The 2006 Recession

Recently, I read an article from a liberal that stated that the 2006 recession was caused by Bush and Obama
was forced to correct the problem when he took over in 2008.  The claim was that Obama has brought the
country back from the recession Bush caused.

Here is the problem, this claim was made by someone that, obviously, does not understand history, finance, the
mortgage process or economics.   The conclusion you make from this is that liberals are ignorant and
uninformed.  Yes, I know, this seems like a pretty heady claim so the only way you can counter the claim is to
better understand the issue.

I will make a claim, the recession would have been avoided if the Community Reinvestment Act had one minor
change.  This single change in the CRA would have kept the market from ever reaching the point where all of
the foreclosures that caused the recession would never have happened.  The change required in the CRA is
the requirement that every mortage approved under the CRA must be a 30 year, fixed rate mortgage.  Under
this requirement, there would be no ARMs, no teaser rates, no discounted rates.

The recession was the result of the foreclosures of thousands of mortgages which burst the home construction
bubble.  How did the market get here?  Before the start of the recession, the real estate market was growing as
a result of the expansion of the economy and the implementation of the CRA.  During this period, many buyers
were speculating by buying homes and starting the construction, then selling the house before it was
completed, often making thousands of dollars.  This was the result of speculation, not consumer demand.  
However, the impact is the same.  With the homes to be started being purchased in advance of construction,
an accelerated demand was forcing the construction companies to speed up the process.  The speculation
reduced the available inventory, driving up the price for homes under construction.  Meanwhile, the existing
inventory of used homes was being bought by the CRA users, driving up the prices of the used homes.

Bear in mind, any existing owner of a home that has a desire to upgrade is tempted by the opportunity to sell
the existing home as he sees the prices rising as the real estate bubble is growing, knowing he can sell his
existing home at the increased prices.  He places a down payment on a pre-construction home, knowing that
the price of the home will increase during the construction period.  The real estate bubble was the result of
people that were not qualified for a mortgage to be approved under the requirements of the CRA.

Anyone that has ever actually completed a mortgage application understands that they must prove to the
mortgage company that they can be trusted, over the term of the mortgage, to make the needed payments and
pay off the mortgage.  These same people understand the requirements of qualifying for a mortgage in term of
credit history, employment history, payment history, and prior years tax returns.  Essentially, you, as the
applicant, are guaranteeing the repayment since there is no one else that will be responsible.

There are various government programs where the load will be guaranteed by a government agency based on
satisfying specific requirements.  One of these programs would be the VA program where the government has
decided that someone that has served in the military will be provided with some assistance in qualifying for a
mortgage, and there are various other programs available but they are limited.

The real problem during this bubble period was the number of homes that were purchased by people that could
not qualify based on the permissiveness of the CRA.  Under this program, the mortgages for the people that did
not qualify were guaranteed by the FHA.  In other words, if someone did not have a profile that pass the
screening process that applied to everyone else, they were exempted under the CRA.  What this did was place
people that were unqualified for a mortgage in a mortgage and placed the FHA in a position that the
government would become the guarantor of those mortgages (the tax payers would pay).

Most people fail to understand what happens with mortgages.  Mortgages are prepared by a broker for a
brokerage fee (see the first problem here)?  All of the unqualified mortgages were processed by a broker
somewhere and that broker charged a fee and then sold the mortgage to a financial organization for an
additional fee.  In other words, every bad mortgage put money in the pockets of the brokers that were simply
cranking them out because everyone was allowed under the CRA.  Good mortgages, as defined by the
financial institutions, were bought and maintained by these institutions and the balance of the mortgages were
sold the FANNIE and FREDDIE.  If you do not know who Fannie and Freddie are then that is part of the
problem.  These are mortgage institutions under the control of the federal government to provide a means for
less desirable mortgages to find a home.  Fannie and Freddie take these mortgages and consolidate a block
together to create a mortgage security which is sold on the open market to investors.  

Imagine, hundreds of thousands of mortgages consolidated into thousands of securities which are dependant
on the potential collapse of unqualified mortgage holders.  As the first of the problems and scope of the
involvement of Fannie and Freddie became known, the Congressional Democrats that supported CRA were
asked about the potential problems, Barney Franks was the primary spokesman and he simply lied to the public
about the potential problems telling people to keep investing.  If he had been the CEO of a public company, he
would have been convicted of misrepresentation, but Barney Franks simply retired from Congress as the
recession was growing around him.

