Running Head: CLEAN UP THE HOUSE 1

Clean Up the House: An Analysis of the Housing Crisis and the Endeavor to Lift the US Housing Market

Neil Smith

Wilmington University

MBA 6400
Economic and Financial Environment of Business

CLEAN UP THE HOUSE 2 ABSTRACT

This is an inquiry of the Housing Crisis that culminated to the Great Recession of 2007-2009. A review of the aspects that led to the Housing Crisis will be considered. The causes that contributed to the Housing Crisis will range from the Community Reinvestment Act of 1977 to the greed and voracity that engulfed the Financial Markets. Such greed maligned the financial markets causing eventual bailouts and measures that the US Federal Government employed to avert a major financial depression. This paper will discuss definite recommendations that will improve the US Housing Market.

CLEAN UP THE HOUSE 3
Clean Up the House: An Analysis of the Housing Crisis and the Endeavor to Lift the US Housing Market In today’s world it is generally accepted that a home is the most expensive thing that any American can buy. The idea of home ownership - a chance to own a home - is a dream fulfilled for many. To have a piece of property and call it your own is reflected in the US Constitution, “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that are among these are Life, Liberty and the pursuit of happiness (Kindig, 1995).” However, in what was meant to be a chance to catch a piece of the American Dream, the Housing Boom of 2001-2005 quickly turned into a Housing Crisis for millions of Americans. This Crisis eventually led to the Great Recession of 2007-2009. This paper is a review and a commentary of the Housing Crisis. The causes that contributed to the Housing Crisis will range from the Community Reinvestment Act of 1977 to the greed and voracity that engulfed the Financial Markets. Such greed maligned the Financial Markets causing eventual bailouts and measures that the US Federal Government employed to avert a major financial depression. This paper will discuss definite recommendations that will improve the US Housing Market. Background There is an adage that hindsight is 20/20. To understand the Housing Crisis that led to the Great Recession of 2007-2009, it is necessary to review the timeline of events that created the economic meltdown.
CLEAN UP THE HOUSE 4
1977 - The Community Reinvestment Act The Community Reinvestment Act of 1977 (CRA) was passed in Congress and signed by President Carter. This Act was passed to help to promote fair lending practices to all parts of the community. It was a measure to curtail redlining. Redlining, as defined by Wikipedia, “... is the practice of denying, or charging more for services such as banking, insurance, access to healthcare, or even super markets, or denying jobs to residents in particular, often racially determined areas (“Redlining”, n.d.).” Hence, the CRA became the social agenda of the Carter Administration to force banks to accept a social responsibility to provide credit to homeowners and businesses in low-income neighborhoods (Corsi, 2009, p. 49). Even though it was risky to lend to poverty stricken areas, banks had to consider everyone when giving loans to the public. According to John Carney in the Business Insider (June, 2009) he states:
A Banker who refused to relax standards risked the wrath of regulators, and - more importantly - if his unorthodox, novel attempts failed he'd be found to be in non-compliance with the CRA. In the real world, lax lending standards, were the only know way of satisfying the CRA regulators.
1990s - The Clinton Administration President Clinton’s Administration took the CRA to the next level. The CRA was revised and it allowed subprime mortgages to be securitized (Corsi, 2009, p. 49). Securitization is a fancy Wall Street term. It is the practice of altering financial assets into profitable capital market instruments (Mishkin & Eakins, 2015, p. 172, p. G-14). These securities are known as mortgaged-backed-securities or MBS.

