion in other mortgage relief, like forbearance for unemployed borrowers, covering roughly one million borrowers in total. Another $1.5 billion will be cash payments of about $2,000 to some 750,000 borrowers who were treated unfairly in foreclosures from 2008 through 2011. And $3.5 billion will go to state and federal governments for what has been described as resources for legal aid and other counseling for borrowers facing foreclosure… What do banks get in exchange for the relief? The answer, in short, is a sweet deal. The banks did not get the blanket release they originally sought from legal liability for all manner of mortgage misconduct. But the settlement still shields them from state and federal civil lawsuits for most foreclosure abuses, including the wrongful denial of loan modifications excessive late fees that enriched the banks but could make it impossible for borrowers to catch up on late payments, and conflicts of interest that led banks to favor foreclosures over modifications. Going forward, the banks will have to adhere to tougher standards for servicing loans and executing foreclosures. But past sins in servicing and foreclosure are largely absolved.” (New York Times, February 11, 2012)

The government praised the agreement as a long overdue admission of guilt by the banks that they had ruined millions of “responsible homeowners” (Obama) with their irresponsible business conduct. It hoped that in practice, the credit relief agreement would lead to more mortgages not being terminated, but continued. For the generous concession by the banks to give up on claims that were unredeemable anyway and to open a way for business to continue with their impoverished customers – how many will ultimately benefit from the offer remains to be seen – the government spared them from civil suits against their illegal practices. The prosecution of legal violations by the Securities and Exchange Commission remained unaffected by it.

The Fed intends to buy the entire U.S. economy out of the recession with mortgage loans

During the whole back and forth between the state and the banks, the real estate and general crisis has entered its sixth year. All the government’s measures has failed to achieve at least one thing: the economy as a whole did not come out of the recession. In September 2012, the Federal Reserve decided on an “unprecedented step”:

“To support a stronger economic recovery …the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” (Fed Press Release, Sept. 2012)

The Fed identifies the pile of illiquid real estate loans in the banks’ balance sheets, still counted in the trillions, as the cause of the persistent crisis. And precisely because there is so much capital in this segment of the credit system, and so much of it is ruined, it also sees this as the starting point for managing the general crisis: it wants to buy up the whole scrap heap step by step and indeed as long as it takes to achieve what it calls a valid measure of a “growing economy”: jobs, a decline in unemployment to normal levels.

The Fed is faced with the effects of the over-accumulation of capital: illiquid mortgage markets, unsellable homes, falling house prices, the depressed housing market as an important part of the economy and its stagnation – too much credit has been given in this sector and everywhere else; too much capital has been invested than would still be profitable. The Fed regards the crisis as a lack of capital and a lack of willingness to invest, which it wants to heal by both increasing and reducing the cost of credit; it fights the over-accumulation of capital with more of it. And if the government’s and the Fed’s own measures to rescue the real estate sector have so far only led the banks, which sit on devalued assets and are threatened by bankruptcy, to get rid of their bad debts and remain halfway solvent, but not to expand their lending and bring about growth, then, the Fed concludes, its substitute measures for the defaulting and shriveling private loans was just not big and persistent enough. It is determined to enforce the qualitative turnover of bad, non-recoverable debts into new profit-yielding money capital and thereby sticks to its basic dogma: banks and citizens would take up credit and use money for something profitable if they could get enough of it in their hands cheaply enough. The ongoing crisis shows it that the price for disposal over capital, the interest rate, must be too high. The less profit that can be made with capital investment, the more it is determined to do whatever it can to lower the interest rate in order to nonetheless ensure a difference between costs and yields of capital investments.

Since the Fed has already been holding the money market rate which it charges private banks for central bank money at close to zero for half a decade, and still not as many want to borrow from it as it considers necessary, it uses the current program as a way to depress the interest rate in the capital market without the banks.

“By buying mortgage-linked debt, the Fed hopes to press mortgage rates lower, helping the housing market and also encouraging investors in MBS to switch into other assets, lowering their yields as well. Those lower borrowing costs should spur more lending and foster faster economic growth, officials believe.” (Reuters)

Its continuous demand for the highly speculative and illiquid MBS securities is supposed to raise their price again and allow returns bought with high risk to decline. This, in turn, should drive investors out of the market to other fields of investment, so that interest rates also decline there and the economy as a whole is more cheaply financed. The Fed again follows its scheme in interpreting the circumstance that hedge funds and others venture into MBS transactions because they do not find less speculative or higher yielding investments: namely, as a consequence of interest rates elsewhere still being too low, which is why the interest rates in the MBS area must therefore be too high for investors to consider alternatives.

The Fed’s contradictory fight against the over-accumulation of money capital through more money capital can’t be bothered by failure; its struggle is surely not a questionable experiment: the central bank has rather used its power as ordered, a power which follows from its sovereignty over the national money. It can hinder the overdue devaluation of mountains of debt by political credit creation and ensure they remain intact as assets and available as investment funds – as long as the further political increase of money does not cause investors to lose confidence in the national currency. In this respect, the Fed can give the all-clear: inflating the dollar is not hurting it, at least so far and in relation to the alternative, equally questionable European world currency.

Notes

[1] http://darwinbondgraham.wordpress.com/tag/rhineland-funding/

[2] http://en.wikipedia.org/wiki/Real_estate_mortgage_investment_conduit

[3] Hence the horror when Lehman Brothers crashed: Nobody ever took the warning in the small print that securities will become worthless in the event of the issuer’s insolvency as a case that would really come true.

[4] The Tax Reform Act of 1986, for instance, allows debtors to subtract their installments from the income tax.

[5] http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline

[6] Ever since Richard Nixon’s illegal bugging of the Democrats’ election headquarters in Washington’s “Watergate Hotel” in 1972, everything in the United States that smells of a scandal is a doorway or passage.

[7] Some states oblige their banks to participate in such mediation talks; others just try to coax them: All in all, the activity reports of the arbitration boards offer nothing but a picture of the misery that over-indebted home owners are exposed to by the fathomless practices of the banks.

[8] In these eleven states, they have so-called “non-recourse debt,” a form of credit that only allows the creditor to fall back on the real estate financed with it; even in the case that the outstanding debt exceeds the real estate’s value, access to the debtor’s other assets is excluded.

[9] “As recently as late March, Washington viewed the companies as saviors of the housing market and the economy… Instead of requiring Fannie and Freddie to scale back, regulators gave them a green light to buy and guarantee more and bigger mortgages. …As the housing crisis continued to widen and deepen, confidence in the companies began to evaporate. Rumors spread that Fannie and Freddie were not fully reflecting losses from rising foreclosures on mortgages they held. The stocks of both companies fell more than 60 percent during the second week of July… and the cost of borrowing money rose for both, reflecting anxiety over growing risk.” (New York Times, September 7, 2008)

[10] “The government would place the two companies under ‘conservatorship,’ a legal status akin to Chapter 11 bankruptcy. Their boards and chief executives would be fired and a government agency, the Federal Housing Finance Agency, would appoint new chief executives.” (Washington Post, September 7, 2008)