The U.S. mortgage market is the financial market most closely linked to the lives of American working families. For many Americans, their home is their most valuable asset and an important source of financial security for their retirement. Yet for a growing number of working families, the American Dream of homeownership has become a nightmare.
American workers are being hit by a double-whammy as they lose not only their homes, but also their retirement savings, as pension funds bear the brunt of overwhelming losses faced by financial institutions. The International Monetary Fund estimates that the financial turmoil triggered by the collapse of the mortgage market could total nearly $1 trillion.
The mortgage crisis can be blamed on the combination of artificially low interest rates and a lack of regulation of the mortgage industry. For years, policymakers aimed to keep interest rates artificially low to prop up the economy through consumer borrowing instead of crafting economic policies that would lead to higher wages. As a result, consumer spending now accounts for nearly 70 percent of the U.S. economy, up from slightly more than 60 percent in the early 1980s.
Because of stagnant wages and the resulting increase in income inequality, the share of the nation’s income flowing to the top 1 percent rose to 22.9 in 2006 from 16.9 percent in 2002, a level not seen since 1928, at the peak of the stock market bubble. Corporate chief executives are among those at the very top. CEOs of large U.S. companies averaged $10.8 million in total compensation in 2006, more than 364 times the pay of the average U.S. worker, according to the latest survey by the United for a Fair Economy.
So long as the Federal Reserve Board complied with keeping interest rates low, the American Dream of owning a house seemed within reach of millions of low-income workers. Stagnant wages and rising housing prices left homeowners with no choice but to treat their houses as piggy banks, using the loans to pay for household bills.
The housing bubble was stoked by the lack of regulation of the mortgage industry, which enabled brokers and lenders to exploit the weakest sections of society—low-income workers, minorities and immigrants—with misleading mortgages they couldn’t afford or with low down payments and artificially low, teaser interest rates on their mortgages that reset after a brief period of time.
The result was millions of subprime mortgages, those with low or no down payments, and adjustable interest rates, built around the fairy tale that housing prices would keep rising. As a result, these subprime mortgages accounted for 20 percent of all new mortgages in 2006, up from 5 percent in 2001.
With real estate prices dropping, foreclosures are on the rise and many homeowners find that they owe more on their mortgage than what their home is worth. In many states, falling real estate prices also have affected renters who face eviction if their landlords can’t pay their mortgages. For the first time, Federal Reserve Board Chairman Ben Bernanke acknowledged that the U.S. economy could be slipping into a recession.
The mortgage crisis also is hurting the retirement savings of working families. In the first three months of 2008, the benchmark Standard & Poor's (S&P's) 500 index fell 10 percent as events unfolded. Mutual funds, money market funds and pension funds face major losses from securitized mortgage bonds (many of which contain a “subprime” component) that were sold to them with AAA ratings from credit rating agencies as safe investments.
What Caused the Mortgage Credit Crisis
Since 2000, mortgage lenders have made more than $2.5 trillion in subprime loans. A large proportion of these mortgages was sold to those with credit scores high enough to qualify for conventional loans with far better terms. Instead, individuals often were pushed into subprime loans by unlicensed mortgage brokers motivated by the more favorable commissions and using deceptive tactics.
The absence of effective regulation of the mortgage market emboldened lenders to flood the market with exotic mortgages that were misleading and exploitative. For example, many home buyers were sold loans with artificially low interest, or “teaser,” rates or interest-only mortgages that then reset to significantly higher interest rates creating unaffordable payments. Others were given payment options that included paying less than the interest charged each month so that the loan balance actually increased over time.
Wall Street played an important role in exacerbating the real estate bubble. Investment banks repackaged their risky mortgages into securities known as collateralized debt obligations that, because they also contained some element of conventional mortgages, were characterized as safe investments by the various rating agencies. But this financial wizardry often resulted in a concentration of risk for speculation by hedge funds that bet on ever-increasing real estate prices. Investment banks, themselves, also got hurt because they bet an increasing share of their own capital on mortgage-related investments.
Meanwhile, government regulators, including the Federal Reserve and the U.S. Securities and Exchange Commission (SEC), failed to adequately police these practices. More than a dozen companies are now under investigation by the FBI for practices that were fueled by the crisis, such as accounting fraud and insider-trading.
The Bush administration’s response to the crisis has been to recommend overhauling the financial system not by beefing up regulation, but by proposing a plan favored by the U.S. Chamber of Commerce that would further .
How Runaway CEO Pay Helped Fuel the Crisis
Over the past several years, CEO pay has exploded at many of the companies responsible for creating the subprime mortgage crisis. Too often, their compensation programs encouraged corporate executives to maximize short-term financial gains at the expense of long-term sustainability. In effect, boards of directors rewarded their CEOs for generating financial results that were often based on taking on irresponsible levels of subprime mortgage risk.
For example, large stock option grants encouraged excessive risk-taking by CEOs to maximize their potential gains through short-term stock price increases. Stock options promise executives all the benefit of share price increases with none of the downside risk. In the worst case scenario, the stock options will expire worthless. In effect, stock options allow executives to gamble with their shareholders’ money at no risk to themselves.
Too many CEOs have their incentive compensation tied to performance measures that rewarded financial results without regard to the risk involved in generating those results. At some companies, focusing on revenue growth encouraged CEOs to expand into the subprime lending business at the peak of the real estate market. Return on equity, another popular performance measure for CEO pay, encouraged executives to use increased leverage.
The pay packages of CEOs at mortgage lenders and investment banks also were sheltered from the inevitable decline in the real estate market because many of them were not required to hold their equity awards for the long term. This allowed CEOs to cash out before the bubble collapsed. Large golden parachutes further insulated CEOs from the financial risk of catastrophic results.
