How The American Dream Transformed To Nightmare

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How The American Dream Transformed To Nightmare

As the current recession plods along, and perhaps deepens, a recurring question haunts us: How could such upheaval in the financial markets have happened in the world’s strongest country?

Many maintain it was greed—executive greed, banker greed, Wall Street greed. Others cite deregulation and a lack of enforcement by regulatory agencies. Perhaps we, the little guys, are also to blame. Our personal financial literacy is often limited, and our financial decisions may not be responsible. All of these have played a role. However, the most critical factor is likely the Federal Reserve’s monetary policy and the government’s encouragement of home ownership.

Economists now see that problems in the financial sector were aggravated by the Fed’s consistent lowering of interest rates. When many former Soviet bloc economies joined the world economy in the 1990’s and China and India’s economies expanded, world production increased dramatically. This increase in the supply of goods reduced the threat of inflation and allowed central banks around the world to lower interest rates without the normal concern about inflation. Starting in 2001, the Fed steadily lowered interest rates from 6.5 to 1.75 percent in less than 12 months. While the rate decreases were not inflationary, they made borrowed money cheap and people responded as expected: they borrowed and borrowed and bought and bought.

The government added fuel to the fire by promoting home ownership. It encouraged Fannie Mae, and later Freddie Mac (private organizations sponsored by the government), to make more loans, and reduced its reserve requirement to 2.5 percent. That meant that they could make $97.50 in mortgage loans for every $2.50 it had in equity to cover possible bad debts. HUD even approved the granting of mortgages without down payments. As a result, home ownership rates increased from the typical 35-year rate of 64 percent to 69 percent; most of the increase in ownership was financed through subprime loans. In 2001 subprime loans totaled $330 billion, and increased to $1.1 trillion in 2004, representing 37 percent of residential mortgages. By 2006, subprime loans were almost half of all mortgages.

A decade of lowering interest rates coupled with the government’s policy of granting easy home ownership with little verification of buyer’s income or credit spawned a nightmare. By 2004 debt had skyrocketed. The average ratio of home prices to income went from 3:1 to 4:1. The Fed, faced with threats of inflation, began increasing interest rates; they climbed to 5.25 percent by 2006. As one would expect, the demand for houses and other durable goods decreased and prices followed the same path. The value of many of the assets supporting the trillions of dollars of mortgage loans was less than the face value of the loans. Freddie Mac, Fannie Mae, banks and other financial institutions were in big trouble.

The analysis of the complex causes of this meltdown has just begun. It may take several decades to pinpoint the real culprits. In the meantime, the current nightmare continues as the economy seeks to find balance and normalcy again.

George Vredeveld, Director of the Economics Center for Education & Research and the Alpaugh Professor of Economics at the University of Cincinnati’s College of Business.