To use the words "economic downturn" or "looming recession" to describe the situation in the U.S. today may be accurate but it is also abstract. The first student reading below describes how the current mortgage crisis is affecting real people and why; the second focuses on the domino effect of sub-prime mortgage loans; the third summarizes proposals for an economic stimulus that President Bush and Congress are considering. Discussion questions and inquiry activities follow.
Student Reading 1:
The housing bubble that burst
Elaine Pellegrino and her husband bought a three-bedroom house for $97,000 seven years ago in an undeveloped area of Cape Coral, Florida. They did not have to make a down payment. A housing boom soon had construction crews putting up new houses in this once vacant area. Demand for houses grew. The Pellegrinos' house and property more than doubled in value.
It was easy for the Pellegrinos to refinance their mortgage at a low rate, effectively borrowing against the higher value of their home, and to use this money to buy an auto repair shop and a lawn service. "We were thinking we were on the way up," Elaine Pellegrino said. ( New York Times, 12/23/07)
So did Leonid Frolov, who bought his first home three years ago, a condo in Washington D.C., with a "piggyback mortgage." This involved two loans. The first was at a fixed rate of interest. The second was an adjustable rate mortgage that he borrowed against to buy a car and pay credit card debt. "Frolov felt confident he could refinance again before it adjusted." (www.washingtonpost.com, 12/10/07)
In the past, most people went to a bank or their workplace credit union to borrow money to buy a house. The fixed or unchangeable interest rate on such a mortgage loan might have been six percent on a house selling for $150,000. Let us also say the buyer had to make a down payment of twenty percent, or $30,000. That buyer had to make monthly payments on the $120,000 still owed at six percent interest for perhaps twenty or even thirty years. Before making the loan, the bank or credit union investigated the buyer's financial situation to make reasonably certain that the loan and the interest rate on it would be paid. And the buyer knew exactly what the monthly payments would be.
Beginning in late 2001 as demand grew for houses, prices began to climb. Developers bought tracts of vacant land and hired construction crews to create housing developments and multiple condos. People like the Pellegrinos and Frolov who might not have ventured to buy a home before began buying them. One major reason was their new access to "sub-prime" adjustable rate mortgages (A.R.M.s) like Leonid Frolov's.
The practice of making loans to people who want to buy houses but who do not qualify for market price or prime rate loans is called "sub-prime mortgage lending." Many people apply for these loans because they have a shaky credit history or do not have enough money to make the monthly payments at the prime rate and cannot make a down payment. A typical sub-prime A.R.M. might call for low fixed rate payments for two years followed by rising adjustable rate payments for the next 28 years of a 30-year mortgage.
Banks and credit unions no longer monopolize the home mortgage business. Today 70 percent of this business is in the hands of mortgage brokers. And some of these brokers, reported National Public Radio, "got bonuses for steering borrowers to higher interest loans in the sub-prime market because so much money could be made from them." (www.npr.org, 1/13/08)
Sub-prime mortgages became such a hot item that brokers and banks packaged and sold them to investment companies. They, in turn, sold them to investors and other companies around the world. Everyone was happy. Hundreds of thousands of Americans who had never been able to afford a house now had one. And brokers, banks, investment groups and individual investors were all making money.
Many brokers fast-talked and manipulated borrowers into signing high-interest sub-prime loans whose initial repayments looked good. The Wall Street Journal reported that more than half of sub-prime loans made as the housing business exploded "went to people with credit scores high enough to often qualify for conventional loans with far better terms." The housing boom led banks and brokers into the careless practice of making sub-prime loans without checking the income of borrowers.
So imagine a new homeowner managing to make mortgage payments of $2,000 per month for two years. But this sum might jump to $2,600 in the third year, then $3,300. By the fifth year the homeowner might be required to pay double what he or she had originally.
During a boom time when there are many new buyers entering the market and house prices are rising steadily, as they did from 2004 to 2006, making higher mortgage payments each year is not necessarily too difficult for the homeowner with a sub-prime mortgage. The homeowner might easily get what is called a home equity loan based on the higher value of the home and use the money for the payments or even to buy a business, as the Pellegrinos did, or a car, as Frolov did. A homeowner might also be able to make payments by borrowing money on their credit card or even selling the house for much more than its original price, as the Pellegrinos might have, and buy another.
But the Pelegrinos, who thought they were on the way up were on the way down, and Frolov's confidence was misplaced. The housing boom years between 2004 and the first part of 2006 turned into a highly inflated "bubble" that burst. More houses were for sale than there were buyers. Low interest rates began to rise. Obtaining credit became difficult.
