Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 7 When Wall Street Owns Main Street

Overview

Chapter 7 deals with one of the most opaque areas of finance, private equity, and how it has  distorted the US housing market. As explained in this chapter, although the US housing market is  recovering from the sub-prime mortgage crisis of 2008, the benefits of this recovery are disproportionately being realized by private equity funds and other investors that were active in the US housing market, that were not individual home owners (a.k.a., the “shadow banks”).

The prevailing opinion expressed by numerous US housing market experts is that the distortions caused by these private equity funds and shadow banks, could lead to another sub-prime mortgage crisis if such activity was not reigned in. And if another sub-prime mortgage crisis occurred in the near-term, it is believed that it would scuttle all hope of further economic recovery.

Events that led to the sub-prime mortgage crisis are also presented in summary form. They help to explain what was done to remediate the damage that occurred in the housing market, as well as what had transpired during the eight years of anemic economic recovery. This chapter also focuses on the role being played by private equity funds and the shadow banks, that had led to the distortions. It then discusses where all this is headed and suggests what needs to be done, if we are to avoid repeating past mistakes.

The American Housing Market and What Transpired

During the 1990s the US economy was booming. The stock prices were experiencing continuous growth, the real economy was growing , disposable incomes had grown and consumer confidence was high.

By the year 2000, regulations affecting the US financing system had been eased and the financial institutions had gained access to large amounts of investment capital and low-cost debt. This led to the availability of sub-prime mortgages, a boom in the American housing market and a run-up of real estate values.

This had a profound impact on the mindset of the all those that were engaged in the residential housing market, including mortgage bankers, managers of private equity funds and shadow banks. They no longer remained focused on investing in the residential housing market in  a way that promoted growth, stability  and adequate returns for all of their stakeholders. Instead the mindset became one that focused on exploiting opportunities to maximize shareholder value through running up property values, encouraging individual home buyers to take on high risk mortgages, buying back blocks of distressed properties once prices fell, purchasing mortgages that became up-side-down, and bundling and securitization of  those sub-prime mortgages with those that were not, so that they could readily be sold in the secondary market.

The role played by mortgage bankers in all of this was as originators  of numbers of sub-prime mortgages that fueled the real estate bubble. In order to support the growth of the sub-prime mortgage market the secondary market for bundled mortgages was needed, and private equity funds and shadow banks seized this opportunity to provide high rates of return, to their investors and to maximize shareholder value to these shadow banks.

Opportunities Created as a Consequence of the 2008 Crash 

When the bubble burst in 2008, and housing market prices fell, not only did hundreds of mortgages held by home-owners become up-side-down, a tidal wave of foreclosures also was created. This resulted in a huge inventory of distress properties and hundreds of sub-prime mortgages that needed to be re-sold.

This created opportunities for private equity funds and shadow banks to acquire large blocks of residential housing at discounted prices, that they then turned into rental properties or that they resold as prices stabilized. It also opened up an opportunity for them to acquire large numbers of sub-prime mortgages that had lost value, that could be bundled and profitably resold (with the help of Fannie Mae and Freddy Mac), in secondary markets.

The new wrinkle in the shadow bank business model was their ability  not only to create value by securitization of bundles of mortgages. It also includes their ability to acquire and hold distressed properties and generating rental income while they are being held, and profits, once properties are resold.

This business model used by private equity funds and shadow banks had proved to be most rewarding. Data presented in this chapter indicated that between years 2012 and 2013, private equity investors purchased $20 billion worth of steeply discounted residential housing properties. It was also reported that in 2015,  Blackstone, the biggest private equity firm, was estimated to have more than $330 billion in such property under its  management and that this portfolio of 46,000 homes and other properties had been estimated to generate $1.9 billion worth of income for Blackstone in 2014.

The impact of the financialization of the housing market in the aftermath of the 2008 meltdown and subsequent protracted and uneven recovery is mixed. Although home sales have started to increase and are now their highest levels in  8.5 years, home ownership has declined from its peak in 2004 and is now at a 20-year low.

With respect to the housing market as a whole, there are still lingering problems. For example, the top 10% richest markets contain 52% of total housing wealth, valued at $4.4 trillion, whereas the bottom 40% contains only 8% of total housing wealth, indicating that prices in large proportions of the housing market have yet to recover.

Further, the federal government is still underwriting most of the new mortgages.  And we still do not have a stable, affordable, inclusive housing market and financing remains highly dependent on availability of lower cost government backed bonds.

Experts agree that a truly healthy housing market matters and is a prerequisite to fixing our economy. Americans spend $2 trillion a year on housing and billions more are on related goods, and services. Unfortunately, this chapter makes it clear that there is a consensus among the experts that if we are to experience a full economic recovery, we have to fix these problems.