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Recap of talk given by Eisenberg and Wallison for M2M Homebuilders Association, January 10, 2013

CRISES, CLIFFHANGERS, AND CHANGES

By Cathy Markle

THE CRISIS

Members and guests of the Mountain to Mesa Homebuilders Association recently heard the best brief description of what actually happened to create the ‘financial crisis’ in America!

Peter Wallison, former General Counsel of the US Treasury Department, White House Counsel to President Reagan and author, and Dr. Elliot Eisenberg, a renowned Washington DC-based national economist, President of GraphsandLaughs, LLC  and former Senior Economist for the National Association of Home Builders gave a quick but informative run down on the causes of the crisis at a discussion on January 10th in El Jebel.

Mr. Wallison explained that the ‘bubble’ was caused by banks being encouraged to buy and sell mortgages, in order to stimulate the housing market and increase home-ownership in the U.S.  Then, in 2006, the Federal Reserve started to raise interest rates.  When interest rates rise, banks start to offer competitive, better terms for borrowers — longer payoffs, cheaper up-front costs, less down – because people can’t afford to pay the costs and rates of borrowing.  So, by design of government incentive, many people were able to buy homes and get mortgages who previously may not have been able to qualify.

However, about half of those mortgages were weak, sub-prime notes, on the books of Fannie Mae and Freddie Mac.  In 2007, at the top of the bubble, defaults and delinquencies drove housing prices down 30 – 40 percent.

Elliot Eisenberg went on to describe what housing is to Americans and what its place as a resource is in our economy.  What is housing?  “Sticks, and bricks, neighborhood, and land”, defined Mr. Eisenberg.  What makes a house more expensive?  “1) the value of the land, and 2) the value of the sticks and bricks.”  In most parts of our country, housing is a ‘non-scarce’ resource.  In other words, we can develop more land and build more housing, except in finite growth areas like Washington D.C., San Francisco, and Aspen.

Traditionally, the price of a home in a given area was about three times income (i.e., income of $100,000/year x 3 = housing prices of about $300,000).  At the peak of the bubble, housing prices across the nation averaged more like five times income.  So super-valuation, drove lots of folks to buy houses and flip them.  At first this raised prices but eventually a dearth of buyers and excess supply of houses drove down home prices, and borrowers began to owe more than their homes were worth, instead of the old scenario where primary housing was an investment.

So bank assets were devalued, personal net worth declined, debt grew on both the private and commercial sides, and in addition, much of that bad debt was government owned by Fannie Mae and Freddie Mac, meaning now debt of the citizens.

THE CHANGE

Mr. Wallison and Mr. Eisenberg went on to discuss the new Dodd-Frank Act which came into effect just prior to our event.  In a nutshell, both agreed that the Act creates a risk shift in lending.  Whereas previously, if a borrower defaulted on a loan he was responsible for the debt and a lender had recourse of foreclosure, under the new Act, the lender is actually now responsible if a borrower can’t pay, and the borrower has a defense to foreclosure for reasons like ‘the job market’ or current income.

Eisenberg and Wallison believe that the net result of this situation is that the debt will be passed off to private investors (in the case of banks) or to the taxpaying public (in the case of Fannie Mae, Freddie Mac, or FHA).  Not only will investors be leery of lending, but also the risk of the government guaranteed loans will be passed on to citizens whose taxes fund Fannie, Freddie, and FHA.

THE CLIFFHANGER

Peter Wallison says that in June of 2012, debt was predicted to stay the same if the Bush tax cuts were to end.  But, both he and Elliot believe that the result of recent laws making the Bush-era tax cuts permanent (making the tax rates on ‘middle’ class Americans fixed) is that the only way of reducing debt now is to ‘starve the beast’.

So this will help explain why Republicans and Democrats are at each other’s throats, failing to agree on anything.  Now, because debt is so severe and money is so tight, there is bitter competition between the factions as they are now fighting over the little money that remains.

Eisenberg explains that if the current deficit is $1 trillion, it can be financed with several tools: a) the 100 billion in increase by reinstituting the Social Security tax in full, b) and about 400 billion in ongoing sustainable debt, leaving about 500 billion.  In the immediate future, his analysis is that half of that will be generated by basic growth, leaving about 250 billion in necessary spending cuts.  Our legislators MUST figure out what to cut in spending, however they (we) have resolved NOT to solve the problem.  Currently, government spending, according to both Wallison and Eisenberg is higher than ever and revenue is lower than ever.

Eisenberg and Wallison differ a bit on the approach to problem solving however.  Mr. Eisenberg believes that both cutting spending and raising taxes are a part of the solution.  Mr. Wallison agrees that cutting spending is crucial, but believes that raising taxes in addition will result in restriction of development and growth in business.  He states that keeping money in the private sector eventually brings more money to government over time by increasing business, employment and growth.

We heartily thank both Peter and Elliot for a fascinating look at these and other topics at the January event, and hope to continue hearing from them regularly.  If you missed it, be sure to come next time we host an event as they are relevant, engaging and stimulating!

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