One of the lessons of the Great Depression is that free markets cannot be totally free, but rather they need to be regulated and supervised.  So when the government steps in to fix the economy or even steer it, it is not necessarily unjustifiable or a bad thing.  But government oversight is not perfect and certainly no panacea.  Although we have had relative stability in the eighty years since the Great Depression, it seems we have just dodged a bullet.  Our current experience questions our complacency in believing that our individual and personal economic future is protected by the government.  It is not.  The government only cares about the economy in the macro sense.  Our current experience is a warning, once again, about how much we should stick to the age old economic principles that we learned from our depression era grandparents.

1.  Borrow only when necessary, and only as much as you need.
2.  Borrow mostly to spend on appreciable assets
3.  Live within your means.
4.  Save for the future in case of an emergency.
5.  If it sounds too good to be true, then it probably is.

These are principles that need no explanation.   As you read this article keep them in mind and you will understand how following them could have given you wealth instead of despair.  Use them in your comments.

Interest Rates and Wealth

Let’s go back a few years.  Remember when interest rates hovered at around 8%?  Most of us don’t think about this consciously, but that figure is one of the most important figures to our economy and to each of us as individuals.  It determines our affordability, which in turn determines how we spend and how much we spend.  Here is an simple way of looking at it.

Say you determine that you can afford to pay a $1,500 per month mortgage.  At 8% APR (annual percentage rate), that $1,500 can afford a mortgage of around $200,000.   However, when that interest rate drops to 5%, that same $1,500 can now afford a $280,000 mortgage.  That’s almost a 40% increase in the price of the home you can afford, and the beautiful part of this is that you didn’t have to do a thing to make it happen.  You didn’t get a raise at work, you didn’t invent anything, you didn’t make a killing in the stock market, you did nothing, nada.  Taking it another step further, if the interest rates dropped again to, say, 3%, then you would be able to afford a $350,000 mortgage.  Wow!  That’s a whopping 74% increase in your purchasing power, which translates to an increase in your wealth.  

Prior to our recent economic debacle, that is exactly what happened.  The government manipulated interest rates to keep the economy pumping, and we the people took the bate.  Remember how fast real estate prices rose?  What do you think drove up those prices?  The low interest rates created a real estate frenzy, and folks of all types raced to jump into the market.  The demand for housing far outpaced the supply of homes, and soon something not seen in modern times began to happen.  Each home sale became a mini auction.  The asking price of a listed home was merely the starting bid, and no home was selling at or below the listed price as buyers regularly got into bidding wars.  They were selling well above their listed prices.  Indeed one such property listed across the street from my home for $359,000 and sold for $400,000 (now it is back on the market for $275,000).

Unintended Consequences

The dramatic drop in interest rates stimulated the real estate market by increasing the demand, but that was not all that was stimulated.  Banks and other lending institutions didn’t miss a beat.  They recognized, as it is their business to do so, the great potential that dropping interest rates presented to them.  With interest rates dropping to levels not seen in ages, practically every existing mortgage became a viable target for a refinancing deal, and the same crew found in the sale of a piece of real estate, with the exception of the real estate agent, stood to make a profit--mortgage brokers, title agencies, appraisers, surveyors, home inspectors, roof inspectors and termite inspectors.  The beauty of the whole thing was how easy it was to sell a refinancing package under those conditions.  

Let’s go back to our numbers.  If you were paying a $200,000 mortgage with payments of $1,500 per month, at 8%, over 30 years, and the interest rates dropped just 2 points to 6%, then your payments dropped to just under $1,100.  That left you with $400 more per month for spending.  And when the interest rates drop again, it would make sense to refinance all over again.  Under the same conditions, if the interest rates dropped again to 4%, then that same mortgage payment would drop down to $975 .  That would be another $200 per month savings.  Under either of these scenarios the borrower could recover the cost of closing on the new loan with the first year’s savings.  You would have been crazy not to take advantage of the refinancing packages being offered at the time.

The problem with the refinancing market was not that there were too many people refinancing because in and of itself, refinancing is more often than not a good thing.  Rather the problem came when the borrower went to the bank to refinance a $100,000 loan and left with a $200,000 loan he couldn’t afford.  Banks and other lenders were all too willing to allow borrowers to borrow their full equity including up to the artificially inflated values caused by the buying frenzy.

What should have been a spectacular reduction in debt payments of the average household, turned into an unprecedented increase in household debt.  Worse yet, as I explain next, underwriting standards had been lowered so much that we turned financially sound 8% loans into risky and unsustainable 4% loans with double or more the principle owed.

