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					The Housing Crisis – What
Happened and What Should
Happen Next


Ray Wu
Disclaimer
 I am not a “classically trained economist”
  and everything I have learned is based on
  reading multiple sources and trying to
  reconcile principles with my own
  experiences.
 Feel free to disagree, but have reasoning
  behind your disagreement.
Primary Reference
   The main source that led me on this path
    was Peter Schiff. His video, “Peter Schiff
    was right” on youtube showed me that
    the collapse of the economy was
    foreseeable and not just a combination of
    circumstances as the “experts” would
    have you believe.
The Catalyst
 The late 80’s and first half of the 90’s had
  been relatively good times for the economy
  and people had some savings. As always,
  people were looking for the best return on
  their investments
 America had started to move away from
  being the manufacturing center of the world,
  but this could be corrected if people
  reinvested into manufacturing with their
  savings
Al Gore Invents the Internet!
 The internet begins to gain prominence as
  more and more people start using it
 People started to see the business
  potential of the internet and a lot of “e-
  business” ideas start to sprout up and a
  lot of businesses based on website sales
  start to appear
America Bets on Red!
 American investors start to see the
  internet businesses as a can’t lose
  proposition and start investing in these
  businesses without viewing their business
  models in the traditional way
 If the American economy was a roulette
  wheel, society on a whole “bets on red”
Self-Perpetuating Cycle Deludes the
Masses
   The NASDAQ, which listed the majority
    of the internet businesses, starts to
    increase and this started a cycle where
    the more it increased the more it spurred
    further investments which ended with the
    NASDAQ reaching 5,000
Reality Sets In
   Stock prices are typically based on an analysis of a
    companies finances (assets-liabilities,
    price/earnings ratio, etc.)
   For the internet businesses, these factors were
    essentially ignored as people knew it was a new
    arena and new rules had to be figured out
   People start to examine the finances of these
    businesses more carefully and realize that the
    finances could not possibly support the obscenely
    high stock prices
Self-Perpetuating Cycle in Reverse
 Now, people started to sell to get
  something out of their investment before
  people realized the unsound investments
 The price starts going down and people
  continue to sell to try to get a return and
  the same reason the stocks got so high
  now worked in reverse and drove the
  NASDAQ down below 2,000
Fallout from the Crash
   A lot of people lost a great deal of money
    as a result of the crash
    ◦ Compared to roulette, society bet on red and
      it came out black
    ◦ In a casino, if you put all your money on red
      and lost, you either leave the casino and try to
      regroup or you can go to the ATM and then
      chase after your losses
      Guess what America did?
              The Rise of China
 Not only did America bet on red and it came out
  black (which in of itself is bad enough)
 China bet on black!
 China invested in factories and production and
  have now essentially cornered the market on
  manufacturing products
 Don’t believe me? Walk around your house and
  flip over some of the products (appliances,
  computers, computer accessories, etc.,) you have
  bought in the last 10-15 years
 I’m guessing at least 75 % of the labels on these
  products say made in China
2000 Elections and September 11
 Unfortunately, the NASDAQ crashing was
  compounded with an exceptionally
  contested 2000 election and the tragedy
  of September 11
 With everyone being so uncertain as to
  what to do next, investment slowed
  dramatically and a recession started
  (which was actually the regrouping
  society needed)
Bush – Greenspan to the Rescue
 With Bush still being considered not
  necessarily the rightful president by some
  people, a horrible recession would have
  cemented the public perception that he
  was not the right leader
 So, Bush encourages people to go about
  their lives and continue spending as usual
 People have a tendency to resist spending when
  they realize that they do not have much in the
  bank
 Greenspan helps spur spending by lowering short
  term interest rates to near zero
 By lowering the interest rate, people got
  essentially no return by putting their money in
  the bank
 Simultaneously, people were encouraged to
  borrow someone else’s money and go back to the
  roulette wheel as the interest they had to pay on
  the borrowed money was near zero
A Quick Aside, The Federal Reserve
   What exactly does the Federal Reserve
    do?