CLEAN UP THE HOUSE 5 Mortgaged-backed-securities were created for several reasons. First, the loan amounts of an individual mortgages were too small to be used as an instrument to trade. Second, with respect to maturity, interest rates and terms, a mortgage is not like a corporate bond or a stock. Third, unlike a corporate bond or a stock, a mortgage demands a lot of time by a banker to service. Fourth, Investors do not want to commit the extra energy to learn the default risk of every mortgage; hence, these problems inspired the creation of a mortgage-backed security (Mishkin & Eakins, 2015, p. 331). Wall Street would package and bundle millions of MBSs and sell them to investment bankers who would turn them to a mortgage-backed security bonds. These bonds were sold to other banks. Money would be raised and anyone who sold these MBSs would receive a fee. In short, a mortgage that was started by the mortgage originator would get paid for the sell. It was an assembly line process and anyone who sold the mortgage would get paid along the way (Corsi, 2009, pp. 50-51). To heighten things further, Senator Dodd (D), Chairman of Banking, Housing and Urban Affairs and Representative Barney Frank (D), Chairman of the Housing Financial Services Committee, threatened banks to make subprime-mortgage loans to people who could not really afford them. FDIC certification would be denied if banks did not comply (“Community Reinvestment Act”, n.d.). Also, in the 1990s, Government Sponsored Entities (GSEs) such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Corporation (Freddie Mac) were required to securitize subprime-mortgages as well (“Fannie Mae”, n.d.). In 1992, Congress
CLEAN UP THE HOUSE 6 passed legislation to broaden the roles of Fannie Mae and Freddie Mac with the following mandate, "The Federal National Mortgage Association and the Federal Home loan Mortgage Corporation have an affirmative obligation to facilitate the financing of affordable housing for low - and moderate - income families in a manner consistent with their overall public purposes (“12 US Code 4501-Congressional Findings”, n.d.). This became known as the Affordable Housing Mission Statement. So, in the 1990s, not only was Wall Street involved, but by using the GSEs, the President and Congress were also involved in pushing the social agenda of allowing the piece of the American Dream available into poor-inner city areas. However, this mandate only made the ground more fertile for a Housing Crisis to occur. Mandated to securitize loans but armed by the Affordable Housing Mission Statement, Fannie Mae and Freddie Mac profited by underwriting trillions of dollars worth of subprime mortgages. They would use the Affordable Housing Mission Statement as a shield from further regulation from Congress. According to Paul J. Wallison from the American Spectator (Feb., 2009), "The GSEs argued that if Congress constrained the size of their mortgage portfolios, they could not afford to adequately subsidize affordable housing." Like a parent handing the car keys over to their teenager, Congress could determine the year, make and model of the car. Yet, this would not stop Fannie-Mae or Freddie Mac from going on joy-ride with that same car.
Late 1990s - The Repeal of the Glass-Steagall Act of 1933 The Glass-Steagall Act of 1933 was passed by Congress in response to the Great Depression of 1929-1933. In the 1920s, banks could take deposits, make loans and sell securities
CLEAN UP THE HOUSE 7 at the same time. When the Great Depression hit in 1929, Congress through their investigations discovered that a conflict of interest that Banks had by doing both deposits and loans and securities and the same time. Hence, the Glass-Steagall Act was passed to separate the two functions of commercial banking and investment banking. Yet, things changed in 1999. Two things precipitated the repeal of the Glass-Steagall Act of 1933: (1) American banks could not compete with foreign banks because of their limited portfolios of securities and insurance products and (2) The merger of Citigroup and Travelers Group Insurance Company. Citigroup was the second largest bank in the country and Travelers owned the 3rd largest investment bank, Salomon Smith and Barney. With the fact that American banks could not compete and the enormity of the merger between Citigroup and Travelers, this pushed Congress to pass the Gramm-Leach-Bliley Financial Service Modernization Act of 1999. In short, this act repealed the Glass-Steagall Act of 1933 and it allowed commercial banks to do investment bank services and vice versa (Mishkin & Eakins, 2015, p. 474). Therefore, banks - with full vigor - became involved with mortgaged-backed-securities (MBSs) and participate in the subprime mortgage industry.
Computer Technology The advancement of computer technology and the use of the internet made it easier to acquire information about a potential borrower. What was a cumbersome and costly process of providing the paperwork to do a mortgage became a cheap and easy process for banks (Mishkin & Eakins, 2015, p. 172). Hence, it was natural for banks and brokerage firms to make subprime-mortgages rapidly and in large numbers. With a few clicks of the mouse, a mortgage could be CLEAN UP THE HOUSE 8 created, e-mailed to Wall Street, securitized, made into a bond, and then sold to investors. Borrowers in minutes, with the aid of computer technology, could apply on-line and get approved for a mortgage. Again, everyone was paid along the way. So with the growth of computer technology, receiving a fee was quick and easy.
2001 - The Federal Reserve Another element that contributed to the Financial Crisis was the Federal Reserve. The Federal Reserve was created in 1913 to battle a financial crises. However, it too played a role in the Housing Crisis. Typically, the Federal Reserve has the role of controlling inflation, smoothing out the business cycle and ensuring financial stability (Mandel, 2012, p. 226). However, the Federal Reserve lowered the prime interest rate 11 times from 6.5% to 1.25% starting in May 2000 to December 2001 (“Open Market”, n.d.). Alan Greenspan, Chairman of the Federal Reserve, admitted that after the 9/11 attacks there was a slowdown in the economy. There was also a concern for deflation (Corsi, 2009, p. 48). With the lowering of interest rates this revived spending made the GDP grow but it also caused a surge in the housing market. The value of the home went up and the cost of borrowing money went down. Overall, borrowing money for anything - houses, cars, appliances - became easy. Alan Greenspan (2007) argued:
This boom provided a big lift in morale. Even if your house was not for sale, you could look down the block and see other people s homes going for what seemed like astonishing prices, which meant your home was worth more too (p. 229).

