The casualties of the sub-prime debacle are mounting. Thousands of banking employees have been or soon will be laid off. CEO’s of major banks and financial institutions have been let go. The integrity of retirement funds and governments has been shaken. Last week Florida local governments pulled 8-billion dollars from a state run investment pool after learning the fund contained more than 700 million dollars of troubled debt instruments, so-called “Structured Investment Vehicles -- sub-prime mortgages bundled and sold as bonds.
According to a study released last week by the U.S. Conference of Mayors, property values of American homes will drop by $1.2 Trillion dollars next year. That projected fall in value will cut property tax revenue by more than 6 and a half billion dollars.
Here to help us understand both the scope of the problem and to identify some of the regulatory and legal solutions are: David Swensen, Iowa State University economist and Katherine Porter, associate professor of Law at the University of Iowa.
Johnson Boyle: Katherine and David, thanks so much for being here. We appreciate it. Dave, let's begin with you. This is a very difficult question but maybe you can give us a quick summary. This is the perfect storm. Can you describe how we got to this point?
Swenson: We didn't know there was going to be a storm, and there were lots of paths to this and there are lots of participants. But if you cast back about eight years, we had a recession. We had a dot-com bust and then we had a recession. The markets were very soft. People didn't know where to put their money. There wasn't a lot of action in the economy. But one part of the economy started to do okay, and that was housing. Housing continued -- there continued to be interest in investing in housing. Also, the central banks at this time lowered interest rates tremendously, and it made capital quite easily accessible to a lot of traditional borrowers. So the housing market became a popular place to start investing, both in terms of new homes, expanded home purchases, as well as home improvements. So the economy locked onto the housing market as a viable mechanism for helping to get the economy back on track. We kept doing this. If you remember back, President Bush talked about an ownership society. Oftentimes during that period when we wanted to point at strengths in the American economy, they pointed to the housing market and how it was driving some percentage of the growth that was occurring. So for a very long time, this is what was carrying the economy forward. It was moving America forward and it was looked to as an asset and a strength in regional economies. It's only been in recent months that people have started to look at this and say, oh my goodness, we've overbuilt, we've over invested, we've overexposed ourselves to a lot of risk and have started to rethink exactly where are we with regard to the housing market and how widely exposed, not just our purchasers, our homeowners, but how widely exposed is the broader financial markets.
Johnson Boyle: You know, I'm going to ask you this, knowing full well the answer. Have we felt the full force of this crisis yet? If not, what should we be prepared to face this?
Swenson: We can't possibly have felt the full force of it because we haven't -- we're just now learning about it and we're just now figuring out very slowly, day by day, institution by institution exactly where we're exposed and how much. We just heard in the last few weeks of different institutions -- just different major financial houses that have had to write down loans, have gotten rid of their CEOs. That's what we're going to continue to hear over time. I think the natural inclination of firms is to kind of keep it in house and see if you can't manage it. And when you find you can't manage it and you've got to come clean. That's what we're seeing, these firms coming clean, both with regard to their shareholders as well as to the public. Have we seen the extent of it? No. The market is -- it's continuing to deal with it. The realtors and the bankers really think this is going to continue on very seriously into the end of next year.
Johnson Boyle: What about for those of us here in Iowa, our people, our communities? What's this doing to our state?
Swenson: Iowa isn't as exposed as the average American to this crisis. We have much fewer subprime loans as a fraction of loans. And just overall, Iowans -- this is more of an issue for rapidly growing areas. There are three areas that stand out: Rapidly growing areas where you have rapidly appreciating housing markets; areas that had high concentrations of people who, for one reason or another, weren't good candidates for home ownership; and third, areas that were regionally in recession like Michigan and Ohio and Indiana. And not one of those three fits Iowa right now, so our exposure is much less than the national average.
Johnson Boyle: Dave and Katherine, either of you can answer this question. Who is to blame for all this? Can we place the blame anywhere?
Swenson: Well, in the broadest sense, we can argue that the financial institutions in an effort to make more money for shareholders and investors started to change the way they viewed traditional lending. And they -- you could argue that they cut corners or they became creative, one way or the another. What they did was they created a different security or a different mechanism for investment. And as a consequence, they increased the risk inherent in that whole process, and the examples, of course, are an adjustable rate mortgage, no interest loans, no down payment loans. Some of the traditional safeguards were done away with in the name of, really, volume, getting as many loans on paper as possible and as many people signed up as possible.
Porter: And I think one of the things that's different about the mortgage crisis that we're facing now is that we have so many more different parties that are involved in that transaction. This is not just a home owner and their local bank. This is a home owner, a broker who may have helped that home owner -- or not helped in fact -- but ostensibly helped the home owner find a loan. Then we have the institution that made the loan, the originating bank. Those loans were normally sold to an institutional bank who bought them, and they were then packaged into securities. Even within those securities, there are different levels or trenches of investors. Some of those investors who are at the top of the investment chain aren't as interested in working with troubled home owners; whereas, the investors who are at the most risky slice of those mortgages stand to take real losses if we continue to see default. So it's just a much more multiplayer market than we had thirty or forty years ago in the residential home market.
Johnson Boyle: Let's make the transition to possible solutions. Treasury Secretary Henry Paulson is proposing the freeze of the reset of subprime mortgages. Will that help alleviate this problem at all?
Porter: I think it will. I think what we've seen so far have been a lot of people into foreclosure even before their loans have reset. What Treasury Secretary Paulson's scheme is really trying to do is to be a preventative. The bulk of A.R.M.s, of adjustable rate mortgages, are going to have their interest rate reset in 2008 and 2009. So this is really a preventative plan to try to help them stem off that coming wave. The proposals would freeze the mortgage rates at the initial rate. There are many families though who can't afford the mortgage even at the initial rate. That initial rate mortgage took up 50 or 60 percent of their family's income just to make the mortgage payment. But for families at risk from interest rate reset, this will help.
