STILLPOINT Archive: last updated 08/12/2008

ARTICLE | Uncertain Riches

Recent economic news has been grim: rising unemployment; loss of consumer confidence; families losing their homes to foreclosure; falling home prices; higher energy and food prices; a credit crunch. If there ever was a time to take seriously Paul's words to Timothy about "uncertain riches" it is now. What's going on in the U.S. economy, and what is the future likely to hold?

Our current economic woes have their roots in the housing market and in the financial system that sustains it. Following quickly on the heels of the bursting dot-com bubble in 2000 and subsequent recession in 2001, home sales prices in many parts of the country began to increase at a rapid pace, resulting in a "housing bubble."

"Bubble" is the term used to describe an increase in asset prices (stocks, housing) far above their fundamental values. Bubbles are driven by market psychology--what former Federal Reserve chair Alan Greenspan famously termed "irrational exuberance." Rising asset prices entice new investors to "jump on the bandwagon," which drives prices up still further. The lure of seemingly endless gain temporarily creates a cycle: higher returns draw in more investment, which creates still higher returns.

The problem is that bubbles don't last forever. As any small child can tell you, bubbles always burst. When asset-price bubbles burst, prices fall sharply. Falling home sales prices are an inevitable correction to the overinflated prices that existed at the bubble's peak. Had this been the only needed correction in the economy, the results would have been manageable. Unfortunately this was not the case.

The fall in home sales prices coincided with the collapse of the market for subprime mortgages--mortgages written for borrowers who would not have qualified for mortgage loans based on typical underwriting standards for prime loans. Subprime loans brought home ownership within reach of many who would not have otherwise qualified, and this is surely a good thing. However, these loans were too often written with terms that should have raised warning signs--such as no income verification, zero down payments and adjustable interest rates. Sometimes initial interest rates were artificially low ("teaser rates"), followed by substantially higher payments when the rates adjusted after two or three years. The combination of falling home sales prices and zero down payments meant that many borrowers owed more than the value of the property and were thus unable to refinance when payments adjusted upward.

Why did mortgage lenders offer loans on these generous terms? The simple answer is bad incentives. Mortgage lenders--those who originate the loans--often sell their loans (prime and subprime) to investors and thus are unaffected by subsequent defaults by borrowers. They make their money through fees charged to originate the loan, and possibly through continuing to service the loan. The more loans they originate, regardless of the likelihood of default, the more money they make. While this brings new money into the mortgage market, allowing lenders to expand the scope of mortgage lending, it appears that investors in these packaged mortgages failed to recognize fully the risk and focused only on the (expected) high rates of return. In addition, firms that rate new securities seem to have systematically downplayed the risk, possibly, as some believe, because they did not want to alienate the firms that were paying them to make the ratings. The result has been huge losses by major financial institutions such as commercial banks, investment banks and hedge funds, and a reluctance to lend to any but the most creditworthy borrowers.

Who is responsible for the current mess? Many economists now blame the housing bubble on the Federal Reserve and its former chair, Alan Greenspan. Following the 2001 recession the Fed pursued a low-interest, rate-easy money policy that provided the fuel for the increase in housing prices. Without the easy credit and low-interest rates, the bubble could not have been sustained.

The originators of subprime mortgages also bear considerable responsibility. They should have known (and in many cases probably did know) that defaults were likely and in large numbers. Regulators should have been alert to what was happening and acted preemptively. Borrowers themselves should have exercised greater caution in agreeing to loans that were clearly not within their reach.

Where are we headed? At this writing the picture is not clear. Some analysts think we have begun to turn the corner and the recession (if indeed there is a recession) will be mild and short-lived. Others call this the greatest crisis our economy has faced since the Great Depression. Time will tell. One thing for sure is that higher inflation looms on the horizon. In hindsight we may see that the Fed's efforts to stabilize the financial system and the economy through low-interest rates and money-supply growth were achieved at the cost of higher inflation--or another asset bubble.

Over the short term, borrowers, including students and their families, will likely face higher rates and stricter credit terms. College enrollments may suffer as families become less willing to commit to large financial outlays in the face of an uncertain economic future. Equity loans will be harder to obtain as will first mortgages. Graduating seniors will face a tighter job market. And unrelated to the turmoil in financial markets, we will all face rising prices at the pump and supermarket.

We can also expect new government regulations. Policymakers should adopt regulations in financial markets that correct abuses without stifling innovation. Capital requirements need to be extended to banks' "off-balance sheet activities" and to mortgage lenders outside the banking system to provide a larger cushion to deal with future crises. Lenders might be required to retain some of the loans they initiate so that greater care is taken to screen out borrowers who are likely to default.

What should be the Christian response? First, we should bring to mind the folly of greed, one of the seven deadly sins. Greed, or avarice, is a vice that drives us to an inordinate pursuit of wealth, often without regard to the effect on others. Greed beckons us to lay aside our ethical standards in the pursuit of ever-higher returns. While "bad incentives" are the proximate cause of turmoil in financial markets, greed is surely one of the principal root causes. On the other side of the ledger, we should weigh carefully the virtue of prudence, or practical wisdom, as we make financial decisions. A prudent investor carefully weighs the possibility of future losses against the prospect of near-term gains. A prudent borrower will consider the consequences of unforeseen circumstances such as unemployment or falling asset prices. Prudence was a virtue in short supply among participants in the subprime debacle--lenders, borrowers or investors.

Second, we should give thanks for the incredible bounty most of us continue to enjoy--even in "hard times." The vast majority of readers of this article have neither lost their jobs nor their homes, nor have they experienced a big decline in their standard of living. Thanks be to God! We should also give thanks for the millions of poor persons in the world whose rising incomes allow them to purchase more food and energy--thus driving up our food and energy prices. Rather than grumbling, we should rejoice and give thanks.

Finally, we should remember the words of our Lord in the Sermon on the Mount: "Do not lay up for yourselves treasures on earth, where moth and rust consume and where thieves break in and steal, but lay up for yourselves treasures in heaven, where neither moth nor rust consumes and where thieves do not break in and steal. For where your treasure is, there will your heart be also." (Matthew 6:19, RSV)

Bruce Webb, Ph.D., professor of economics and business since 1977, coedited the scholarly journal Faith & Economics for 19 years. He is Core Curriculum coordinator. His research and teaching interests include macroeconomics, biblical teaching on economics, and environmental issues.


Bruce Webb