The Triangle

Issue date: 10/31/08 Section: Ed-Op

Media Credit: US Federal Reserve

Some years ago, my son was thinking of buying a house in the San Fernando Valley and asked my advice about getting an adjustable rate mortgage. I told him to stick to the old fixed rate. Happily, he did.

Recently, Alan Greenspan was asked about the adjustable rate mortgage - and sub-prime-driven housing bubble that has brought capitalism's house of cards crashing down all over the globe. Greenspan replied that he had never advocated ARMs, and had always bought his own houses (like John McCain, he didn't disclose how many he had) at fixed rates of interest.

Greenspan - whom you may recall as our high priest of finance - created the housing bubble by cutting interest rates to the bone as chairman of the Federal Reserve. This bubble was intended to replace the tech bubble (also created on Greenspan's watch) that collapsed in 2000 and popped us into a nasty recession. Housing prices, rising unsustainably for some time already, went through the roof. My son's house doubled in value in five years. Walking around his pleasantly upscale but by no means affluent neighborhood, I wondered who was forking out $800,000 to $1 million for ranch houses with little yard space, even in Southern California. Even without the benefit of a degree in economics, it occurred to me that very few people could afford such prices, or that banks could believe in the ability of such borrowers to meet their loan obligations.

It turns out that the banks didn't believe it. Instead, they were perfectly happy to repossess homes on default. In effect, buyers had been giving them a return on property the banks knew they'd have back in a few years at double or triple value. They could then sell to the next round of buyers, and make the same killing. In effect, all the buyers bought was the illusion of home ownership. They were merely renters of the bank's property. Why, after all, should the mortgage department sit for 30 years at a decreasing rate of interest on property it could turn over with enhanced equity in four or five?

As for the buyers (whom Henry Paulson is so determined to punish for their poor judgment), they were not entirely irrational in their calculations. On the same assumption the banks made - namely, that housing values would go up indefinitely - they could buy houses they knew they couldn't afford, and sell them at a profit before their ARMs made them unaffordable. Such rational buyers would view their purchases instrumentally, and their houses not as homes to live in, but as temporary assets to be exchanged. Of course, the risk was on the buyer - that he could sell before the hammer of foreclosure came down on him, and that he could turn a profit on his investment.

Continued...

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