Johnson Boyle: Who is going to pay for this?
Porter: Ultimately, the investors will pay, and to some degree most of us are invested in the housing market. Most of us own, through our 401(k) or pension vehicle, shares or securities, either a bank security or a real estate investment trust. The investors will ultimately take the hit. But to be clear, if these loans proceed to foreclosure the losses would be even greater. That's why you're seeing the banks and the investors willing to come to the table with Secretary Paulson. Some of it's political pressure, but some of it is a growing realization, I think, that they need to do something to try to modify these loans, or if they let them go all the way to foreclosure, the losses could be even more severe.
Johnson Boyle: How feasible is it to work out some of these loan issues under the circumstance?
Porter: It's very, very hard for consumers right now. One of the things that my research looked at was how do consumers fair in terms of getting information from their mortgage services. Right now the person that you, as a consumer, send your payments to is usually a mortgage servicer. That's a separate company from the company that originated your loan, and it's usually a separate company from whoever owns your home loan. These mortgage servicers do not work for the consumer. They work for the investors, and they don't have an incentive to provide good customer service. So we've heard a lot of stories about consumers, troubled home owners. They want to work something out. They want to make a payment a month late. They can't get a hold of an employee. They call back. They call 26 times. They get put on hold. I've had lawyers who are trying to help these people relay the same stories. It's very, very hard to get through. I think that's why secretary Paulson is looking for a more systematic solution.
Johnson Boyle: Katherine, I just want to interrupt you for a minute to mention that on your screen, for those of you watching at home, you will see a number for the Iowa Foreclosure Hotline, so if you are having trouble making your mortgage payments, you can call this hotline to get more information. David, what kind of effect is all this having, very briefly, on the lending market, and do you have any advice for viewers out there?
Swenson: Well, first off, on the lending market, that's probably the crux of the crisis is that money supply has tightened, banks have had to become much more cautious with regard to lending. They did not want -- their exposure to these risky instruments have increased over the last few months, and they've tightened up their credit. So that's why we have the central bank reacting now and trying to do what they can to ease the markets. So where are we with regard to that? What we're doing is we're still shaking that out and we're trying to figure out what's the worth of those investments, and we're watching these major financial houses write down some of the values. In the future what we're going to be dealing with, it's going to tighten up credit, and that affects everybody. It affects everybody who wants to borrow money for anything, whether it's a business, a home, or to buy a car. Everybody has to pay higher borrowing costs, and that's affects, also, the pace and pattern of economic growth.
Johnson Boyle: Katherine, I want to mention, before the interview ends, that you've done some research about home owners who file for Chapter XIII bankruptcy protection, and they're facing actually fees from mortgage companies with no documented merit. Do you want to discuss that?
Porter: So my study looked at 1,700 families who had filed for bankruptcy protection, because they wanted to hang onto their home. They came into federal court. They were willing to file bankruptcy. They wanted to keep their houses. And what I found is that more than half of the loans, the mortgage company had failed to follow the law that requires them to attach the documentation, that is they weren't able to come up with the evidence that showed exactly what the consumer owed. There were also a lot of troubling fees, some of them very small but, applied to thousands of families, added up to a large amount. So I really encourage consumers to keep their paperwork from their loans; if they get in default, to work with their lender very, very early in the process before they get hit with these fees, which can easily amount into the hundreds of thousands of dollars.
Johnson Boyle: So how do we bring integrity back into the housing system?
Porter: Well, one of the problems is -- in the bankruptcy system, we're starting to see the U.S. Trustee, a branch of the department of justice, do some looking at the mortgage lending and mortgage servicers to make sure they're following the bankruptcy rules. The problem is for most consumers, foreclosure is a state law process, which means we have 50 different systems of law. And so it's very, very difficult for a consumer to get information and to make sure that they're following the rules. We simply need more government attention to this process -- to the foreclosure process and making sure it's being carried out fairly.
Johnson Boyle: Dave, do you want to weigh in on this as well?
Swenson: Well, I don't know that I can add anything to this other than we've got a ways to go to figure out exactly what are going to be the needs of some of the most vulnerable people versus people in the middle. There's a lot of people exposed to this whole credit crisis problem who aren't necessarily destitute or facing foreclosure, but they're going to be living through stress over the eighteen months to twenty-four months to thirty-six months. They're having massive increases in their mortgage payments because of these adjustments. They're making payments on this borrowed money. They're not buying things in your economy. We're going to see an economic impact as we shift from consumption to paying off these loans, and we'll feel that as well.
Johnson Boyle: I know you mentioned it earlier, but it bears repeating that you feel we have only begun to see the very first effects of all this?
Swenson: That's correct. I think we're still learning and we've got a ways to go. We don't quite know -- we've heard now about official reactions to this. It's like the farm crisis or any other crisis. We sort of feel our way along as we go along, and we're not sure how it's going to resolve itself because we're yet to figure out what the depth of this crisis is.
Porter: One of the problems is that the government really doesn't have very good data about foreclosures or about how many families are being affected, so there's not a good government handle on the extent of this either at the federal or the state level. But we haven't yet seen the bankruptcy filings go to the level that I think they're going to go in reaction to this problem. I think we really are at the beginning of what's going to become a much bigger problem.
Johnson Boyle: All right. Well, thank you so much for shedding light on a very complicated and complex problem. I know we've just scratched the surface of it, but I really appreciate your insights. Katherine Porter and David Swenson, thanks for joining us here today. Appreciate it.