Bubble: The Great Recession (2007-08) was the worst financial crisis since the Depression. Its roots predate the speculative dot-com bubble of 1995-2000 and lie in the birth of the World Wide Web in 1989.

The second half of the 1980s were the glory days of the Web, the time when everything was possible. In 1986 there were 2,000 networks online, growing to 30,000 by 1987. By 2019, the worldwide number exceeded 4 billion. Clearly, no responsible person in 1987 could have looked 30 years ahead and foreseen a 4 billion user base, but the public did witness the 15-fold increase from about 2,000 to a little less than 30,000 in a single year, and that was enough to attract attention.

If one invests $2,000 in an investment that grows to $2,200 in twelve months, well, the gain is 10%. It’s an entirely different game when one invests $2,000 in an asset class and a year later it’s worth $30,000. “Honey! At that rate in five years it’ll be over a billion dollars! We have to get into this! Maybe we can refi and pull some money out of our home!”  The issue was no longer making a discounted cash flow analysis and hoping for a reasonable return. The new goal was speculative gain. Honey’s husband had to get in as early as possible if he hoped to get out with as much as possible. 

And that came to mean, for a while, to invest whether or not the company was profitable. Since earnings were not considered, other methods of valuation were employed. One purchase metric was “eyeballs”, as in “Yeah, we know that company won’t be profitable for years, maybe never, but it’s got 2,000,000,000 eyeballs on it!”

The NASDAQ composite index, where many of these stocks were listed, began 1995 at a touch over 750. By March 2000 it was over 5,000. Then it collapsed 75%.

Crash: Many companies declared bankruptcy. Even if no bankruptcy was involved, sell-offs of internet companies drove their share prices further down. Even though some online and internet companies survived to eventually recover and even prosper, investor losses by 2002 were estimated at around $5 trillion. With a “T”.

Cyclical Economy: Think of the economy as a cruise ship. The thing that rocks the ship, sometimes dangerously, is the shifting collective weight of the passengers. If someone excitedly shouts about the porpoises cavorting off the left side of the ship, all the passengers run to the port side to take selfies. Their combined weight causes the ship to list left. Suddenly, the porpoises decide to play off the starboard side, someone announces the change and the passengers all race to the right side. And, of course, the ship now lists right. That describes the cyclical economy. We don’t always know why the public runs this way or that, but we do know that too much rocking and the ship will capsize. To prevent turning turtle, we expect the Fed to proactively do something that will prevent the economy possibly sinking. In other words we expect the Federal Reserve act as if it were the ship’s keel. 

While fiscal policy (i.e., tax and spend) is controlled by the government, monetary policy (interest rate) is the provenance of the Federal Reserve. The tool they use to moderate a cyclical economy is the adjustment of interest rates. When the passengers overweight one side, the Fed serves as the ship’s keel and rebalances rates.

Cyclical Rates : The Fed tends to respond to the threat of inflation with raised interest rates, and the possibility of deflation with lowered rates. Raising rates makes credit more expensive, reduces purchases, and lowers asset values. Alternatively, in a depressed economy, rates might be reduced and the economy goosed a little.

The difference between a too-hot economy and one too-cold can be found by parsing employment figures. When wage gains exceed increases in production, the Fed might raise rates to reduce the threat of unwanted inflation. If current employment is historically low, interest rates might be reduced to incentivize people to buy things on credit. The more people buy, the more jobs are created and the more the economy strengthens.  A useful mnemonic is “employment low, rates drop, employment high, rates climb”. Rates track the direction of employment figures. (EMployment, not UNemployment.)

As an example, near the end of the Dot-Com bubble the economy became heated and rates started to go up. Eventually the 10-year Treasury rose to 6.5%. That worked, and the economy weakened. To compensate for a now weakening economy the Fed began lowering rates and by June, 2003, the 10-year Treasury note was at 3.3%.

The steep downtrend was in response to the weakened economy following the Dot-Com denouement. The reduction to 3.3% was an attempt to accelerate the economy’s recovery. And it did that so well it enabled the Great Recession.

