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How We Got Into Real-Estate Crisis

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United States of America has solely and equitably enjoyed the superpower status since 1990 after the fall of Russia by posting record GDP growth rates. For decades the capitalistic principles of America have been richly rewarded by propelling innovation in defense, technology and infrastructure. The Laissez-faire principles of USA have helped companies nurture their growth by competing globally.

The dot-com Boom

Late 1990’s can be rightly termed as the golden era of entrepreneurship as the period changed the landscape of technology and the ways of doing business. Businesses were integrated through the seamless flow of Electronic data interchange (EDI) through internet. The entrepreneurship peaked between 1998 and 2000 with internet at the core of business and E-Commerce as a product line brining in customers across the world. Customers were able to purchase products, perform feature comparison, and cost comparison without ever visiting stores. The luxury of shopping from home via computers flourished. The world was connected by internet via World Wide Web (WWW). As technology flourished, the NASDAQ reached the highest points of 5,132 on March 10, 2000 (Varian, 2005).

A study by Ofek and Richardson on the internet stocks between 1998 and 2000 found that the first day returns from the IPO of dot-com companies was 125.4% and they earned 1000% returns between that time frame and amounted to 6% of US market capitalization (OFEK & RICHARDSON, 2003, p. 1114). According to IPO Vital Signs, which hosts comprehensive IPO data and facts, around 1,357 companies went public between 1998 and 2000 most of which were internet technology based companies. All of these companies were initially funded by venture capitalists and as entrepreneurship peaked venture capitalists came out in record numbers to provide financial assistance to bring the products out to the market.

Many companies went live without a physical product, offering services only. More businesses started to sell service as a product brining convenience to consumers. As the number of start-ups increased, product differentiation decreased. Many companies were competing with similar product offerings and racing to the finish line. The early birds were rewarded and the pressure to deliver lasting products on subsequent non-IPO companies was too high to sustain.

The growth outlasted the consumption. The supply was more than the demand and venture capitalists started to run out of funds to support non-IPO organizations because of stiff competition and no room for niche marketing. As the production differentiation was not much, business sustainability and sales became a challenge as companies looked for funds to stay afloat. As uncertainty creped in, consumer confidence eroded and the bull market was taken over by bears. NASDAQ plunged from 5,048 points in March 10, 2000 to 1,423 points in September 21, 2001 completely taken over by bears.

The dot-com Bust

The plunging stock market made many companies go bankrupt. Even the successful companies like Carrier One International went bankrupt in less than two years (IPO Dec 06, 2000 and bankrupt on Feb 22, 2002). The plunging stock market sent America in to recession. Many traders lost significant savings and retirement accounts were wiped out. Companies like Enron and WorldComm added fuel to the fire. Within a span of three years, the entrepreneurship spirit was dampened but capitalistic principles still widely regarded and valued.

Fed’s intervention to address Dot-Com crisis

In order to revive the economy Treasury lowered the interest rates. According to Bankrate.com, Treasury lowered the prime interest rates to 4% in 2003 and as interest rate started to decline, consumers started to buy homes. Technology sector continued to tank and real estate market started to flourish due to low interest rates. As activity around real estates increased so did home ownership. As per U.S Census Bureau, year 2003 to 2006 has witnessed highest home sales. More than 4.62 million homes were sold in those 4 years making the highest sales ever. To tap into low interest rates America entered a new era of business where homes were the commodity. GDP increased to record 7% during that period.

Most of the lending institutions like Freddie Mac, Fannie Mae, Citicorp, Bank of America, and many regional banks started to report record profits. Home prices increased nearly 30% nationally in that time frame (Kirchhoff, 2005). Regional banks recruited record sales members to get new buyers and sold the loans to Freddie Mac and Fannie Mae which were originally created by government to create equal housing opportunity for all. Freddie Mac and Fannie Mae bought the loans without any checks assuming lenders have performed consistent background checks and sold them as mortgage backed securities (MBS). Knowing Freddie Mac and Fannie Mae would purchase the loans institutions resorted to predatory lending where loans were provided knowing home owners cannot make the payments on continued basis. Salary did not support payments. Basic background checks and business ethics were violated.

Predatory lending is an unethical business practice that was approved and encouraged by the executive management to get more buyers. Buyers on the other hand started to treat real estate as short term investment. In many instances people purchased homes with as little as 1% down payment and bought multiple homes hoping they can dispose one in the near future to make profits. As home owners’ stake in the market capital increased the credit default swaps (CDS) programs increased and so did hedging around real estates. Many insurance companies like AIG were operating heavily on CDS programs and Citicorp was heavily into CDS and hedging.

