The banking industry effectively created the current crisis in real estate lending when they fueled the conspicuous consumption of the 1980's and 1990's.
August 2007 was a messy time for the Real Estate industry. It was even worse for real estate lenders as there were bankruptcies, rumors of bankruptcies, acquisitions to avoid financial implosions and at least one major bank stopped doing new home loans entirely. Pundits have, as is usual in the financial markets, offered a variety of reasons for what happened. Some of it may be true, while a lot of it is quite certainly hot air. Watching the Michael Douglas film “Wall Street” gives one a certain insight into how one should treat the news and public information floating around in the financial markets; don't take it seriously unless you can independently verify what you hear.
After having seriously followed investments for over 30 years, spending a significant amount of time as a petitioner's bankruptcy attorney and as a real estate broker, I have come to my own theories about what happened. You can believe it or not, as you wish; but I seriously believe that my own analysis is better than you are likely to receive in the Wall Street Journal, simply because it deals with realities, and human motivations. More importantly, it is not designed to promote any particular interest including faith in the financial markets, and is not mired in financial language that is incomprehensible to the uninitiated.
The story really begins with the rise of the credit card industry, which was a post World War II phenomenon. American prosperity was on the rise, consumerism had taken hold of a society that wanted to forget the Great Depression and wartime rationing. Easily accessibe credit would help to make this possible and the more credit that was available in the economy the more consumer goods could be bought and paid for later. With the proper promotion instant gratification was another social phenomenon that took hold, not only of the average American, but of the generation that spawned the anti-war movement and the “sex, drugs and rock and roll” culture of pleasure now and deal with the future later. It went hand in hand with the buy now and pay later mantra of the credit industry.
It took quite a while for this to truly take hold of the economy. BankAmericard touted convenience, rather than consumption before it became Visa. It wasn't until the late 1970's that the credit card industry began to permeate society to the extent that people began to want a wallet full of cards that they were all to willing to max out. Visa and Mastercard promoted it, that the merchants went along, knowing that they would profit from the convenience the system offered their customers, whether it was on a store issued card or on one of the major names. By the 1980's it was a fixture. But the banks and the merchants thought little of the probability that someday the house of cards would come crashing down, as eventually it did.
The problem centered on one important fact. Credit had always been available, but generally it had to be earned. The first half of the 20th century was a time when you did business with a local bank and the employees there knew you, your business, and your financial capabilities. They had been there for years and would continue to be. They were careful to lend only what they believed you would be able to pay back. They wanted to preserve the bank's financial health and yours as well. But the banking industry changed. Electronics replaced the personal relationship. The local bank officer you did business with for years was replaced by one who might be there for 6 months or a year, only to be replaced by someone else who also didn't know you, and who couldn't work with you from the position of a trusted friend or advisor. And, the credit cards multiplied.
There was a reason for this multiplication; profits. Figures I obtained some years ago from one of California's Chapter 13 Trustees indicated that the average credit card bank was making a fifty percent return each year on a dollar lent through a credit card. This return was calculated after defaults, bankruptcies and other costs. There was no question that the system was a major gold mine. The reason for this was deregulated interest rates, late payment penalties and the “never never” system that encouraged people not to pay off their accounts. When anyone would be overjoyed to earn twenty-five percent a year the banks were, according to these figures, totally cleaning up. It might have been better than running a casino.
Things began to hit the fan when the dot com companies imploded in the 1990's. Significant layoffs in the electronics industry had a serious impact on the credit market as people who believed that they were sitting pretty suddenly weren't and the banks were left holding the bag. But the lesson that virtually unlimited easy credit was not a good idea didn't take hold. While most banks did cut back on their unsecured lending, many transferred their high risk lending to the real estate market.
High risk real estate lending actually began much earlier and contributed to the demise of some of the savings and loan companies during the 1980's. These businesses overextended themselves and in some cases may have issued loans based on falsified appraisals. This resulted in the demise of weaker businesses, but the stronger one's survived, and as the real estate markets in several states, including California took off in the 21st century a buying frenzy fueled by speculation created a another example fit for Charles MacKay's Extraordinary Popular Delusions and the Madness of Crowds. It was the dot com bubble all over again, with people assuming that no one was going to lose any money. Of course people did, but not immediately, and many actually made money. Those who got in, got a profit and got out did all right. Others who got in too late or stayed too long took the losses.
As the market became more heated many banks involved in real estate lending showed increased profits. Competition to make real estate loans became more intense and the lenders began to offer increasingly risky loan programs; risky for themselves if the borrowers defaulted, and risky for the borrowers because there were often insufficient examinations of their ability to pay, leading them into loans they could not afford long term. When low payment teaser plans expired borrowers either had to sell or go into default. That is precisely what happened when the markets cooled. Borrowers had less opportunities to sell, and overpriced properties were next to impossible to dispose of. Because many borrowers bought their properties with one hundred percent financing, and the expectation to sell relatively quickly, they had no incentive to hold their property. They walked away and left the banks to deal with the problem. When this had happened enough times banks had little choice. Risky loan plans were suddenly cut off. One hundred percent financing became impossible, except for the wealthy, and even full documentation loans suddenly required high credit scores and minimum down payments.
Of course this created other problems. The real estate industry had expected the easy credit to continue when it should not have been instituted in the first place. Real estate lenders suddenly found that they were overstaffed in the sales department and laid off numerous members of their customer service staff. And those middle income people who might have qualified for loans if they had money for down payments didn't because the money they might have saved to begin the “American dream of home ownership” went to pay for credit card based consumption. Thus, the banks sowed the seeds of the real estate slowdown when they fueled excess consumer buying through overextension of easy credit.
The present situation is not a happy one. Real estate professionals are caught in tough situation. Bankers are taking less short term profits and are going back to better business practices, at least for now. How long this will last, who can say. What we can expect is that this shake out will last for some time. It is likely that many banks will have to take losses on some of their loan properties. Others who were more circumspect in their lending practices will have less effect on their bottom lines. Home buyers will have to find ways to achieve less risky financing and sellers will have to wait longer for buyers to qualify. Realtors will have their hands full trying to help both sides cope with the radically changed market and it will be difficult. However, it was predictable. Holidays don't last forever. Neither do bull markets. That's the nature of business. The good news is that it happened during a time of general prosperity, and the probability of a recession or worse is probably quite low. We should thank our lucky stars for that fact as well as for the absence of massive government intervention which would probably have made the situation worse.
slaib@intellectualconservative.com
http://intellectualconservative.com
Read more articles by Steven D. Laib