The Market Adjusts: The market adjusted to the sequential lowering of interest rates in multiple accommodative ways. With lower interest rates, housing prices shot up early on. As rates continued dropping, housing continued climbing. As an example, a $1,000 monthly principal and interest payment will support a 100% LTV mortgage of $124,000 at 9% interest (6.5% index plus 2.5% margin). But look what happens at a 4% interest rate: as interest dropped to 4% (1.5% index plus the same 2.5% margin), that $1,000 monthly payment would now fund a 100% LTV mortgage of $209,000.

That means that the person who bought the $124,000 home could sell it for a 68% gross profit . . . and the only change was the slide in rates. That kind of profit felt good, and most speculators sold out and went looking to do it again. But in a very real sense all it meant was that when they speculated on their next $124,000 house, they would have to pay $209,000 for it. It wasn’t only their $124,000 house that shot to$209,000, it was all $124,000 houses. 

Note to self: a rising tide lifts all boats. 

By the middle part of the bubble, when the rabbit was part way through the snake, it became more difficult to find promising speculative properties at a favorable price. A bunch more “investors” (many of them novice) had entered the market, forcing prices up. Existing owner(s) saw what the market was doing and demanded their share of the buyer’s potential profits. This was accomplished by raising the sales price. It was not uncommon to find properties that would normally appraise for (example) $400,000 receiving multiple offers and selling for way over the appraised value. 

Eventually, however, the pool of qualified borrowers began to dry up. Again, the market compensated.

Lenders, many of whom had grown accustomed to the bonuses enabled by the lavish fees generated by massive numbers of new loan applications, refreshed the buyer pool by lowering borrower acceptance standards. The revised approach was through non-qualifying loans. They were called such because the borrower was not required to personally financially qualify. With these new loans the borrower was not required to prove any income at all. The borrower just announced what their income was and the lender agreed in advance to accept their assertion. The conversation might go something like this:

 

Borrower: “How much do I have to make to get this loan?”

Lender: “$340,000 a year. You make that?”

Borrower: Of course, I do!”

Lender: “Thought you said you did pedicures?”

Borrower: “I’ve got two chairs!”

 

Prices of homes being flipped, in the latter stages of the bubble, rose faster than interest rates were declining. Resale homes were being priced out of their market niche. Start with a $124,000 house, add purchaser closing costs / renovation expenses / maintenance / mortgage payments / taxes / insurance / seller closing costs / state and federal income taxes on gains and do that for three or four or five cycles and the house becomes heavily burdened.

Predictable Happened: At first slowly, then suddenly, the house could not be profitably sold. And speculators lost the ability to carry the house. If the speculators kept it they’d be negative. Rent it and (i) they’d still be negative and (ii) they’d have to spend several thousand dollars to restore it to marketability when the renters leave.

With the housing crash in process even the largest institutions were damaged, some critically so. Both Fannie Mae and Freddie Mac went into conservatorship in 2008. They haven’t yet found their way out.

The Great Recession: The thoughtful Manoj Singh has written on this. He noted that by summer, 2007, as a partial record of the period, already more than one Bear Stearns hedge fund had collapsed. BNP Paribas was warning investors that they might not be able to withdraw money from two of its funds. The British bank Northern Rock would plead for emergency funding (“Please, sir, more porridge?”) from the nation’s central bank, the Bank of England. The housing implosion was international.

Domestically, the financial crisis continued well into 2008, passing through the collapse of Lehman Brothers, the near-death experience of AIG, a series of corporate accounting scandals, and a massive Wall Street bailout. 

The full effect of the Great Recession was not immediately recognized. Banks would die but not be buried until the regulators could get around to them. As a point of reference, in 2008 there were 25 bank failures in the United States. A year later, by 2009, the worst of the Recession was over but in that year there were 140 bank failures. There were 157 dead banks in 2010; 92 in 2011, and 51 in 2012. It would be 2013 before the number of bank failures would return to the 2008 level.

More, later.

 

This article is for informational purposes only and is not intended as professional advice. Nothing in this article is presented as investment guidance. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, perhaps Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].