The entire recession was the result of thousands of purchased homes by unqualified buyers, relying on the
changes to the CRA processed during the Clinton administration.  Now it is important to note that many
mortgage brokers and financial institutions made money on these questionable mortgages and this was
possible because the Democrats in Congress and Bill Clinton provided the means by loosening the restrictions
that existed in the CRA.  These purchases created a shortage of available homes and drove up the demand,
creating a bubble in the prices.  The recession was the result of the bubble bursting and thousands of people
ending up with property that dropped in price virtually overnight.  When the demand was stopped because the
bubble burst, the construction industry also stopped with many companies going out of business.  

So the question should be asked, could this have been kept from happening?  And the answer is yes.  First,
the simple change discussed earlier would have kept about 50% - 90% of the unqualified mortgages from
happening.  How?  Very simple.  Each of the unqualified mortgages approved under the CRA required that the
buyer be able to make the payments during the initial period.  This problem was overcome by using ARMs and
Teaser Rates (once again, if you do not know what these terms are then you are part of the problem).

These ARMs and Teaser Rates reduced the payments during the initial period to a level that the buyer could
make, however, they would never be able to make a payment once the real rates kicked in.  During this period
of time, there were thousands of stories of buyers that complained because the new payment amount was
greater than what they had been told to expect and they would need to sell the property quickly to get out from
under the new rates.  This mass sell off caused the prices to collapse and the bubble to burst.  Once the
market was flooded with available inventory, the foreclosures started and thousands of homes were simply
abandoned and taken over by banks and other agencies

So, could the recession have been averted once the bubble was burst?  The answer is no.  By the time the first
signs of the potential foreclosures became apparent, the number of foreclosures in the pipeline, on top of the
number of homes already on the market, there was no way to keep the economy growing since the construction
industry needed to stop because there was no market for the output.   Most people fail to remember President
Bush making claims that Fannie and Freddie were on the verge of collapse.  The problem was that by the time
the problem was observed, there was nothing to do except wait for the pipeline to be emptied.

The recession was the result of government intervention in a commercial market function, nothing more.  The
Democrats felt there was a need for everyone to be able to buy a home.  The solution was the Community
Reinvestment Act.  This piece of legislation provided the means for someone without the proper qualifications
to be able to get a mortgage and this goes back to Carter but it was very weak.  During the Clinton
administration, the CRA was loosened so that someone did not need to qualify, they simply had to agree to
make the payments.

With the easing of the controls, anyone could be convinced to buy a home and apply for a mortgage but there
was no way these people could make the monthly payments for years so mortgage brokers came up with
options.  Why would they develop a mortgage for someone they knew was unqualified?  Simple, if they
generated a mortgage, then they would be paid a broker fee.  In other words, there was money to be made.  All
of the bad mortgages were generated so that a broker could make money and many made lots of money
before the bubble burst and they then went out of business, closing down their businesses and taking their
money with them.

In order to get the mortgage approved, the broker had to convince the buyer that they could afford the home.
The way to do this was simple, manipulate the loan numbers.  There are two basic types of mortgages: a fixed
rate 15 year or 30 year mortgage, with fixed payments every month for the term of the mortgage.  This first
type is simple to budget because the amount does not change each month.  The problem is that the amount is
higher than other options and would be out of reach for most people.  

The second type is referred to as an Adjustable Rate Mortgage (ARM).  This loan has a lower rate with a lower
payment but reprices each year based on the market interest rate.  Because the loan has the option of
repricing, this loan rate can be adjusted during the first year.  Many times, the broker negotiates a low interest
rate, interest only, for the first year, providing the lowest possible payment but after one year, the loan will
reprice and the monthly payment will often double.  This is what happened setting up many loans for likely
failure.  If you remember the news story of the time, many new home buyers were surprised when the ARMs
repriced and the change in the rates resulted in payments that could not be maintained, leading to foreclosure.  
Many of these buyers tried to dump their homes on a market that already had excess inventory so the prices
dropped.

So, it is apparent that Bush did not cause the problem.  The recession was the result of the layers of
government interference piled on by Carter and Clinton.  This was the result of a small tap on the Dominoes
and watching them fall during the end of the Bush Administration.