Thursday, October 09, 2008

Answering a students question

Recently, one of my students asked what sociology might make of the current financial crisis. As I explained in the class, the current financial crisis is multidimensional, and has a number of different causes. The housing collapse of the housing market and the housing financing market is just one of several threads in the situation, but it helps illustrate some sociological principles of interest to us -- such as the distinction between use value and exchange value.

The use value of a house is that it protects its occupants from the elements, from cold or heat, rain or sleet. The use value includes the functionality of its bathrooms and kitchens. Its use value also includes the pleasure the owners get from privacy or from enjoying the way their house looks or feels. Moreover, ownership versus renting housing adds use value through the ability to make changes, alterations, and modifications to the home, the freedom to have pets, put up fences, and outbuildings that might be restricted by leases or rental agreements. The use value of a house can decline -- wiring and plumbing can break down, roofs can leak, paint can fade and crack, families can grow larger and the space may no longer be adequate, or undesirable "neighbors" can move in next door (like a strip mine)and lessen the pleasure or privacy derived from the home. But declines in use value tend to be slow and incremental. The decline in housing value over the past year or two has been a decline in exchange value, not use value; a decline in what one can sell one's home for (exchange it in the market place). The recent plunging market or exchange value of houses across the country has little to do with the use value of homes. Moreover, the rise in housing costs over the past two decades, had little to do with increases in the use value of housing. So why did housing prices rise so much, and why have they now crashed? How does the housing market and the financial market interconnect?

Let's begin with talking about the rising cost of housing. First, the facts on how the cost of housing has risen. In 1970 the median (mid-point) family income was $7,550 a year, and in 1965 the median (mid-point) price of a new home was $23,300. So the cost of the average, mid-point house was only 3.1 times the income of the average (mid-point) family's income. By the year 2000 the median (mid-point) new housing cost was $169,000, while the 2000 median (mid-point) family income was $41,990, making the average, mid-point house 4 times the average (mid-point) family's income. In other words it was a whole lot harder for the average family to afford the average house. Thing were even worse by 2007. In 2007, the median price of a new home had jumped to $247,900 while the median family income had only risen to $50,233, making the average, mid-point new house 4.9 (or almost 5) times the average, mid-point, family income.

Why did the cost of housing rise so much? For one thing, there was increased demand for housing, population grew. But even more important was that the age structure of the population changed. Beginning in 1965, a big "boom" of young people (the Baby Boomers who were born beginning in 1945) began to hit their 20's and begin looking to start families and buy houses. There was a huge flood of new home buyers moving into the market in the late 1960's and early 1970's. But these were mostly young people with young families, and they did not have large incomes, so even though there was a demand for new houses, the cost of those houses remained modest to meet the incomes of the young families that needed them. By 1990 and 2000, however, the number of young couples and young families looking for housing was fewer than the numbers of middle aged (40's and 50's) Baby Boomers looking to purchase housing (either to upgrade as they received promotions or to change due to their children growing up and leaving home). These middle aged Boomer house hunters had high incomes and were interested in more luxury in their homes. Luxury is to some extent related to use value; some of the greater cost of luxury items comes from them being longer lasting, more durable, more reliable, or just working better. But some luxury is purely a matter of exchange value (a result of supply and demand). The luxury good may not be more functional or useful, and is some times actually less so, depending upon the needs of the houses residents. For example, a synthetic Corian counter top will probably last longer, resist stains better, and require less maintenance than a marble slab counter top, but has a lower exchange value.

Home developers and builders were far more interested in providing homes for these more affluent buyers than they were in providing homes for the smaller number of young couples and young families with less money to spend. The reason is that there is more profit to be made from an expensive, high end house than there is from a smaller lower cost house. For example, if a developer can make a 20% profit (over costs) on a new house (a modest estimate just for arguments sake, profits are sometimes higher and sometimes lower), then the developer makes $20,000 on a $100,000 house, but $100,000 on a $500,000 house. The developer can only build so many houses, and the amount of time to build a house $100,000 house is not much less than to build a $500,000 house, so clearly the preference would be to build $500,000 houses, if you can find buyers for them.

Rising costs of housing were beginning to price a larger percentage of Americans out of home ownership in the 1980's and 1990's. Those lower income Americans wanted homes and had few choices at the low end of the price spectrum (since developers prefer to build higher cost houses). The percentage of families being home owners began to drop in the 1990's. What should have happened when home purchasing began to slide was that builders should have started to offer more lower cost housing. But they didn't do that, because developers and builders really wanted more buyers for their higher end houses. At the same time financial sector was looking for new opportunities for profit(in the interest they charged on loans). The interests of the building sector and the interests of the financial sector coincided, and focused on trying to find ways to expand credit to new customers, and make more people able to afford the rising cost of housing.