CLEAN UP THE HOUSE 9 Alan Greenspan also justified the lowering of interest rates because there was an enormous liquidity internationally and the savings that was created in markets such as China and India during the 1990s. In an article that he authored in the Wall Street Journal (March 11, 2009) he contended: The presumptive cause of the world-wide decline in long term interest rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of saving propelled global long-term interest rates progressively lower between 2000 and 2005.
Greed
The Housing Crisis is comparable to creating a witches brew - 2 spices of this, 4 spices of that - and you have something that is very toxic. The stage was set. With the Community Reinvestment Act of 1977, mortgage-backed-securities, Fannie-Mae and Freddie-Mac, computer technology and the militancy of the Federal Reserve, greed was the final ingredient to the worldwide Global Recession of 2007-2009. The Webster’s Dictionary defines greed as a, “Selfish desire to have more of something (especially money) (Greed, n.d., para 1).” Greed is observed with the following quotes in Financial Markets and Institutions (Mishkin & Eakins, 2015):
CLEAN UP THE HOUSE 10 The mortgage brokers that originate the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell (distribute) the loans to investors in the form of mortgaged-backed securities. Indeed, in some cases mortgage brokers would even extend loans that they knew were beyond the capability of the borrower to pay back . . . Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on his or her payment? The mere volume the broker originates, the more he or she makes (p. 172).
It continues. Risk loving investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could walk away if housing prices went down. The principal-agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or commit fraud by falsifying information on a borrower’s mortgage application in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans (p. 173). Indeed, greed affected the subprime-mortgage lending Industry. Companies like Countrywide Financial, Ameriquest and American Freedom Mortgage brazenly engaged in wonton manner of predatory lending practices. Mark Bornchill, a former employee of Ameriquest in an LA Times Article (Hudson, 2005), said that Ameriquest, "…Forged documents, hyped customers' credit worthiness and ‘juiced’ mortgages with hidden rates and fees," Other
CLEAN UP THE HOUSE 11 ex-employees from Ameriquest said that, "loan sales people used fast talk and slight-of-hand paper shuffling to get them to sign a document without knowing the consequences." (Hudson, 2005). Of course, greed was the motivating factor. Bornchill reported on the working conditions at Ameriquest and said, "It was like a Boiler room…You produce, you make a lot of money. Or you move on." However, the greed does not stop. Investment and Commercial banks who made money underwriting these mortgage-backed securities had no intention to see that the owners of these securities were paid off. Hence, insurance companies like AIG, jumped on the bandwagon and wrote hundreds of billions of dollars worth of the contracts to bondholders if these securities ever defaulted (Mishkin & Eakins, 2015, p. 173). To make things worse, Credit-rating agencies also gave inaccurate ratings. Blinded by the huge fee they would receive, they gave ratings that were way too high for investors to notice that these securities were too hazardous (Mishkin & Eakins, 2015, pp. 173-174). The Housing Bubble With Greed being the final aspect to the Housing Crisis, a bubble in the financial market was created. The prices of homes rose wildly from 2001-2005 and everyone thought this trend was simply going to continue. It was addictive. If home prices are going up, it is okay to invest more in the housing industry. A cocky attitude dominated the housing industry. Mortgage brokers would virtue their prosperity to soaring profits and their competency to make such a profit. Word of mouth would constitute an enthusiasm in others to think, act and behave the same way. Hence according to Mishkin and Eakins (2015), "…the result is a so-called
CLEAN UP THE HOUSE 12 positive feedback loop in which prices continue to rise, producing a speculative bubble." This word of mouth scenario spread like a virus throughout the country. Reporter Barry L. Ritholtz from the Wall Street Journal (2008) noted: Unscrupulous home appraisers found that they could attract more business by inflating appraisals. Intrinsic value was ignored, so referrals kept common in. This helped borrowers obtain financing at prices that were increasingly unstoppable. When honest appraisers petitioned both Congress and the bureaucracy to intervene in the widespread fraud, neither branch of government acted.
Moreover, the value of the home has always gone up since the Great Depression (Mandel, 2012, p. 266). The Bubble Bursts Plain economics ruptured the housing bubble. Mishkin and Eakins (2105) observed in the following: When housing prices rise too far out of line with fundamentals - in the case of housing, how much housing costs if purchased relative to the cost of renting it, or the cost of houses relative to households median income - they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006 the rot in the financial system began to be revealed (p. 174).
In other words, order had to be restored when the gap of owning and renting the same house became too great. Therefore, the price of the house began to fall. It became clear that the real-estate industry was still about human beings buying a home and living in it. Why pay for a
CLEAN UP THE HOUSE 13 mortgage loan payment that was extremely too high when a person could simply rent it out and live in it for much less? Home prices went up by 80% between 2000 and 2006 but the owners rent only went up by 20% (Mandel, 2012, p. 148). Hence, to resolve the huge disparity, home prices started to plunge dramatically in 2006. The Economy Shrinks The Great Recession of 2007-2009 is the result of the Housing Crisis. As home prices started to fall in 2006, foreclosures went through the roof. As a result, the banks and every other financial intermediary involved with a mortgaged-backed security took a hit on their net worth. This, in turn, made banks less inclined to lend to any borrower nor to each other (Mishkin & Eakins, 2015, p. 176). Because banks balance sheets started to take a turn for the worse, lenders became suspicious of each other and required more collateral just to get a loan or credit. Other Banks were forced to sell off assets, or de-leverage just to raise money to use as collateral for a loan. However, the selling off of assets only hastened their demise and it would hurt their net worth even more. This de-leveraging that occurred in financial institutions was the catalyst to the Great Recession of 2007-2009. When it was hard to obtain credit for anything, the flow of money in the economy slows down and the economy shrinks (Mishkin & Eakins, 2015, p. 177). The Bailout In September 2008, several financial institutions were forced to take dire action because their net worth took a loss. Bear Stearns was sold to JP Morgan. Fannie-Mae and Freddie-Mac were taken over by the US Federal Government. Lehman Brothers filed for bankruptcy. (No one