    ◦ The reasoning behind the Federal Reserve
      was that the government could smooth out
      business cycles by raising and lowering
      interest rates to spur the circulation of
      money
    ◦ Great on paper, but does not work in practice
      (kind of like communism)
Inflation vs. Deflation
   Inflation – the money      Deflation – the
    supply increases            money supply
    while the supply of         decreases while the
    goods remains the           supply of goods
    same, thus making           remains the same,
    each dollar in              thus making each
    circulation worth           dollar in circulation
    less                        worth more
Fed’s Theoretical Role in Controlling
Inflation/Deflation
 Sometimes society               Sometimes society believes
  spends/invests capital           that no investments are
  rather than saving more          safe and starts putting a lot
  than a stable economy can        more money in the bank
  handle                          without money for
 the Fed can encourage            research the economy can
  people to start saving again     stagnate
  by increasing interest rates    the Fed can encourage
                                   more capital investment by
                                   lowering interest rates so
                                   that research and
                                   development can lead to a
                                   higher rate of return than
                                   putting the money in the
                                   bank
The Fed. does the Opposite
 After the NASDAQ crash, it certainly was
  not the case that people were putting too
  much in the bank and investment needed
  to be spurred
 Instead, people had spent too much on
  investments and an encouragement for
  society to start saving again was what was
  really needed (this should lead to higher
  interest rates)
Consumer Spending vs. Capital
Investment
 The US GDP is currently 70 % consumer spending. (This is
  not a good thing).
 Consumer spending consists of you spending money on a
  good produced somewhere else. Once the good has been
  “used up” the money spent on this is gone forever.
 Capital investment is investing in factories and other means
  for PRODUCING goods.
 While any economy is going to have some consumer
  spending as people need to buy some goods for day to day
  purposes. However, if the MAJORITY of your spending is
  consumer spending you are essentially trading long term
  prosperity for short term cheap products. (An economy
  cannot be based solely on spending and no production.)
Doubling Down on the Problem
 By lowering the interest rate, people saw
  less of a downside in gambling with other
  people’s money (borrowing money at the
  casino with your credit card to go back to
  the roulette wheel because the interest
  rate on your card was low)
 Where did these new investments go?
Housing – Another “Can’t Lose
Proposition”
 Historically, housing tends to go up at the
  pace of inflation as there is less and less
  space for housing and a growing population
 However, this occurs because people are
  only buying houses as a place to live rent
  free when they eventually pay off their
  mortgage
 When people start buying houses as
  investment properties rather than as a place
  to live, the rules are changed entirely
The Traditional Mortgage
 In the past, banks had a careful screening
  process to determine who they would lend
  money to for a mortgage
 Some of the traditional mortgage terms
  were:
    ◦ 30-year fixed rate of interest
    ◦ 20-25 % down payment
    ◦ Monthly mortgage payment could only be a
      certain percentage of your monthly income
Why the Rules?
 Bank’s kept the mortgage on their books for
  30 years!
 The Bank’s therefore had a huge interest in
  finding people that were most likely to pay
  the money back.
 30 year fixed loans gave people a guaranteed
  amount of payment per month to determine
  if they could afford it. Banks also could look
  at your income to see if it is was reasonable
  that you could make your house payment
  and still afford to eat, save for college, etc.
The Down Payment
   The down payment was a crucial part of the
    mortgage terms.
    ◦ 1) If you eventually defaulted, the bank would have
      still gotten at least $20,000 on a $100,00 house which
      would cut their losses
    ◦ 2) Being able to save up a down payment says
      something about your spending habits and your fiscal
      responsibility.
    ◦ 3) If you put down $20,000 and then let the bank
      foreclose, you lose this $20,000! This gives you an
      incentive to cut down in other areas if you lose your
      job so that you can still make your mortgage payment
      and not lose the $20,000
A “New Era”
 Banks essentially threw these rules out the window in the
  early 2000’s
 Adjustable rate mortgages (ARM’s) these were rates that
  reset at certain times based on the short term interest rates
    ◦ These types of mortgages usually started off with a “teaser rate”
      (an artificially low amount to coax people into buying the home
      – these rates were even lower than the short term interest
      rates)
    ◦ With short term interest rates close to zero, this encouraged
      people who really had no business owning a home to take
      chances on a mortgage
    ◦ With variable interest rates, it is actually mathematically possible
      to owe more as time goes on (this requires rates to be set much
      higher, which is very possible in the current climate)
The “Stated Income”
   Banks also stopped asking for proof (such
    as a tax return) for how much money you
    made
    ◦ People were allowed to just state their
      income with no proof
    ◦ Clearly, this already shows that banks were
      taking bad chances
Last But Not Least, The Down
Payment
   The final straw in enticing people into
    mortgages that really couldn’t afford
    them?
    ◦ Banks stopped requiring a down payment!
    ◦ So, now if people were to have their homes
      foreclosed on, they didn’t lose anything other
      than the rents they had paid
What Did It All Mean?