"During the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets. Reasonable estimates suggest that more than 10 million American families will end up owing more than their homes are worth, and investors will suffer $400 billion or more in losses." (Paul Krugman, "Blindly Into the Bubble," New York Times, 12/21/07)
In December 2006 Elaine Pellegrino's husband died suddenly, leaving her with two businesses heavily in debt and owing $207,000 borrowed against the inflated value of her home. She says the home has gone down in value to $130,000 and that she and her daughter are "probably going to lose the house" and be "put out on the street."
Cape Coral is in Lee County, "where a tidal wave of foreclosures is turning some neighborhoods into veritable ghost towns. Real estate agents and construction workers are scrambling for other lines of work, and abandoning the area. Creative finance lubricated the developing boom, making it easy for buyers to take on more mortgage debt that they could otherwise handle, driving prices skyward." ( New York Times, 12/23/07)
As for Leonid Frolov, the value of his condo dropped as the bubble burst. He now owes more than the condo is worth, so he can't refinance the mortgage. Like the Pellegrinos, he too may find himself out on the street.
For discussion
1. What questions do students have about the reading? How might they be answered?
2. How has the mortgage business changed? Why has it changed?
3. What made it possible for low-income Americans to buy homes? Define these terms: mortgage, down payment, sub-prime A.R.M., home equity loan.
4. Why have brokers been eager to convince prospective homeowners to get sub-prime A.R.M.'s? What are the risks associated with them? How and why did investors around the world become owners of them?
5. The Pellegrinos and Leonid Frolov represent more than 2 million Americans who were eager to buy homes on easy credit terms. Why did their sub-prime mortgages turn sour on them?
Student Reading 2:
A tanking economy?
The debt problems and anxiety over possible home loss experienced by people like the Pellegrinos as home sales nose-dived spread in widening circles to millions of Americans. Falling home prices made it very difficult or impossible to borrow against property. This meant less money to spend. As consumer spending dropped, businesses reduced hiring and limited salary increases. This became another brake on consumer spending.
Banks and other institutions took huge losses on mortgage-related investments. The nation's largest bank, Citigroup, announced it had lost nearly $10 billion in the last three months of 2007 and that it was laying off 4,000 workers in addition to the 17,000 fired earlier. AT&T said that a number of customers were not paying their bills. American Express reported a drop in spending by its cardholders.
"Housing starts and new-home sales are off 50 percent from their peaks," said Ben Bernanke, chairman of the Federal Reserve System or Fed, as it is usually called. The New York Times reported that "Foreclosures are rising, and so is the number of households behind on their mortgages. In the financial markets, the sub-prime shock 'has contributed to a considerable increase in investor uncertainty,'[Bernanke] reported, adding that the Fed is seeing 'considerable evidence that the banks have become more restrictive in their lending to firms and households.'" ( New York Times , 1/11/08)
The Fed is composed of a board of governors appointed by the president. It regulates monetary policy. One way it does this is to set interest rates within the banking business that affect the interest rates charged on everything from home mortgages to payments on cars, TVs, and washing machines.
Adding to fears of an even more serious downturn in the economy were other signs:
- the weakest holiday shopping season in five years, not only for big chain stores like Target and Kohl's but also for firms selling expensive items like Nordstrom's and Tiffany's
- high oil and gas prices
- volatile and mostly sinking stock market
- rising unemployment
According to the Labor Department, 7,655,000 people in December 2007 were unemployed and looking for work. This was 13.2 percent higher than in December 2006. But these figures did not include unemployed people who are not looking for jobs because they have given up trying to find one. Their number is unknown.
A recession seemed more and more likely. A recession, or economic downturn, is defined by the National Bureau of Economic Research as "a significant decline in economic activity spread across the economy, lasting more than a few months." Seventy percent of U.S. economic growth depends on Americans buying things. Worried about their future, Americans were buying fewer things. The Pew Research Center reported that consumer satisfaction with the economy as of mid-January 2008 was at a 15-year low.
Meanwhile, investigations got underway in New York State and Cleveland. Did banks and other mortgage lenders lure people to sign on to sub-prime mortgages knowing they would not be able to repay them? Did lenders knowingly fail to disclose risks to investors? A spokesperson for a firm that verifies borrowers' incomes for mortgage companies said that lenders ignored their warnings. "Common sense was sacrificed on the altar of materialism," he said.
Cleveland suffered more than 7,000 foreclosures in each of the past two years. "Entire city blocks have been abandoned, the New York Times reported. "The city's budget has been strained by the effort to maintain thousands of boarded-up homes, and by the cost of responding to a rise in violent crime and arson." The city is suing such prominent Wall Street firms as Citigroup, Bank of America, Wells Fargo, and Merrill Lynch for forcing the city into this crisis by selling sub-prime mortgage loans to people those financial institutions should have known could not repay. ( New York Times, 1/12/08)
Sub-prime mortgages make up only 13 percent of existing home loans but 55 percent of all foreclosure proceedings, according to the Mortgage Bankers Association.
