– Anonymous Iguana Reader
This is the second part of a three-part series addressing the reader’s question about the American Dream. In this installment, Mr. Econ tackles home ownership.
Home ownership was viewed as critical to America and its communities because it provided a stable place to live and raise a family, thereby producing stable communities. Home ownership was also the basic component of “wealth” for a family.
Starting in the 1970s, the U.S. housing market changed dramatically. A home was no longer viewed as a stable place to live; instead, it became an investment.
Prior to the 1970s, homes, home prices and home mortgage loans were the bedrock of the U.S. economy in many ways. Banks were mainly local and did a majority of their lending in the local housing market. In fact, many banking institutions were only allowed to make home loans, and those had to be in the local market.
Banks got the money to make home loans from “Passbook Savings Accounts.” Many economic calculations were historically judged based on what was called the “Passbook Rate,” which was around 5 percent. This is the rate banks paid depositors on passbook savings accounts. Banks lent out this money at somewhere between 5 and 10 percent, depending on the type of loan and the creditworthiness of the borrower.
Because people could always earn about 5 percent on their money in a passbook savings account, if some transaction yielded a return of less than 5 percent, it was considered a bad deal. If the transaction yielded more than 5 percent, it was considered a bargain. Hence, economists often made judgments in relation to indicators connected to owning a home.
Traditionally, housing real estate was a very stable commodity and did not appreciate much more than the 5 percent banks were paying depositors. During this time, general prices and inflation were low. The amount of appreciation that did occur, when combined with the then-rising incomes of working class people, allowed the middle class to build equity in their homes and use the equity and increased incomes to purchase larger houses. Hence, there was a filtering in the housing market. First-time buyers purchased the smaller houses that were owned by previous first-time buyers. Typically, in about seven years, this family purchased the house of a family moving on to their third house.
Housing was also very affordable (“affordable” being a home price that is equal to approximately 2.5 to 3 times household income). This was the case in 1970 when the median home price was $23,000 and median household income was around $9,300 (in 1970 dollars from U.S. Census data).
However, in 2010, the median price of a home rose to $241,200. The jump in housing prices was more than double the rate of inflation as measured by the Consumer Price Index. And the price of a home compared to household income now stood at about 5 times the median annual household income.
The Banking and Home Mortgage System
The vast majority of people who buy homes finance the purchase using a loan called a mortgage. These loans are typically available from banks, savings and loans, mortgage companies, and more recently, credit unions.
What happened in the early 1980s is that banking regulations were not enforced. Local savings and loan institutions provide the majority of loans in the housing sector. However, seeing greater returns in speculative real estate, banks figured out ways to get around regulations requiring them to lend locally and limiting what types of products they could provide customers.
Many banks began lending to markets they had no knowledge of and invented new products to make the funds in savings accounts more liquid.
Savings accounts were meant to be more stable than checking accounts and give banks the capital they needed to make loans, especially long-term loans like home mortgages. Technically, deposits in savings accounts could not be withdrawn without a 30-day notice to the bank.
To get around this regulation, banks invented “NOW” accounts – Negotiable Orders of Withdrawal. In effect, savings accounts became no different than checking accounts, thus depriving the home lending market of a stable source of long-term capital.
A further development was that savings banks/savings and loan associations found a loophole so that they could either become commercial banks or merge with commercial banks and expand what they did with the money depositors entrusted to them.
No longer did the U.S. banking system have institutions that were totally focused on home mortgage lending. Not only that, but many savings and loans associations, as a result of their greed, made questionable loans outside of their original markets that proved to be worthless. The resulting collapse in the 1980s became known as the S&L Crisis.
Inflation measured by the CPI was above 10 percent in the late ‘70s and early ‘80s. Housing markets in many areas led the inflationary trend with housing prices in places like New York City, Boston, California, Phoenix and Washington, D.C. rising far faster than any other commodity. The Bureau of Labor Statistics reported housing costs rising about twice as fast as general consumer prices during this period.
The upper classes, whose incomes were rising and whose existing homes were increasing in value, had the luxury of selling their homes for huge profits and purchasing ever larger houses, even second and third homes.
A speculative bubble in housing began, and housing began to be looked at as not just a place to live but also as an opportunity to make money.
Traditional commercial banks also began to look at the housing market as an avenue for profit. The 1980s saw an explosion of bank mergers and take-overs, and local community banks disappeared for the most part. And just like the regulations governing savings institutions were ignored a decade earlier, regulations governing commercial banks became totally non-existent.
The critical regulations at issue were those set up as part of the Glass-Steagall Act, a law set up to protect consumers in response to the Great Depression. Glass-Steagall split commercial banks and made loans mostly to individuals and small businesses in their local communities. Investment banks financed large businesses that produced basic goods and services for the economy, and made loans that were far more risky, but in many cases these loans offered the lure of greater returns. Investment banks were not supposed to offer retail or commercial banking services.
Commercial banks, seeing the greater returns generated by investment banks, began underwriting the capital needs of large corporations and governments. Investment banks, seeing the retail customer as a source of cash, began offering “brokerage accounts” that looked very much like a typical checking account. But there was a major difference.
Whereas the commercial bank had a legal responsibility to invest the money of depositors in safe financial instruments like government bonds and home mortgage loans, the investment banks were not constrained by these regulations. Funds deposited in a brokerage account could and often would be invested in exotic things like derivatives, or thin air, in other words.
In 1999, the Glass-Steagall Act was abolished, releasing the banks from virtually any oversight. Not only were commercial banks officially allowed to do what investment banks were supposed to do and vice versa, but the two types of banks could also merge. Hence, one of the largest investment banks, J.P. Morgan, merged with one of the largest commercial banks, the Chase Manhattan Bank, and a new round of mergers and acquisitions began.
Home mortgage lending was not a profitable business for the newly expanded banks. Banks and mortgage companies saw the originating of home loans as profitable due to the fees they could charge to borrowers, and in some cases they could also charge the sellers of homes. But having money tied up for as long as 30 years in a global economy, where millions of transactions are taking place every second, didn’t seem like a good deal.
As a result, the banks invented a new product called a mortgage-backed security and got the U.S. government, through Fannie Mae and Freddy Mac, to insure them. This allowed the banks to make the mortgage loans, earn the fees and then sell the loans to someone else for an additional profit.
The rest is history. In their drive to make money, banks and mortgage lenders made loans to people who could not afford to pay them. Further, the loans were often made for houses that were worth less than the loans. And new, creative types of mortgage products were developed that made it easier for people to qualify for loans.
Then the storm hit, and the bubble burst. People lost jobs at the same time balloon payments were coming due or interest rates were being adjusted on these new mortgage products. As the first wave of home buyers defaulted on their loans, housing prices dropped.
In other words, a massive downward spiral began spinning out of control.
As a result of the housing bubble burst, tougher lending policies were instituted, the major ones requiring a 20 percent down payment and proof of income to support the loan for the long-term.
Given the decreasing wages of the middle class and the decreased buying power of those wages since 1970, these more stringent lending requirements excluded many middle class families from the dream of owning a home.
Equity in one’s home eroded for two major reasons. The first is the decrease in housing prices and values, which now make the home worth less than the amount due on the mortgage. The second might be the homeowner borrowing against the equity that had been built up in the home. The balance due on the original mortgage plus the amount borrowed against the equity is more than the current value of the house. Again, a situation where the borrower is underwater.
All of these factors in the housing market, along with the general factors in the economy laid out above, have combined to deprive the middle class from being able to purchase a home.
In the next issue of the Iguana, I’ll take a look at the specific factors that have developed recently in regards to a college education, which make the American Dream so difficult to obtain.