Financial deregulation since 1980 unleashed a craving for adjustable rate mortgages (ARMs) by Wall Street’s five largest banking institutions. Once unleashed, the ARM craving artificially accelerated real estate prices, ending with the implosion now known as the Millennium Boom that brought the California real estate industry to its knees, or worse.
Around April 2004, a dramatic 40% reduction occurred in the capital adequacy ratio of these largest banks. This freeing up of funds for investments led to a competitive advantage frenzy among these Wall Street banking institutions driving them to directly acquire ever-more risky ARMs. The ARMs they acquired were bundled into investment pools, then the pools were sliced into various levels of priority for investors to choose from, called tranches. These pools of mortgages were packed as mortgage-backed bonds (MBBs) and peddled to other banking institutions and individual investors, a process called securitization.
Among the nation’s five largest money handling institutions, loan securitization increased 32% after April 2004, according to data from FirstAmerican LoanPerformance. This increase was not mirrored by smaller American banking institutions.
When demand for mortgages peaked in mid-2005, Wall Street had perfected its vertically expanded system for gathering, bundling and reselling mortgages through the MBB market to millions of investors worldwide. This peak in homebuyer demand for purchase-assist mortgages was the result of a dried up supply of financially able homebuyers. Thus, in order to satisfy Wall Street’s demand for mortgages to securitize, tenants-by-nature had to be enticed to become homeowners, and property owners of all sorts had to be motivated to refinance. The answer to both problems came with the use of ARMs. These loans provided low initial interest rates to qualify, called teasers, and very low payment schedule options for up to five years, with no verification of income necessary.
first tuesday take: This research demonstrates the ancillary (but fully expected) consequences of relaxing regulations on money handling institutions, consequences the American homeowner is now becoming well aware of. In their report, the Federal Reserve (the Fed) puts solid research behind what the first tuesday philosophy has always been: Banking institutions operate in an abstract world brokering U.S. dollars which are initially and exclusively supplied by the Fed to sustain commerce as a trusted medium of exchange so barter and related labor complications are avoided. Until the 1980s, mortgage lending was subject to specific and fine-tuned rules crafted to prevent risk taking by bankers that jeopardize society and its institutions.
The government reins controlling money lending institutions established after our prior financial crisis of like magnitude (the Great Depression of the late 1930s) required government to harness the animal spirit of Wall Street’s competitive-advantage ethos. Letting the reins go has produced devastating consequences throughout the world’s economies. Particularly hardest hit are owners of homes in California who are far removed from the inner-workings of the time-honored money-printing system of central banks. More intimate knowledge of the banking system by real estate brokers and homebuyers might have protected Californians from risks created by private bankers running loose on the wild side of the economy.
Private banking (money handling) institutions must not be given the chance to gain a competitive advantage over their banking peers beyond reasonable government determined parameters of risk taking. Any greater leeway given to banking institutions, as commenced in 1982 and continued with a vengeance by all facets of national government, allows private bankers to throw caution to the wind and pursue unreasonably risky money-making financial wizardry by merely increasing their bet through the use of ARMs. Thus, they must be regulated by limiting the range of their activity, to keep risky money-making schemes well out of public reach. Nationally, that process is now underway.
Bankers know the government must always bail them out and cover their losses should they over-extend themselves and their businesses fail. Evidence of this is the current bailout and the savings and loan bailout in the late 1980s, both the direct result of deregulation. It is for this overreaching, not profit making, which regulation will again exist. For real estate sales, reregulation will level out the cyclical swings in sales volume, and significantly reduce the feast or famine markets we have increasingly experienced for the past 30 years.
The deregulation of money always goes up in smoke.
Re: “Demand for subprime credit or higher housing prices: Solving the conundrum of which came first,” from the Federal Reserve Bank of Atlanta