CLEAN UP THE HOSUE 14 bought them.) Merrill Lynch was sold to Bank of America (Mishkin & Eakins, 2015, pp. 178- 179). However, AIG was bailed out by the US Federal Government. It was considered that AIG was “too-big-to-fail”. Indeed, the Bush Administration felt it was imperative to bailout AIG because his advisors warned that inaction of the US Federal Government could lead to a terrible financial depression. His advisors, Secretary of the Treasury, Hank Paulson, and Chairman of the Federal Reserve, Ben Bernanke, made it clear that they needed outright authorization to buy up mortgaged-backed-securities deemed as toxic assets (Bush, 2010, p. 440). In his book, Decision Points, President George W. Bush (2010) asked, “Is this the worst crisis since the Great Depression?” Yes, Ben (Bernanke) replied, “In terms of the financial system, we have not seen anything like this since the 1930s, and it could get worse.” Bush concluded his meeting with, “If we’re really looking at another Great Depression . . . You can be damn sure I’m going to be Roosevelt and not Hoover (Bush, 2010, p. 440).” In response to the Crisis, the Bush Administration presented a $700 Billion plan to Congress. Congress and their constituents were angry that they were faced with a decision that would bailout the Banks because of their greed and mismanagement. So, they voted down the plan. At the same time, on that very day of September 29, 2008, the Stock Market crashed 777

