Even though each month brought more bad news about the housing market, economists couldn’t agree on how dangerous it was. Definitions of recession, bear market, and a stock market correction are well standardized. The same is not true for a housing market slump. The research did show that price declines of 10%-15% were enough to eliminate most homeowners’ equity. Without equity, defaulting homeowners had little incentive to pay off a house they could no longer sell. Economists didn’t think prices would fall that far. They also believed homeowners would take their homes off the market before selling at such a loss. They assumed homeowners would refinance. Mortgage rates were only half those in the 1980 recession. Economists thought that would be enough to allow mortgage holders to refinance, reducing foreclosures. They didn’t consider that banks wouldn’t refinance a mortgage that was upside down. Banks wouldn’t accept a house as collateral if it were lower in value than the loan. On February 28, Fed Chairman Ben Bernanke’s testified at the House Budget Committee. He reassured markets that the United States would continue to benefit from another year of its Goldilocks economy. On March 2, 2007, the Federal Reserve Bank of St. Louis President William Poole said that the Fed predicted the economy would grow 3% that year. Poole added that he saw no reason for the stock market to decline much beyond current levels. He said stock prices were not overvalued as they were before the 2000 decline. Did that mean everything was okay with the U.S. economy? Not necessarily. For one thing, the stock market reflects investors’ beliefs about the future value of corporate earnings. If investors think earnings will go up, they will pay more for a share of stock. A share of stock is a piece of that corporation. Corporate earnings depend on the overall U.S. economy. The stock market then is an indicator of investors’ beliefs about the state of the economy. Some experts say the stock market is a six-month leading indicator. The stock market also depends on investors’ beliefs about other investment alternatives, including foreign stock exchanges. In this case, the sudden 8.4% drop in China’s Shanghai index caused a global panic, as investors sought to cover their losses. A big cause of sudden market swings is the unknown effects of derivatives. These allow speculators to borrow money to buy and sell large amounts of stocks. Thanks to these speculators, markets can decline suddenly. For these reasons, sudden swings in the U.S. stock market can occur that is no reflection on the U.S. economy. In fact, the market upswing occurred despite several reports that indicated the U.S. economy was doing more poorly than expected. Since hedge funds use sophisticated derivatives, the impact of the downturn was magnified. Derivatives allowed hedge funds to borrow money to make investments. They did this to earn higher returns in a good market. When the market turned south, the derivatives then magnified their losses. In response, the Dow plummeted 2% on Tuesday, the second-largest drop in two years. The drop in stocks added to the subprime lenders’ miseries. Instead, the Fed was worried more about inflation. It ruled out a return to expansionary monetary policy anytime soon. Lower interest rates were needed to spur homeowners into buying homes. The housing slump was slowing the U.S. economy. In addition, Fannie Mae and Freddie Mac committed to helping subprime mortgage holders keep their homes. They launched new programs to help homeowners avoid default. Fannie Mae developed a new effort called “HomeStay." Freddie modified its program called “Home Possible.” It gave borrowers ways to get out from under adjustable-rate loans before interest rates reset at a higher level, making monthly payments unaffordable. These programs didn’t help homeowners who were already underwater, and by this time, that was most of them. Comparing the orders on a year-over-year basis told a different story. When compared to 2006, March durable goods orders declined by 2%. This decline was worse than February’s year-over-year decline of 0.4% and January’s increase of 2%. In fact, this softening trend in durable goods orders had been going on since last April. Why are durable goods orders so important? They represent the orders for big-ticket items. Companies will hold off making purchases if they aren’t confident in the economy. Even worse, fewer orders mean declining production. That leads to a drop in GDP growth. Economists should have paid more attention to this aspect of this critical leading indicator. The NAR also predicted the national median existing-home price would decline by 1.3% to $219,100 in 2007. It thought prices would recover by 1.7% in 2008. That was better than May’s forecast of a low of $213,400 in the first quarter of 2008. It was still down from a high of $226,800 in the second quarter of 2006. Banks had stopped lending to each other because they were afraid of being caught with bad subprime mortgages. The Federal Reserve believed lower rates would be enough to restore liquidity and confidence. Chip Somodevilla / Getty Images The London Interbank Offered Rate (LIBOR) rate usually is a few tenths of a point above the fed funds rate. By September 2007, it was almost a full point higher. The divergence of the historical LIBOR rate from the fed funds rate signaled the coming economic crisis. Kroszner observed that collateralized debt obligations and other derivatives were so complex that it was difficult for investors to determine what the real value should be. As a result, investors paid whatever the seller asked, based on his sterling reputation. When the subprime mortgage crisis hit, investors began to doubt the sellers. Trust declined, and panic ensued, spreading to banks. Kroszner predicted that the collateralized debt obligation (CDO) markets would never return to health. He saw that investors couldn’t ascertain the price of these complicated financial products. Everyone realized that these complicated derivatives, which even the experts had trouble understanding, could critically damage the country’s finances. In October, existing-home sales fell 1.2% to a rate of 4.97 million. The sales pace was the lowest since the National Association of Realtors began tracking in 1999. Home prices fell 5.1% from the prior year to $207,800. Housing inventory rose at1.9% to 4.45 million, a 10.8-month supply. The U.S. Treasury backed the superfund to ward off further economic decline. The goal was to give the banks enough time to figure out how to value these derivatives. Banks would be guaranteed by the federal government to take on more subprime debt. To keep liquidity in the financial markets, the Fed created an innovative new tool, the Term Auction Facility (TAF). It supplied short-term credit to banks with sub-prime mortgages. The Fed held its first two $20 billion auctions on December 11 and December 20. Since these auctions were loans, all money was paid back to the Fed. TAF didn’t cost taxpayers anything. If the banks had defaulted, taxpayers would have had to foot the bill as they did with the Savings and Loan Crisis. It would have signaled that the financial markets could no longer function. To prevent this, the Fed continued the auction program throughout March 8, 2010. TAF gave banks a chance to unwind their toxic debt gradually. It also gave some, like Citibank and Morgan Stanley, a chance to find additional funds. The Center for Responsible Lending estimated that foreclosures would increase by 1-2 million over the next two years. That’s because 450,000 subprime mortgages reset each quarter. Borrowers couldn’t refinance as they expected, due to lower home prices and tighter lending standards. The Center warned that these foreclosures would depress prices in their neighborhoods by a total of $202 billion, causing 40.6 million homes to lose an average of $5,000 each. Home sales fell 2.2% to 4.89 million units. Home prices fell 6% to $208,400. It was the third price drop in four months. The housing bust caused a stock market correction. Many warned that, if the housing bust continued into spring 2008, the correction could turn into a bear market, and the economy could suffer a recession.