Between 1980 and 2007 the financial industry turned to the federal government to have the government remove some of the controls and regulation that limited lending practices. Lobbying by the banks and other financial institutions contributed to the repeal or overturn of several key laws that had existed to regulate the financial industry, giving banks and financial institutions more freedom to loan money to people who previously would not have qualified either because they were borrowing for risky projects (like "flipping" houses) or because their income or credit history was not suitable. Some of these changes made by Congress began in the 1980's but most took place between 1999 and 2004.

The financial sector, freed from controls over lending practices developed some new types of loans, such as new types of Adjustable Rate Mortgages that reset to much higher rates after a period of time, and "interest only" loans that require payment only of interest for an initial period before principle payments kick in. The lenders begin to target people who have been priced out of the housing market, with loans that looked affordable or at least the initial few years of payments look affordable, but which are actually well beyond the means of the consumer. As a result, people making the median income of $50,000 a year, were buying median houses of $200,000, because the banks and other lending institutions were making the first few years of payments something that was affordable. [A family with $50,000 income should not be purchasing a home worth more than $100,000, and even that's pushing it -- but the number of homes less than $100,000 are few and hard to find and often not large enough for young growing families].

So a housing industry (developers and builders) looking for more profits and a banking/finance industry looking for more profits (and allowed to make more risky loans by removal of regulation), offered loans to speculative borrowers and "subprime" (lower income) borrowers, loans that those borrowers could not really afford in the long run. Speculative borrowers are people who buy a house they can't really afford to pay for in the long run, in order fix it up and sell it for a higher price, and make a profit. Called "flipping" the buyer of the house is not planning on living in the house and can only afford to make a few months worth of payments. Their plan is to remodel the house and make it attractive to high end buyers, in homes of making $50,000 to $200,000 in profit in a couple months time.

The banking and finance industry had argued that it was okay to make loans that would have low payments initially and after some years would reset to higher payments because (so the argument went) people's salaries and earning went up as they got older, and the economy expanded over time and wages and salaries increase. The problem is that while it was true that salaries and wages had increased during the 1990's (from 1993 to 1999), the same was not true from 2000 to 2007. Wages and salaries stagnated, and did not keep up with inflation. In recent years, the increasing costs of petroleum and energy caused inflation to rise much faster than wages and salaries.

Of course, some of the blame has to go to the consumers who borrowed more money than they could really afford. They were sometimes pressured by banks and loaning institutions to do so, and were not always given all the information that they needed to make good decisions. But do hold some responsibility for taking on more debt that they could afford. Substantial responsibility lies on the banks and financial institutions that saw loaning to subprime and speculative borrowers as a way to make more money in the short run, because they should have and could have foreseen what would happen. Some responsibility lies on the builders and developers who were unwilling to construct more affordable housing and accept slightly lower profits. Everyone was short sighted, they went for the big bucks up front, and ignored the high likelihood of big losses down the road.

Why does a problem like this in the home building/ home financing area of our economy have so much spill over into other areas? One reason is that the home construction industry is a huge purchaser of goods from other industries -- from raw materials (lumber, steel, glass, plastic), to manufactured products (carpet, appliances, furnaces, doors, counter tops, etc.). Also new home owners also spend a great deal of money themselves on new furnishings (furniture, drapes, lamps, etc.). This has always been true about the housing industry. However, one very new thing, that makes the problem with the housing and finance industry in 2008 a more serious problem is changes in the rules governing financial institutions.

In 1933, the Glass-Steagall Banking Act was passed that said that banking (taking people's money in checking and savings deposits, and making home loans and small personal loans), and that neither banks nor insurance companies could do "investment" (using their own capital to invest in business as well as helping connect people with capital to invest with businesses looking for capital to fund their activities). Banking, is an activity that the government insures, so that people know that their money is safe, and "banks" are required to hold on to a certain percentage of the money deposited to have it on hand at all times to meet depositors needs. Investment businesses make no promises at all about customers money, they take the money and place it in investments, the money is not insured, and there is no requirement to keep cash on hand, and no promise that investors will get any of their money back; although most of the time investors get more money back than they put in, there is no guarantee that this will happen -- banks on the other hand guarantee that every penny you put in you will get back, and insurance companies guarantee that if you pay your premiums without fail and you have a qualifying disaster then you will get more than your money back.

So the 1933 Glass Steagall act, said these businesses, which have very different purposes and very different requirements in dealing with money should not be allowed to be merged together in a single company. In 1999, that law was repealed, and this allowed banks, insurance companies and investment companies to all merge together into large financial institutions. This allows problems in one area of finance to spill over into other areas of finance -- for housing loan problems to affect business investment and vice versa.

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