GUEST OPINION: Banking and Real Estate in America
Donald Arace | March 2016
The Story of 100 Years of Boom and Bust
Editor’s Note: In recognition of the 100th anniversary of the Hudson Gateway Association of Realtors and its predecessor organizations, HGAR Affiliate Member and long-time contributing columnist Donald Arace takes a look back at the past 100 years in the mortgage lending business.
There used to be an amusing term used in the banking business for many years. The term was in the form of an acronym of sorts “The 3/6/3 rule,” which meant that banks typically paid depositors 3% interest on their money placed in the bank. The banks would charge 6% interest for loans provided to mortgagors, thereby earning a 3% profit and bankers would go golfing at 3 p.m.!
It is interesting to note that since 1916 things have changed dramatically and yet underlying causes of the “Boom and Bust” remain even after 100 years of maturation of the capital markets.
The subtitle of this article could be “Liquidity Drives Real Estate.” The truth about real estate in 2016 is that 95% of the time you cannot buy and sell real estate without mortgage financing. When banks have “liquidity” they can lend money for real estate investment. When banks don’t have liquidity there is inevitably an economic downturn, recession and or depression.
Prior to 1914 liquidity was very regionalized and fragmented. Lending was provided by regional banks that enjoyed large balance sheets or money provided by Wall Street investment houses and barons of industry at that time. Due to the boom and busts related to this paradigm and associated volatility in 1914, the Federal Reserve was born. It was primarily created to control and or dampen the volatility that witnessed the stock market and subsequent real estate crashes of 1873, 1893 and 1907. It was also intended to bring order to the United States money market system and provide a mechanism for controlling credit centrally. The founding of the Federal Reserve did not prevent what was to follow.
The Great Depression of 1929 was due to excessive stock speculation (too much liquidity) that resulted in an overly exuberant stock market with unrealistic stock prices relative to the return on investment. The Federal Reserve was tepid during the run-up of the overheated market and did not safeguard and regulate banks sufficiently. Inevitably the market reached peak prices and tumbled thereafter. One by one, investors pulled out of stock positions and families withdrew money from banks causing “a run on banks” as the U.S. experienced the effects of lack of liquidity once more.
The entrance of big government in the banking business occurred during the Great Depression in the 1930s. Two important associations were born—The Federal Housing Association (FHA) and National Mortgage Association (later known as FNMA.) These associations provided the much-needed liquidity to banks and borrowers that were missing during the depression and helped bring the banking system back to health.
Maturation in the finance marketplace followed over the next 60 years. In the 40s after World War II, the U.S. had a flourishing economy that expanded with bountiful liquidity to meet the demands of a growing economy. This environment was helped by both public and private sectors working together through cooperation, providing ample employment and sufficient liquidity into the 1950s and 1960s. Product enchantments in financing, such as revamped “Private Mortgage Insurance” allowing for lower down payments by more potential homeowners, followed and the advent of the “Adjustable Rate Mortgage” to combat high interest rate environments of the 70s and 80s were brought to market.
The capital markets (Wall Street) provided further liquidity in the 80s, 90s through the use of “Private Mortgage-Backed Securities” initially used for non-conforming loans such as Jumbo mortgages, as well as the acceptance of alternate forms of credit. These products provided a niche for otherwise acceptable credit profiles.
Unfortunately, the advent of these products and their success brought about newer dangerous products in the 2000s that ultimately proved to be false exuberance with the development of sub-prime loans. These products with multi layered risk combining low down payment, no income verification and poor credit would ultimately become toxic.
The exuberance created by sub-prime loans was unsustainable. Real estate speculation increased alarmingly, which once again led to over speculation and the mortgage melt down and financial crises of 2007-2008. Liquidity quickly disappeared. The financial markets froze overnight and the Federal Reserve Bank had to step in to provide stability to Wall Street and to the national banks.
We are now in the post Dodd-Frank world where mortgage financing for real estate requires serious review and reasoning. All commercial banks and investment banks must reserve for possible loan losses, and are subject to periodic stress tests to ensure their financial health. There is dampened secondary market and rigid compliance to originate and sell mortgages. Expectations of receiving easy money is a thing of the past for consumers, although there is a distinct thaw these past few years from the depths of 2008-2009.
In the last 100 years the U.S. Congress in its attempt to tame the economy and prevent Depressions created the Federal Reserve Bank, FHA, FNMA to name a few and took precautions to protect consumers through RESPA, TILA and Dodd Frank legislation, yet we are still left with an imperfect system called capitalism.
The balance between boom and bust in real estate relies on the delicate nature of liquidity. Too much liquidity (under-regulated) and the economy run the risk of over speculation, which leads to a recession and or depression. Not enough liquidity (over-regulated) and you have a tepid economy with low GDP growth where jobs and wages stagnate.
Where is the Sweet Spot?
The capital markets and banks have been trying to get this formula right for more than 100 years. I have two theories. Maybe we are still an immature financial market that requires more innovation (the good kind.) Or is it more likely that the inherent problem is human nature, otherwise known as “greed” that has not and does not seem to change with successive generations? We should learn from history, but unfortunately we do not.
I would be interested to see an historian’s article 100 years from now and whether the old adage still applies “The more things change the more they stay the same.”
Happy anniversary HGAR!