 Essentially, it became easier to buy a house
  than to rent!
 So, the goal of increasing home ownership
  was certainly attained
 While, in an abstract sense, this goal is
  laudable, it has to be put into context
    ◦ There are costs associated with owning a home
      Some people do not have the means to pay these costs
      This is a fact of the real world and all the “community
       organizing” in the world won’t change this
Why Did Banks Take These
Chances?
   In a sound lending environment, banks
    have to be careful about who they loan to
    if they want to stay in business
    ◦ Why did so many banks take these crazy
      chances at the same time?
      You guessed it, government intrusion into the free
       market economy!
Enter the GSE’s!
 Government sponsored entities (GSE’s)
  such as Fannie Mae and Freddie Mac
  distort the market
 Fannie Mae has existed since 1938 and
  Freddie Mac since 1970
    ◦ While these organizations had existed for
      such a long time with an “implied government
      guaranty” it was only in the 2000’s that they
      caused the problems for several reasons
Creating the Secondary Market
 With the exceptionally low interest rates of the federal
  reserve, the banks could borrow a great deal of money at
  nearly no cost and relend it in the form of mortgages
 Banks then started lending to low income families and could
  afford to give them a very low interest rate (it is easy to
  make a profit if you borrow at 0.5 % and relending it at, say, 2
  %) at these margins, volume is how you make the really huge
  profits
 Also, banks were working under the assumption that if the
  low income families defaulted, the government would pay the
  mortgage for them
    ◦ This resulted in a no pain all gain situation for lending to
      unqualified borrowers
Collaterized Mortgage Obligations
(CMO)
 Of course, Wall Street wasn’t going to
  turn down a new source of revenue in the
  home mortgage market
 So, companies sprang up where their
  entire business was buying up mortgages
  from the banks and letting people invest
  in these companies where the revenue
  streams were based on the monthly
  mortgage payments
CMO’s Ct’d
 Based on the previous description, it is
  pretty obvious that these are very
  complicated financial instruments for the
  average investor
 As it turns out, it was too complicated for
  the credit rating agencies as they rated
  these instruments as extremely safe
  investments which drew in investors who
  typically found stocks to risky
House of Cards
 It is obvious that no one was particularly concerned with the
  credit worthiness of lenders as everyone wanted their piece
  of the pie and someone else would have to pay for it if things
  went bad (each time the mortgage gets resold is another
  floor in a stack of cards)
 Once one of the legs gets knocked out, the whole house
  comes down
    ◦ Why did a leg get knocked out? There were fewer new buyers
      for houses so the cycle stopped repeating itself.
    ◦ When the cycle stopped, the housing market could not employ
      as many people and with people losing their jobs, some people
      stopped making their mortgage payments
    ◦ Just like the NASDAQ, the same cycle that raised housing prices
      so high now worked in reverse in lowering housing prices
The Deflation Fallacy
 Now that housing prices have lost 40 -50 %
  in the really bad markets, people call this
  “deflation” and that the government has to
  “do something” to get the prices back up
 The problem is, these higher prices were
  artificial and were bid up because of the
  housing bubble
    ◦ Therefore, the lower prices are the market trying
      to correct itself into a more realistic value of
      housing
The Deflation Fallacy Ct’d
   Don’t believe me?
    ◦ Think about your personal shopping expenses – has
      anything else gotten cheaper along with housing?
    ◦ I remember when I was in high school, the McDonald’s
      Extra Value Meals were all $4.99. Are those prices still
      there?
    ◦ The only area where prices are consistently going down is
      the electronics industry. This is due to the rapid
      technological advances that despite inflation things are still
      getting cheaper.
    ◦ Also, Americans have a negative savings rate. So it is not
      possible that the money supply is decreasing in relation to
      the supply of goods.
       Believing that “a little inflation” will solve everything is a quick
        way to entirely destroy the value of the dollar
“Stimulus” and Your Savings
 As the government is already in huge
  debt, any “stimulus” is funded by either
  printing money or borrowing it from
  foreign countries
 Either situation has dire consequences for
  the value of your nest egg
Printing Money
   Fed Chairman Ben Bernanke earned the
    nickname “Helicopter Ben”
     for stating that he would be willing to fly
    in a helicopter and drop money to people
    if the US Dollar loses too much value
    As stated before, printing money
    increases the money supply relative to the
    same supply of goods
Printing Money Ct’d
   So, the printing money strategy essentially
    results in creating enough inflation that a
    house that is valued at $200,000 now goes
    back up to $400,000
    ◦ Great, everything is solved and back to normal,
      right?
