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9/11 legacy includes effect on housing boom and bust

In the months after the attacks of Sept. 11, the Federal Reserve took a series of steps to lower overnight interest rates in order to ensure the tenuous economy didn’t tip back into recession. The economy, still recovering from the dot-com bust and dealing with the psychological effects of the attacks, needed to be propped up in the form of easy money, according to Chairman Alan Greenspan and the rest of the Fed.

The Federal Reserve of New York funds rate in 2001 was 5.5 percent. After the attack, it was lowered to 1.75 percent. In 2002, it was 1 percent, where it stayed as of the middle of 2003.

Meanwhile, through the first half of the decade, mortgage rates mirrored the Fed funds rate. This, combined with easing of underwriting standards and other developments in the mortgage industry, allowed consumers to lower the monthly payments on their homes through refinances, encouraged new buyers to purchase more home than they could otherwise afford and influenced others to take out second mortgages or to tap the equity in their home for cash.

“The Fed’s slashing rates certainly contributed to the housing boom,” said Michael Lea, director of the Corky McMillin Center for Real Estate at San Diego State University. “Low borrowing costs, along with the dramatic easing of underwriting standards, were strong contributing factors.”

“It wasn’t the only factor, but it was a significant factor that allowed people to buy more house than they could have afforded,” said Bob Kevane, president of the San Diego Association of Realtors. "That, easing credit, liar loans, together did it.”

Changes in the mortgage industry that coincided with these historically low rates were not directly related to the Fed’s actions and had nothing to do with the events of Sept. 11. Both developments were necessary causes of the ensuing housing boom, but neither was sufficient, in and of itself. So-called “liar loans” surged during the period, as zealous mortgage brokers sold loans to buyers with little or no documentation of their income or savings that would justify them. Knowing they’d eventually sell the loans to private mortgage securitizers or pseudo-government entities Fannie Mae and Freddie Mac, the brokers had no incentive to guard against the risk of default, because the consequences wouldn’t be theirs.

Norm Miller, economist at the Burnham-Moores Center for Real Estate at the University of San Diego, said the actions of Fannie Mae and Freddie Mac were more to blame for the housing boom than the actions of the Fed to slash rates after 9/11.

“It definitely was the perfect storm of Fannie and Freddie jumping into the subprime mortgage market, private market providing low interest rate teaser loans, the private market providing second mortgages like crazy, and brokers who had no skin in the game and kept pressuring people to refinance and pull cash out of their houses like ATM machines,” he said.

Interest rates definitely influenced the process, he said, but the actions of the mortgage industry itself should shoulder most of the blame.

“I can’t blame everything on Fannie and Freddie,” he said. “Teaser rate loans were coming out of the private market, and those initial rates made people jump into it. I have to put blame on the ignorance of the general public to take on mortgages without understanding what they were getting into.”

Teaser rate loans enticed buyers who’d normally be unqualified to buy a particular home to do so under the promise of an extremely low rate for a short time. The assumption that real estate values could only appreciate convinced them they’d be able to sell the home at a profit before the rates readjusted. The Fed’s moves to lower rates were consistent with historical reactions to unexpected economic shocks.

“I can’t blame Greenspan for lowering interest rates,” Miller said. Instead, he’d blame the chairman for not using his position to ensure that Fannie and Freddie were properly supervised.

The chairman falsely believed consumer protections were unnecessary because the market would take care of it, he said. Similarly, Lea said there was a strong consensus among economists that the Fed was taking needed steps to support the economy. Instead, the error was in not raising the rates fast enough.

“The Fed refused to believe that a price bubble was developing,” he said. “That’s where the error was made.”

Beginning in the middle of 2004, the Fed funds rate was ratcheted up 25 basis points a month. It eventually reached 5.25 percent in the middle of 2006. Lea said that action came a year too late. In that respect, it contributed further to the magnitude bubble. To choke off the bubble more effectively, he said the rate of monthly increase needed to be sharper and should have come earlier.

“The Fed sending a signal in tightening money supply would have had effect on long-term rates,” he said. “It would have slowed it, not stopped it.”

Interest rates in many ways drive the cost of homes, by allowing buyers to afford more home with a lower monthly payment.

“If tomorrow the Fed raised rates by 50 percent, you’d see real estate down 30 percent,” Kevane said.

When the lowered rates drove up home prices, he said, they commensurately boosted the bankrolls of government agencies through increased property tax revenues. Assessed values of homes increased more than 100 percent from January 2000 to January 2010. To Kevane, this means understanding that the housing boom is essential to understanding current budget crises.

“That means for every $1 our schools collected in 2000, they were collecting $2.10 in 2010, but they were still broke,” he said. “They will never see a period where income doubles in 10 years. If they can’t make it under those circumstances, there’s no doubt the system is broken.”

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