Many, including myself are wondering who is responsible for this mess. Many point at Greenspan, but I think it is not so black and white.

One problem that we have is that people don’t understand the mathematics and dynamics of mortgages. I even get the feeling that mortgage lenders are pretty clueless. In particular I would like to quote the following from Housing Bubble.

“One was a waitress who made decent money at a high end restaurant, but couldn’t prove it because so much of her pay was in cash tips. Another was a young lawyer, making nearly $200,000 in the city but who didn’t have the money saved for the down payment on a $800,000 Manhattan condo.”

Regarding the waitress, sorry, but unless you actually declared the income, and paid taxes, it ain’t gonna work. Being an independent I know about these problems, and what is possible and not possible.  

Though let’s look at the case of the lawyer and his dilemma. I used to write mortgage calculation algorithms and thus know what numbers the banks usually look at. Yes I wrote algorithms like 28/2, and so on.

This person makes 200,000 (I will round up) in the city, and assuming this person is single his pay-check would be as follows.

Weekly Gross Pay $3,846.15
Federal Withholding $988.94
Social Security $238.46
Medicare $55.77
New York $264.74
NY SDI $0.60
City Tax $144.25
Net Pay $2,153.39

This lawyer would make $111,956 per annum.

Let’s calculate how much his mortgage would cost him (doing a quick calculation here).

800,000 at 6.375% for a 30 year fixed mortgage equals payments of $59,891.51 per annum.

When calculating whether or not you can carry a mortgage you do a really rough calculation of net income to mortgage cost. And in this case it puts him at 53%, which is a no-brainer easy answer, NO!

So sorry dude, but you need to put some money down.

My algorithms had some simply flags; < 30% pretty much go, between 30 and 40% lender needs to consider, but probably not, >40% no way, not gonna happen.

The problem is that the lawyer does not make enough, or the apartments in New York are too expensive. I tend to think the latter, and think in general the latter for the entire real estate industry including here in Europe.

Though here is question, why did the lawyer think he could have gotten the mortgage?

The answer lies in playing with the numbers. What interest rate could make this no-money down deal work? It ends up that if the interest rate were 1.9% he could get the mortgage, and at 3% it would be a lender’s call on whether or not to grant. With rates being 6.375 its a no-answer call.

The problem is memories tend to be short, and people think it is “new economy.” I looked at some historical Fed interest numbers.

Starting Time Frame Average
August 2002 2.75%
July 1954 5.69%

There you have it. People are thinking that the average interest rate should be 2.75%. Thus people are thinking, that they should be able to afford a mortgage. People are not looking at the historical averages, or should I rather say, people are ignoring the historical averages and hoping for a rate cut.

You can argue this expectation is the fault of Greenspan for lowering the interest rates to such low levels, but I am actually hesitant to point fingers at Greenspan. Look at the interest rate for the time frame from November 2000 to December 2001.

Nov-00    6.51
Dec-00    6.4
Jan-01    5.98
Feb-01    5.49
Mar-01    5.31
Apr-01    4.8
May-01    4.21
Jun-01    3.97
Jul-01    3.77
Aug-01    3.65
Sep-01    3.07
Oct-01    2.49
Nov-01    2.09
Dec-01    1.82

Look how much interest rates dropped in the space of a year. They went from 6% down to 1.82%, for a drop of 4%. This all happened in the year 2001!

People have collectively forgotten how bad 2001 was. Yes we know about the Twin Towers, but people have truly forgotten about 2001. The bubble burst, we had a major terrorist attack, and some weenie sending anthrax mail!

During 9/11, I was in Europe at the time, and people in Europe were in a panic on what America would do and what would happen. The Internet came to screeching halt as people tried in vain to see what was going on. Most websites could not cope with the traffic. Airports across North America and all planes in North America stopped moving. Time literally stood still!

All this happened on Greenspan’s tenure he drove down the interest rates and advised people to buy to primp the pump. I argue the year 2001 sucked people! And I mean it SUCKED ROYALLY! We seem to have forgotten how close we were to a global depression.

So when the interest rates dropped down 1% the cost of capital dropped to nothing. Thus the prices of houses went up. Instead of people taking the good fortune to save for the future they just spent and spent and spent to “buy more house” or worse used their house as an ATM to go on vacation! 

Greenspan left the interest rates that low until the economy started cranking again, and then did not hesitate to increase. He started increasing in July 2004 and kept increasing. When Greenspan left office the interest rate was 4.16%.

As Bernanke took over the interest rate went up another 5 times until the current level of 5.25%. If anything Bernanke wanted a goldi-locks-economy too much. He wanted a soft landing where nothing is too hot nor too cold. I do think that a couple of more rate increases were in order.

Now we have a “liquidity” crisis where banks don’t trust each other and don’t want to lend. Though the spike of the interest rates is the result of a free market economy. I see this rush to provide liquidity as a major mis-step (echoed opinion)

I understand liquidity is a problem, as the central banks don’t want an interest rate that deviates too much from their rates, but I do want to see some blood on the street. I personally would have let the investment banks and brokerages stew over the weekend and say about mid-week provided some relief.

Though as a side thought, this week is the inflation data. Could it be that they rushed this quick because things look bad? No idea, just a thought that crossed my mind.

In the end I don’t think a single actor can be blamed. It was the combination of many actors that drove a system to the edge that caused this mess. Though a footnote is that Bernanke should have driven the interest rates up a few more notches. It would not stop a recession or slow-down, but maybe not make as deep.

So where will things go? No 100% idea, I have thoughts, but that is another story. Though here is a long term idea, buy forests a’la Bismarck!

Monday Update: Europe market is up, and ECB keeps pumping in the money! I am truly disappointed in Trichet! As one CNBC commentator said, “Its hard to keep spending and then talk like hawk.”