      Not even close, by doing this, your average meal at
       McDonald’s will cost $ 15 - $ 20
      So, now rather than the people who took on the
       mortgage paying the penalty, everyone with dollars has
       to pay the price with reduced purchasing power
Why No Inflation Yet?
 So far, the government is relying more on
  the borrowing money from foreign
  countries option
 Why is this bad?
 Foreign countries are buying bonds that
  mature in 1 year and the US owes both
  China and Japan about $1 trillion each
  (the US owes a lot of other countries
  money as well, but these are the two main
  ones)
What China Could Do
   With China’s debt maturing every year,
    the government has to pay more interest
    if China renews the bonds for the
    following year
    ◦ If China were to say, we don’t want to renew
      these bonds anymore, just send us the trillion
      over in dollars, what happens then?
      The government doesn’t have it so it will have to
       just print it – taking us back to the inflation
       dilemma
Manufacturing Is So Passe!
 I’ve heard that America is now “too hip” and
  “new school” to go back to a manufacturing
  industry
 Despite the new “Obama – we are the
  world” foreign relations policy, China still
  exports to the US with the expectation of
  importing something in the future
 Unless the US starts shrinking the trade
  deficit to foreign countries (ideally, a trade
  surplus would start to shrink the US federal
  debt)
Not Convinced About
Manufacturing?
   Think of this scenario. Assume that everyone over 25 in the world
    catches some disease and dies (this is purely hypothetical).
   Now China and other countries that the US imports from have all
    the manufacturing capacity in the form of factories and equipment.
   Which jobs do you think will come back first?
    ◦ The manufacturing jobs in the plants or the paper shufflers on Wall
      Street?
    ◦ While there is nothing inherently wrong with the “service jobs”, there
      needs to be manufacturing in the foundation to support the service
      jobs.
    ◦ Put another way, the world could still survive if there were no stock
      brokers but there was manufacturing (goods may not be produced and
      transferred the most efficient way without higher lever management –
      but they would still be made)
    ◦ The world could not survive if there were only stock brokers and no
      manufacturing.
This Isn’t The 30’s!
   Indeed, the American economy is       Now
    very different than in the 30’s       -The US is the world’s
   30’s                                  largest debtor nation
   The US was the world’s largest        (actually to give proper
    creditor nation
                                          credit, largest debtor in
   US made the majority of the
    world’s goods                         the history of the
   The US was on the gold standard       world)
                                          -US imports most of its
                                          manufactured products
                                          - The US dollar is backed
   So, yes, this isn’t the 1930’s. The   by nothing than the
    underlying economy is actually        government’s promise not
    much, much …                          to print too much
WORSE!
The Implications
 If all this has terrified you about the state
  of the economy, it should!
 There is no way the government can
  solve the structural problems of the US
  economy
 Does that mean that America should just
  roll over and give up?
The Solution
 No! The best thing the government could do is
  to dramatically slash its spending (to lower its
  burden on the taxpayers) and lower regulations
  to tempt more businesses and countries to invest
  capital in America again
 The consumers can help by saving more capital
  which will allow entrepreneurs to come up with
  new innovations to increase productivity
 If the government and consumers just try to
  spend their way out of debt, the US could be
  knocked out for the count
Hope for the Future
   There is a saying, “Rome wasn’t built in a
    day.” This is to teach the lesson that
    perseverance and hard work are required
    to build a strong nation.
The US Can Recover
   This saying is especially true for the US
    right now. There are some hard times
    ahead, but the US can meet the challenge
    if people (and politicians) are willing to
    make some sacrifices in the short term
    for prosperity in the long term. If people
    keep asking for, and government keeps
    trying to give, people a quick fix, I have my
    own saying. “Rome wasn’t built in a day
    …
BUT IT DIDN’T FALL IN A DAY
EITHER!”
The Elephant In The Room
 Throughout the presentation, I have said that China’s
  economy is in a good position in relation to the US.
 Being an Asian American, some might accuse me of pro-
  China propaganda
    ◦ Well, I was born in the Taiwan which has been in a decades long
      dispute with China as to whether it is a part of China or not
    ◦ At any given time, China has hundreds of missiles pointed at
      Taiwan
    ◦ I still have several relatives who live in Taiwan and some younger
      cousins who will have to serve in the military in the future
    ◦ So, believe me, I really have to grit my teeth to say anything
      positive about China
    ◦ However, you have to give the devil his due
Questions?

				
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