CLEAN UP THE HOUSE 15 points. One week later, now that Wall Street got Congress’s attention, the Toxic Asset Relief Program (TARP) was passed in Congress. The US Government bailed out Wall Street and the Economy went through a deep Recession instead of another Great Depression (Bush, 2010, p. 463). Measures to Clean up the Housing Market This analysis of the housing crisis started with a quote from The Declaration of Independence. It seems therefore appropriate to summarize this analysis with a quote from the Preamble of the US Constitution which states that a government is needed to, "...form a more perfect union. Establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity (“Why do we need Government?”, 2014).” Hence, the US Government is mandated by the US Constitution to promote the general welfare of all Americans. In distinction to the housing crisis that was started by the Community Reinvestment Act of 1977 and culminating to the ferocious greed that engulfed the nation, the following quote from Thomas Paine in his pamphlet Common Sense can aptly summarize the role of the US Government in the Housing Crisis: Society is produced by our wants, and government by wickedness; the former promotes our happiness positively by uniting our affection, the latter negatively by restraining our vices. The one encourages intercourse, the other creates distinctions. The first is a patron, the last is a punisher. (Beck, 2009) The US Government must take a leading role in fixing the US Housing Crisis. It must recognize, identify and correct its own mistakes and then must pass measures to adopt monetary policies
CLEAN UP THE HOUSE 16 that will strengthen and grow the Economy. As the role of “punisher”, the US Federal Government must also reign in the greed that swallowed our conscience. There are many things to learn from the Great Recession of 2007-2009. For example, the US Federal Government had good intentions of curtailing discriminatory practices by banks. However, this led to unintended consequences. Banks were making bad loans to people who could not pay them back, thus hurting the net value of banks. Second, we have allowed the US Federal Government to advance these social agendas through our agencies, Fannie-Mae and Freddie-Mac. They have allowed them to grow into something more than what their original purpose was to be. By letting them securitize mortgages it opened the door for Wall Street to gamble with a house loan. Third, we love our computers. This term paper was written on a computer. However, when it comes to buying a home, real-estate agents, mortgage brokers and bankers should remember that these loans involve people’s lives. Borrowers should meet their lenders face to face. Life should not be a few clicks of the mouse. The home buying process should be put into the context of a borrower trying to live their life out with a roof over their head. Fourth, greed ignores common sense. Why think that if things are going great today that things will keep being great forever? Is this how we live our lives? Is life always upward-sloped and linear? This is a false belief. In his book Decision Points George W. Bush (2010)states, “I was furious the situation had reached to this point. A relatively small group of people - many on Wall Street, some not - had gambled that the housing market would keep booming forever. It didn’t (Bush, 2010, p. 440).”
CLEAN UP THE HOUSE 17 Therefore, in response to this situation and along with these suggestions, we should also embrace the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response to the Great Recession of 2007-2009, this act was passed and signed into law by President Barak Obama in 2010. The Act can be summarized by the long title of the Act which states: An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too-big-fail", to protect the American Taxpayer by ending bailouts, to protect consumers from abusive financial service practices, and for other purposes (“Dodd-Frank”, 2010). In specific, title XIV (14), which is titled Mortgage Reform and Anti-Predatory Lending Act, set specific standards in the following: (1) Residential Mortgage Loan Origination; (2) High Cost Mortgages; (3) Mortgage Servicing; (4) Appraisal Activities; and (5) Mortgage Resolutions and Modifications. This act also created a new Office of Housing Counseling (“Dodd-Frank”, 2010). It is important to embrace this Act because it is clear that a house is a symbol of the American Dream that is to be protected and defended - not for the sake of making a quick dollar. It is important for everyone to study the causes of this particular credit boom and to learn to develop the skills to identify any credit boom on the horizon. Hence, an education in Economics and Finance is a must for all consumers. Overall, all legislators, mortgage brokers, commercial bankers and investment bankers have to ask themselves the following: Why gamble on the value of a house which happens to be the most expensive thing anyone can buy? If a house loan fails, so does everything in that house! Jobs disappear and families are affected. Every industry that was involved in the
CLEAN UP THE HOUSE 18 building of that house are affected. The plumbing, lumber, plaster, nails, concrete, wood, chemicals, fertilizer, the labor and transportation costs are all affected. In short, the thousands of things that it takes to build a house are affected by the failure of a mortgage loan. In addition, all the things that furnish a home are also at stake. When the extension of credit came to a halt in the housing industry, the car industry - and the lending that financed it - also came to a halt. Like the Housing Crisis, the Federal Government had to bailout the Car Industry too! If a house does not get paid for, what convinces a lender that a vehicle, fridge, sofa or credit card does not get paid for either? A bad house loan influences every loan in that house. A bad house loan - millions and millions of them - alters the Economy.

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