Underwriting Standards

The combination of decreasing interest rates and rapidly rising home values created yet another, and even worse, phenomenon--the elimination of creditworthiness as a standard for getting a mortgage loan.  Who cared if the borrower was creditworthy or not.  The mortgage would be backed by a piece of real estate that was surely going to be worth more by the time the ink dried on the closing documents.  

Opportunity, and the exploitation of opportunities is one of the cornerstones of capitalism, and where there is money to be made, entrepreneurs race to serve an under served market or to expand the market to its full potential.   It seemed that the size of the lending market was not big enough to satisfy eager bankers hungry to originate as many loans as possible.  And there was a problem--too many potential borrowers could not qualify for new mortgage loans, specially at the new price levels.   Steadily dropping interest rates created a huge market.  Lenders and their mortgage brokers were hungry for more and more loan origination.  So in came a new kind of lending also known as sub-prime mortgages:

1.  No income verification loans, which is a nice way of saying, lie about your income loan.
2.  Loans with teaser rates, which offered you an extremely low starting interest rate that would go up over time, but you were qualified not at the highest potential interest rate, but at the teaser rate.
3.  Interest only loans where the borrower only paid the interest.
4  Zero down-payment loans also known as 80/20 loans where you got an 80% first mortgage and a 20% second mortgage.

These are just a few.  Anything that could be done to get anyone that had a heartbeat and was breathing into a mortgage loan was being done.  Don’t believe me?  Take a look at the foreclosure rates.   

The Overall Economy Reacts

Okay, perhaps now you are wondering how all of this affected the overall economy.  Well, lets break it down.  The lower interest rates increased the purchasing power of the average home buyer, which brought millions of buyers into the market.  Buyers not only did not need cash to purchase the homes, but in many cases also walked away with cash in the thousands.  That money was readily pumped back into the market through purchases of cars, boats, vacations, home improvements and yes, even into another purchase of real estate.  

On the sellers‘ side, they more often than not walked away with hundreds of thousands of dollars in cash as they realized their newly inflated equity, and when they went to upgrade to another home, they soon learned that they didn’t need much of that cash to make that purchase since the down-payment requirements were practically none.  What did they do with their cash, well as you might have guessed--cars, boats, vacations, home improvements, etc.  Everybody was rich, and the economy churned at an ever increasing rate.  It seemed endless.

What no one was realizing was that it was all fake, artificially created by monetary policy .  Everyone had collectively won the lottery except for one important difference.  When you win the lottery, you don’t have to pay it back.  All of the wealth created during the boom was borrowed money.  We all know what happened next.

The government is now trying to fix it, and this article is not about criticizing whatever efforts are underway.  Rather is my intent to get people to understand how important to them it is to know how government policy can affect them in ways they did not imagine.  There is a sense of detachment that most of us feel when we hear news about government policy and the economy as if it didn’t apply to us.  Think again.

There are an estimated 15 million homeowners upside down on their mortgages (i.e., the owe more than their home is worth).  Millions of others have lost most of their retirement money that was invested in the stock market like one poor soul I know that worked for Merrill Lynch for 42 years and had most, if not all, of his retirement in Merrill Lynch stock.  The stock lost almost all of its value, and the only thing he got out of it was a pink slip.  There are millions of others unemployed, changing careers, scrambling to make ends meet.  The government owes trillions of dollars, and we have nothing to show for it except cutbacks and plenty of political posturing.  

I did get a couple of things out all of this.  I know it will sound a little cynical, but I truly do not believe that any politician (from either party) has your interest in mind.  It is all about what is politically expedient.  Your plight is only important if you fall into the class being assisted.  Homeowners who got into ridiculous loan arrangements, misspent their proceeds, are now getting out of their loans through short sales and other remedies.  But the poor guy who lost his job and his retirement despite all of his right decisions, he gets nothing.

The other thing I got out of all this is that I don’t believe any experts exist.  Every time I hear one of those talking heads talking about the economy and what needs to be to done, I can’t help but to ask the question:  Okay smart guy, where were you before everyone lost their money?  

I know I’ve oversimplified the matter.  I wanted to keep it simple.  I didn’t talk about mortgage derivatives and the idiots who insured them.  In a different era I think those two types would have been taken out to the town square and executed (just making a point not advocating that).  And to think that those companies involved in derivatives  were supposed to have been run by the best the brightest.  

Give me feedback whether you agree with the above or not.  Be my guest and add to it if you think I’ve missed an important point.