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The mortgage crisis is really a savings crisis


This article first appeared in the St. Louis Beacon: July 8, 2008 - While it can be argued that all levels of the lending industry played some part in the sub-prime mortgage collapse, economist William Emmons of the Federal Reserve Bank of St. Louis adds another factor: household financial behavior.

Emmons believes thesub-prime mortgage meltdown was a long time coming and is linked to the downward trend in both U.S. personal and national saving.

"I think it goes back 20 years, and this is the manifestation,'' Emmons said. "To me, the big story is we have a national savings crisis, and this goes back to at least the 1980s.''

In 2005, the U.S.personal savings rate hit zero and kept heading south -- to a negative 0.4 percent, according to the U.S. Commerce Department. It's called negative spending, a polite word for debt. 

"Saving is defined as 'not spending': income after taxes not spent. And we've now gotten downto the zero or negative rate. How do people do that? By borrowing.That's how the growth of spending has been much faster than income,''Emmons said.

How can consumers cope?

Online, consumers share their struggle to reduce mountains of debt. Credit card debt helped set the stage for the mortgage crisis, psychologically and financially.

Put It on My Tab 

Why have Americans been borrowing so much?

Emmons, whose researcharea includes banking, financial markets and financial regulation, points to financial deregulation that increased access to credit in a big way in the 1980s. Lower nominal interest rates opened the door to more borrowers by effectively stretching out payments and shifting the burden of repayment further into the future. So, more people were able to qualify for loans.

At the same time, advances in technology simplified the lending process. The simplicity of credit scoring, for example, gave lenders more confidence in lending outside their markets and lending to more people, he said.

But access to credit is still only half the story, Emmons believes.

"The other thing that has been instrumental and pernicious was asset booms,'' he said. "When we think about asset booms we think first about the stock market boom, but that wasn't as widespread because not as many people have large stock portfolios. And more important, you can't borrow as much against stocks. But the housing price boom in this decade was widespread. Large dollars are involved, and it opened the door to borrowing.''

Emmons said that at the height of the boom, he talked to a cousin who lives in California about that state's skyrocketing housing prices.

"He said, 'It doesn't matter what you pay, as long as you can get the financing. It doesn't matter what the price is because it is going up. I'll always make a profit,' '' Emmons said. "So, in that sort of a market, price is sort of meaningless. The constraint is not the price but the credit access. You can not have a bubble without credit.''

And consumer credit seemed to be readily available everywhere.

"Everybody wanted to offer you financing,'' Emmons said. "Everybody wanted to finance you whether it was furniture or automobiles. You can even borrow against home improvements, like a new door.''

While Emmons acknowledges that credit is a good thing, the question became: Is this too much of a good thing?

"Economists would always say that more choice is better, but at the same time, do people understand their options? Do they understand how to make good financial decisions? Which loops back around to financial literacy,'' he said.

Risky business

Responsible borrowing can make it possible for people to buy homes, or fulfill important needs, such as health care or transportation to get to work. But things got out of hand when the mentality of got-to-have-it-now trumped saving-for-the future, analysts say.

"If it's medicine, that's a need. But if it's a durable good, a large purchase -- a house -- the timing is the question. Do you buy it today, tomorrow, or two years from now?" Emmons said.

"The sub-prime market has always existed on a small scale, but the modern sub-prime market is very different,'' he said. "One of the major effects of the sub-prime market was to accelerate home ownerships. It wasn't that certain people should never buy a house, but before this current market it was more difficult. You had to wait longer, build up a larger down payment."

In the end, it was all about risk, explains Yuliya Demyanyk, an economist and colleague of Emmons at the Federal Reserve Bank of St. Louis.

"It used to be that when a bank loaned you money, you owed the money to the bank. In the case of default, the bank would lose the money," she said.

As new loan products arrived on the market and access to credit improved, banks could diversify their risk. Sub-prime mortgages were sold and pooled.

"Any particular loss as long as there was no massive default, was not the bank's loss,"Demyanyk said. "On one hand, that's an overall improvement in the financial market because you could share the risk. It was a bad thing for you if you were to lose your home, but in the opinion of the bank it was no loss. So, they didn't need to be scrutinizing borrowers to the same extent, and there is a cost associated with screening borrowers.''

That lack of scrutiny proved costly in the long run, Emmons points out.

"The flaw on the investor side was they thought they could get this risk pooling without affecting the risk. But, in fact, the incentive for the loan originator had changed, and underwriting quality seemed to decline. So, this logic of spreading the risks still holds, but there was a lot more risk being put into this pool than the investors originally thought," he said."That's the big mistake made on the investors side -- Wall Street, the rating agencies, the ultimate investors were naive in thinking they did not change the nature of the risk by opening up this huge pool of capital to the mortgage markets."

With those investors out of the market, the result has been a credit crunch.

"That's the big question mark: Whether those big investors will come back," Emmons said.

The process to create mortgage pools was elaborate and complicated and won't just snap back, he said.

"Investors have to have confidence in every link in the chain. And each of those links has been discredited, whether it is mortgage brokers, appraisers, securitizers, rating agencies, bond insurers. All have been through the wringer," Emmons said.

It Was Like a Virus

Demyanyk says her research on sub-prime loans indicates that when housing prices stoppedrising, it didn't cause all the mortgages to become bad all of a sudden.

"Those mortgages were bad, even when the house prices were rising,'' she said. "But the mortgage had an escape: The house market is wonderful; you could always sell. The market was hot -- you could get away with a bad mortgage situation. The crisis was in the quality of the mortgages."

She believes the industry didn't see the collapse coming because it was masked by housing prices.

"It is like a virus feeding in your body during the incubation period. You do not see it. You do not know it's there. It is ready to show signs, but before it does, you would not go to the doctor and start checking on different things because you feel so well," Demyanyk said. "After the first sneeze, then you start getting it. What happened? You have a lot of sneezes in 2006, and boom we're in a crisis."

She also speculates that the bust was inevitable, given the mindset of the market.

"Knowing there will be a crisis won't necessarily spurn the crisis but could make it happen sooner," she said. "If you were told two years ago, when things were going great, that if everyone takes the equity out of their houses to buy boats there will be trouble two years from now. Would you not do it? You might say, 'I need to do it sooner, while I still can. I need to do it faster because I need that boat.' "

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