Community Banks: Surviving Unprecedented Financial Reform

THE BEGINNING: THE REAL ESTATE CRISIS To veteran financiers, the recent mortgage debacle follows the classic pattern of a typical financial craze. Investors were enthusiastic for an asset (residential real estate in this case), which drove the prices up, which attracted more capital, and inflated prices even more, until prices were so bloated that a market failure was inevitable (Ip, Whitehouse & Luccetti, 2007). Martin Feldstein (2008) summed it up by stating, "The unprecedented combination of rapid house-price increases, high loan-to-value (LTV) ratios, and securitized mortgages has made the current housing-related risk greater than anything we have seen since the 1930s." At first, there were fundamental reasons for home prices to rise. The economy was in a recession, and the Federal Reserve cut interest rates in 2001 and kept them low until mid-2004 (see Appendix C--Historical Target Fed Funds Rate). A migration of foreign savings into the U.S. market also helped keep mortgage rates low. The environment of rising prices may have lulled both buyers and lenders into a false sense of security about the health and stability of the real estate market. Former Federal Reserve Chairman Alan Greenspan even argued repeatedly that there could be no housing bubble in the U.S. He said in late 2004 that the inconvenience and high cost of moving "are significant impediments to speculative trading and.. .development of price bubbles" (Ip, Whitehouse & Luccetti, 2007). The Fed began raising interest rates in 2004, and mortgage rates followed suit. Buyers started turning to mortgages with lower initial payments, assuming they could sell or refinance the home before the rate adjusted upwards, so home prices kept ticking up. The higher prices allowed borrowers who had trouble making payments to refinance into even bigger loans. Easy refinancing enabled low default rates, and rating agencies continued to give mortgage-backed securities their blessings and high ratings. By the end of 2006, the value of all homes in the U.S. (excluding rentals) reached 153% of GDP, which approximated $21 trillion, and marked the highest proportion in at least 60 years. Before the end of 2007, home prices began to drop and the market value fell to 150% of GDP (Ip, Whitehouse & Luccetti, 2007). Between 2000 and 2006, home prices had exploded, increasing 60% over rent levels. But between mid-2006 and early 2008, prices had fallen by 10%. In March of 2008, experts were forecasting an additional downward price correction of 15-20%. Widespread defaults and foreclosures lead to an even more dangerous situation, where prices could fall even more substantially. Historically, homeowners facing default were reluctant to part with their homes, expecting that real estate prices would continue to rise. But in the market of falling home prices, reneging on the obligation became a rational decision in the minds of many debtors, causing a continued spiral of foreclosures (Feldstein, 2008). There are several factors that fostered the growth and imminent demise of the sub-prime mortgage market. For several years, home prices in the United States had consistently appreciated, which made mortgage lending and investing (of all types) very attractive and very profitable. Fueling the fervor, historical evidence gave market participants a false sense of security that home prices would not fall, but instead would "only moderate, in a soft-landing" (Deutsche, 2008, p. 24). This 'fail-proof market allowed originators, investors, buyers and lenders to get too comfortable. As confidence in sub-prime lending soared, credit standards loosened. Sub-prime borrowers were being offered loan features that were previously reserved for prime mortgage markets. This hysteria over what seemed to be a foolproof market led to irresponsible lending. Mortgages were being closed with loan-to-value (LTV) ratios of around 100%, and borrowers who previously did not qualify for a conventional loan were acquiring mortgages outside of their means. …