Newton Law of Gravity states that “What goes up must also come down” and applies to economy as well not just to objects. According to Newton gravity always self asserts. Gravity in this case was equilibrium. 2007 witnessed great GDP growth, low unemployment rate, 4.5%, DOW reaching 14,000 points and consumer confidence at 100 points. When all was going exceptionally well, the demand for the homes started to decline as the effects of predatory lending became visible. As the demand decreased the prices of the homes started to fall. Home owners who were victims of predatory lending could not make the continued payments and started to default.

As the defaults increased the prices fell even more and defaults resulted in foreclosures. As supply was more than demand the prices of new homes fell and those who purchased the homes their homes were much less worth than what they paid for and felt comfort in defaulting than continuing with payments. The free market had more sellers than buyers and market entered correction phase. The correction was too much for the corporations to handle. The trend started to reverse in middle of 2008. Lenders now had lot of foreclosed homes in their balance sheet as assets that do not generate any revenues. Freddie Mac and Fannie Mae that bought the loans without proper scrutiny was starting to become a victim of their own encouragement, predatory lending.

Banks were holding off to their foreclosed assets in the absence of buyers and the credit flow ceased. They could no longer offer loans due to shortage of credit. Companies like AIG whose line of business was CDS were losing billions due to homes losing the value and AIG posted $10 billion dollars loss due to CDS (Cole, 2008). Some of the big banks like Bank of America and Citicorp suffered along the same lines. 150 year old Lehman Brothers declared bankruptcy. Merrill Lynch and Countrywide suffered brutally. Ford posted $80 billions in losses in 2008 and was hanging on a fine thread to survive. Auto makers, retailers, financial corporations, home owners and all technology sectors were badly hit by the consequences of predatory lending and lack of consumer confidence.

With revenue stream diminishing corporations were forced to cut back on their programs and started to lay off employees as part of restructure. Laid off employees increased the foreclosures which increased the toxic assets on corporation balance sheets. With no funds to operate, corporations looked for government intervention to seek additional cash reserves. The damage caused by unregulated market was hard for the government to ignore. What appeared rosy in 2007 appeared bleak in March 2009 with negative GDP growth at 6.2%, unemployment at 7.6% and consumer confidence at the lowest level of 37, government decided to intervene in the capitalistic market to infuse the require capital.

Government quickly and swiftly came out with bailouts, quickly asserted itself in the free market and took ownership of Freddie Mac and Fannie Mae and owned 80% in AIG and 40% in Citicorp. Many economists questioned government intervention into capitalistic market for the fear of intervention creating a socialistic environment. Either the government would sit on the sideline and watch companies declare bankruptcy sending unemployment to double digits or provide the required capital for companies to stay afloat. Government decided to pursue the latter option to protect the economy and jobs.

Treasury released more than 2 trillion dollars as part of three different bailout programs under Emergency Economic Stabilization Act (EESA), Trouble Asset Relief Program (TARP) and American Reinvestment and Recovery Act (ARRA). Each of these bailout programs had one common agenda of infusing finance into distressed financial market by government purchasing mortgage backed securities, equity and troubled assets.

Government which is elected by the citizens to carry out social programs for the welfare of the citizens was now in charge of the major financial institutions too. With government fostering partnerships with major corporations the environment evolved into socio-capitalistic environment where capitalistic environment was overseen by government officials. Government reached out to the corporations quickly and failed to show the same urgency to troubled home owners who had to foreclose due to no aid.

The economic data released by U.S Bureau of Labor Statistics showed no improvement in economy and jobs despite government’s two bailout programs of EESA and TARP. Board of Directors on the other hand started to offer incentives to CEO’s from the money received from government as bailout. The taxpayers’ money that government provided to the struggling companies was supposed to have gone to building better programs and to write off loses so economy can revive. But the greediness of the corporations had different agenda. Their agenda was to fulfill personal gains first and address corporation needs next. CEO’s made millions despite firms posting huge losses showing compensation has no bearing on performance.

Conclusion

Recent crises have exposed the tremendous greed in the capitalistic markets. Ethics which were the founding principles of business fully evaporated. Governance was no longer a measuring yardstick and corporation performance no longer a criterion to measure CEO performance. Many questions surround the interference of government in capitalistic market and the efficiencies such interference might bring, if any. Transformational leaders like Jack Welch completely disappeared from the free market and agency theory fully violated. Any thing and everything that could go wrong went wrong.

For the first time since the free trade evolved America never looked so weak in ethical management aspect. Treasury and corporations were focusing on short term gains instead of long-term vision. The crises that started domestically impacted countries all over the world impacting global GDP.

There is a direct correlation between the current real-estate crisis and the dot-com crisis that started in 2001. Instead of solving one problem (stocks losing value), the fed is now attempting to solve three problems where stocks loose value, real estate losing value and Dollar losing value.

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