The Fed made it clear that such lenders had acted deceptively. In December 2007, the Fed issued new regulations requiring lenders to: 1) show that borrowers can afford their mortgages, 2) disclose hidden sales fees, and 3) stop running misleading advertisements. But these rules do not help some two million people who will probably lose their homes when higher interest rates kick in. Critics accused the Fed of ignoring warning signs of a crisis and acting too late.
For discussion
1. What questions do students have about the reading? How might they be answered?
2. What were the domino effects of the "housing bubble" that burst and why?
3. What is a recession? Why are many people worried about one?
4. What questions have been raised about the business practices of mortgage brokers?
Student Reading 3:
What should be done?
The worsening economy has caused national anxiety. President Bush called upon Congress to "provide a shot in the arm" for the economy by providing $145 billion in tax relief for individuals and businesses.
Republicans, Democrats, and their respective presidential candidates agreed that Congress should quickly adopt temporary measures to stimulate the economy and to promote consumer spending and confidence. The Fed signaled that by the end of January it will lower interest rates, providing an additional boost to the economy. But how effective all of these actions will be in preventing a recession was uncertain.
Democrats proposed measures aimed at middle- and lower-income Americans on the theory that they need money most and would probably spend it immediately, providing a quick economic stimulus. Among the proposals advanced by Democrats:
- Issue income tax rebates to middle- and lower-income Americans.
- Extend the tax rebate to 45 million families earning too little to pay income taxes.
- Raise unemployment benefits.
- Create new jobs with a sustained program of infrastructure rebuilding-roads, bridges, tunnels, airports, public works of many kinds.
- Increase food stamp benefits.
- Provide money to help low-income family pay heating bills this winter.
- Create investment incentives for small businesses.
Republicans emphasize measures to help businesses. For example:
- Lower the corporate income tax rate.
- Offer an expanded tax deduction businesses take for investment in equipment.
Because the pressure for an economic stimulus is overwhelming, Democrats and Republicans will probably reach agreement quickly on a package that includes at least some of the items above, and the president will probably sign this legislation. Individuals and businesses will begin receiving these benefits by spring.
At a time of growing anxiety among many Americans about homes, jobs, income, and paying off debt, it is also important to consider the following government statistics released by the Internal Revenue Service in March 2007:
1. 37 million Americans live below the official poverty line, which is $19,971 for a family of four. That is one of every eight Americans. Another 50 million Americans live on or just above the poverty line.
2. These 87 million Americans-almost one in every three-in a nation of 300 million and the richest on earth live what Princeton sociology professor Katherine Newman calls "a fragile existence." (Newman is author of The Missing Class: Portraits of the Near Poor in America. Her findings are the subject of "The Missing Class" on this website.)
3. 300,000 Americans, the top 1 percent, have average incomes above $1.1 million.
4. These 300,000 Americans enjoy as much income as the bottom 150 million Americans.
5. Income inequality in America is at its greatest since 1928.
In offering its own stimulus plan, the Economic Policy Institute said, "The distribution of wages, income, and wealth in the United States has become vastly more unequal over the last 30 years. In fact, this country has a more unequal distribution of income than any other advanced country." (www.epi.org) EPI describes itself as a "nonprofit, nonpartisan think tank that seeks to broaden the public debate about strategies to achieve a prosperous and fair economy."
A quick cash infusion to promote immediate consumer spending may prevent a recession, But even if all 87 million Americans living in poverty or on the edge get a tax rebate, their condition will only improve briefly. Some need jobs. Those who have jobs need higher wages.
For discussion
1. What questions do students have about the reading? How might they be answered?
2. Have students consider the stimulus proposals. How well do they understand each one? What questions do they have about each? How might each give the economy a boost?
3. Do students understand typical differences between the Republican and Democratic parties and why these differences exist?
For inquiry
1. Study the website of a presidential candidate. What specific proposals to deal with the growing economic crisis does this candidate propose? What reasoning is behind each proposal? How do you evaluate it?
2. John Edwards is the only presidential candidate to speak regularly about America's poor and how to help them. What are his proposals? How would you evaluate them? See www.johnedwards.com (website no longer active).
3. Inquire into sub-prime mortgage lending. What evidence can you find that mortgage brokers did or did not employ deceptive practices?
4. What evidence is there that enacting current proposals to stimulate the economy and avoid a recession will work? See such websites as the Center on Budget and Policy Priorities (www.cbpp.org), The Heritage Foundation (www.heritage.org), the American Enterprise Institute (www.aei.org) and the Economic Policy Institute (www.epi.org) for differing political and economic analyses.
5. Investigate the recession of 2001 and consider how that period is similar and different from our economic situation today.
This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: lmcclure@morningsidecenter.org