Cul-de-Sac Syndrome

This is an essay I wrote that appeared on several websites, mostly drawn from my “Cul-de-Sac Syndrome.”

By John F. Wasik

Even before the home bubble burst, homes cost too much for more than four out of 10 Americans. Only 56 percent of Americans could afford a modestly priced home in 2002, the first full year of the bubble. And as Americans went deeper into debt to finance their dream, they accumulated less and less of a tangible ownership stake. Home equity as a percentage of market value peaked in 1982 — at 70 percent — after a brutal recession. More than half of American homeowners with a mortgage would owe more than they owned at the end of 2008. About 7.5 million were spending more than half of their income on housing costs.

The craving for upward mobility through home ownership escalated even as families on the edge of “making it” were falling behind economically. The think tank Demos said that 23 million families became “economically insecure” from 2000 to 2006, while 4 million experienced economic decline. This erosion in prosperity was triggered by a 22 percent decline in financial assets (following the dot-com bust), loss of health benefits, and an overall rise in the cost of homeownership (up 9 percent during that period). The reaction to this backsliding — buying a home as an investment — was the equivalent of a couple on the verge of divorce deciding to have a child in hopes that it would save their marriage. For more than 3 million in or facing foreclosure in 2009, this thinking proved financially catastrophic.

The housing bust represents a profound loss of wealth since few households had significant savings outside of their homes, as values dropped to a median $200,000 in early 2009 from $221,900 at the height of the bubble in 2006. In California, always on the fault line between profound innovation and multiple disasters, the boom and bust was a tragic manic-depressive episode. The median home price in Southern California alone slid to $285,000 by the end of 2008, 44 percent below the peak of $505,000 in 2007. Although the decline allowed more people to afford homes, even during the bust only one-fifth of Los Angeles residents could afford the median-priced home — up from 2 percent during the boom.

The Bust’s Fallout

The housing bust created a firestorm of collateral damage.

* Lehman Brothers, one of the oldest and most venerable investment banks, was forced into bankruptcy and liquidation during a run on its assets in the late summer and fall of 2008. Its subprime mortgage and credit default swap holdings were essentially to blame, creating the largest business bankruptcy in U.S. history. Its demise released a tsunami of securities- and derivatives-related demons. Basically, when home prices collapsed, the value of the securities holding mortgages also went south. These “toxic assets” imperiled any institution that held them.
* When the run commenced on Lehman, it drove Merrill Lynch, the country’s largest brokerage house, into the arms of Bank of America, creating the world’s largest brokerage with more than $2.5 trillion in assets and 20,000 “financial advisers.” Merrill, whose symbol was an optimistic though ferocious black bull, had also invested billions in tainted subprime securities. Government regulators also forced the sale of Bear Stearns Companies, another major mortgage securities player, to JPMorgan Chase for a bargain-basement sale price of $10 a share (the initial price was $2 a share). Like Lehman, Bear effectively evaporated.
* The U.S. government seized Freddie Mac and Fannie Mae, the two largest mortgage issuers and guarantors, and promised to infuse the companies with cash to keep them afloat. Their liabilities vastly exceeded their assets and they were losing a total $50 billion in the third quarter of 2008 alone. Since they insured, loaned, or sold securities representing $5 trillion — about half of the U.S. mortgage market — they were deemed “too big to fail.”
* Caught in the opaque business of insuring mortgage securities through the shadowy and then-unregulated world of credit default insurance, the government effectively took over AIG, the world’s largest insurer. The Federal Reserve lent it more than $80 billion
by early 2009, part of a $150 billion bailout. It, too, was deemed too large to go bust, because its mortgage and derivatives positions threatened the global financial system.
* Seeking refuge in the regulated banking system, the remaining Wall Street investment banks morphed into old-fashioned, deposit-oriented banks. Goldman Sachs and Morgan Stanley applied to become regulated banking companies with federal oversight. American Express followed later in the year. The Age of Froth was truly over as the cowboy operations that thrived on 30-to-1 (and higher) leverage became history.
* The mother of all bailouts came as wintry storms arrived with an Old Testament vengeance in the autumn of 2008. With rancorous and reluctant Congressional approval, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke on October 1 ushered through a sketchy $700 billion bailout package called the Troubled Asset Relief Program (TARP), which would pump money into banks, possibly buy bad mortgages, and prop up the financial system for a short time. This massive cash transfusion was designed to prevent credit markets from shutting down and avert a global depression. Meanwhile, the Fed was lending some $2 trillion to banks, attempting to break a credit freeze that threatened to shut down all institutional lending. Paulson later backtracked on his earlier proposal to buy mortgages, triggering even more concerns that his master plan was ill conceived and ineptly managed. Sensing that the real purpose of all of the bailout measures was to stem the foreclosure crisis, the Federal Deposit Insurance Corporation announced its own mortgage bailout plan on the heels of the Paulson announcement. Several large banks said they would do voluntary loan modifications to reduce the cost of adjustable-rate loans, although they were under no legal obligation to do so.
* After more dithering over how TARP funds would be allocated, Secretary Paulson and Fed Chairman Bernanke moved to prop up Citigroup, one of the largest global lenders, with a $20 billion cash infusion and guarantee of more than $300 billion of its loans. Within days, responding to criticism that banks were the exclusive benefactors of the government’s bailout, the Fed moved to guarantee certain mortgage, credit-card, and student-loan securities.

John F. Wasik, author of The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream, is a personal finance columnist for Bloomberg News and the author of several books. His most recent book, The Merchant of Power, was praised by Studs Terkel and well reviewed by The New York Times. Wasik has won more than 15 awards for consumer journalism including the 2008 Lisagor and several from the National Press Club. He has appeared on such national media as NBC, NPR, and PBS. He lives in Chicago. For more information, visit www.johnwasik.com.

Copyright © 2009 John F.Wasik, author of The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream.