01February 21, 2003: Buffett Warns of Financial Weapons of Mass Destruction
The first warning of the danger of mortgage-backed securities and other derivatives came on February 21, 2003. That's when Warren Buffett wrote to his shareholders, “In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” (Sources: Ron Hera, “Forget About Housing, The Real Real Cause of the Crisis Was OTC Derivatives,” Business Insider, May 11, 2010. “25 People to Blame for the Financial Crisis,” Time Magazine.)
By June 2004, housing prices were skyrocketing. The Federal Reserve Chairman Alan Greenspan started raising interest rates to cool off the overheated market. The Fed raised the fed funds rate six times, reaching 2.25 percent by December 2004. It raised it eight times in 2005, rising two full points to 4.25 percent by December 2005. In 2006, the new Fed Chair Ben Bernanke raised the rate four times, hitting 5.25 percent by June 2006.
Disastrously, this raised monthly payments for those who had interest-only and other subprime loans based on the Fed funds rate. Many homeowners who couldn't afford conventional mortgages took interest-only loans. They provided lower monthly payments. As home prices fells, many found their homes were no longer worth what they paid for them. At the same time, interest rates rose along with the fed funds rate. As a result, these homeowners couldn't pay their mortgages, nor sell their homes for a profit. Their only option was to default. As rates rose, demand slackened. By March 2005, new home sales peaked at 127,000. (Source: “Historical New Home Sales, U.S. Census.)
Dr. Raghuram Rajan was chief economist at the World Bank in 2005. He presented a paper entitled "Has Financial Development Made the World Riskier?" at the annual Economic Policy Symposium of central bankers at Jackson Hole, Wyoming. Rajan’s research found that many big banks were holding derivatives to boost their own profit margins.
He warned, "The inter-bank market could freeze up, and one could well have a full-blown financial crisis," similar to the LTCM crisis. The audience scoffed at Rajan’s warnings, with Former Treasury Secretary Larry Summers even calling him a Luddite. (Source: "Economist Raghuram Rajan Risked Reputation to Predict Credit Crisis," Economic Times, June 9, 2010.)
Right after Rajan's announcement, investors started buying more Treasurys, pushing yields down. But they were buying more long-term Treasurys (3- to 20-year) than short-term bills (1-month to 2-year). That meant the yield on long-term Treasury notes was falling faster than on short-term notes.
By December 22, 2005, the yield curve for U.S. Treasurys inverted. The Fed was raising the Fed funds rate, pushing the 2-year Treasury bill yield to 4.40 percent. But yields on longer-term bonds weren't rising as fast. The 7-year Treasury note yielded just 4.39 percent. This meant that investors were investing more heavily in the long term. The higher demand drove down returns. Why? They believed a recession could occur in two years. They wanted a higher return on the 2-year bill than on the 7-year note to compensate for the difficult investing environment they expected would occur in 2007. Their timing was perfect.
By December 30, 2005, the inversion was worse. The 2-year Treasury bill returned 4.41 percent, but the yield on the 7-year note had fallen to 4.36 percent. The yield on the 10-year Treasury note had fallen to 4.39 percent.
By January 31, 2006, the 2-year bill yield rose to 4.54 percent, outpacing the 10-year’s 4.49 percent yield. It fluctuated over the next six months, sending mixed signals.
By June 2006, the Fed funds rate was 5.75 percent, pushing up short-term rates. On July 17, 2006, the yield curve seriously inverted. The 10-year note yielded 5.06 percent, less than the 3-month bill at 5.11 percent.
05September 25, 2006: Home Prices Fall for the First Time in 11 Years
The National Association of Realtors reported that the median prices of existing home sales fell 1.7 percent from the prior year. That was the largest such decline in 11 years. The price in August 2006 was $225,000. That was the biggest percent drop since the record 2.1 percent decline in the November 1990 recession.
Prices fell because the unsold inventory was 3.9 million, 38 percent higher than the prior year. At the current rate of sales of 6.3 million a year, it would take 7.5 months to sell that inventory. That was almost double the 4-month supply in 2004. Most economists thought it just meant the housing market was cooling off, though. That’s because interest rates were reasonably low, at 6.4 percent for a 30-year fixed-rate mortgage. (Source: “Home Prices: First Drop in 11 Years,” CNN, September 25, 2006.)
Slowing demand for housing reduced new home permits 28 percent from the year before. This leading economic indicator came in at 1.535 million, according to the November 17 Commerce Department Real Estate Report.
New home permits are usually issued about six months before construction finishes and the mortgage closes. This means that permits are a leading indicator of new home closes. A slump in permits means that new home closings will continue to be in a slump for the next nine months. No one at the time realized how far subprime mortgages reached into the stock market and the overall economy.
At that time, most economists thought that as long as the Federal Reserve dropped interest rates by summer, the housing decline would reverse itself. What they didn't realize was the sheer magnitude of the subprime mortgage market. It had created a "perfect storm" of bad events.
07Background Reading: A Must If You Are the Least Bit Confused So Far
Interest-only loans made a lot of subprime mortgages possible. That's because homeowners were only paying the interest, and never paying down principal. That was fine until the interest rate kicker raised monthly payments. Often the homeowner could no longer afford the payments. As housing prices started to fall, many homeowners found they could no longer afford to sell the homes either. Voila! Subprime mortgage mess.
Mortgage-backed securities repackaged subprime mortgages into investments. That allowed them to be sold to investors. It helped spread the cancer of subprime mortgages throughout the global financial community.
The repackaged subprime mortgages were sold to investors through the secondary market. Without it, banks would have had to keep all mortgages on their books—and perhaps would have been more careful about whom they made loans to.
Interest rates rule the housing market, as well as the entire financial community. For more, see How Interest Rates Are Determined, Relationship Between Treasury Notes and Mortgage Rates, Federal Reserve and Treasury notes.
Before the crisis, real estate made up almost 10 percent to the economy. When the market collapsed, it took a bite out of gross domestic product. Although many economists said that the slowdown in real estate would be contained, that was just wishful thinking.
As home prices fell, bankers lost trust in each other. No one wanted to lend to each other because they would receive mortgage-backed securities as collateral. No one knew what the value of these derivatives once home prices started falling. But if banks don't lend to each other, the whole financial systems starts to collapse.
Subprime Mortgage Crisis, Its Timeline and Effect
Follow the Timeline of Events as They Happened
The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds and corporations who owned these derivatives. It led to the 2007 banking crisis, the 2008 financial crisis and the worst recession since the Great Depression.
Here's the timeline from the early warning signs in 2003 to the collapse of the housing market in late 2006. Keep reading to understand the relationship between interest rates, real estate and the rest of the economy.