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How We Got Into Real-Estate Crisis

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United States of America has solely and equitably enjoyed 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 the USA have helped companies nurture their growth by competing globally.

The dot-com Boom

The late 1990s 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 the Internet. Entrepreneurship peaked between 1998 and 2000, with the Internet at the core of business and E-Commerce as a product line bringing in customers worldwide. Customers could purchase products and perform feature and cost comparisons without visiting stores. The luxury of shopping from home via computers flourished. The internet connected the world via World Wide Web (WWW). As technology advanced, the NASDAQ reached the highest point of 5,132 on March 10, 2000 (Varian, 2005).

A study by Ofek and Richardson on internet stocks between 1998 and 2000 found that the first-day returns from the IPO of dot-com companies were 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. Venture capitalists initially funded all of these companies. As entrepreneurship peaked, venture capitalists came out in record numbers to provide financial assistance to bring the products to the market.

Many companies went live without a physical product, offering services only. More businesses started to sell services as a product bringing 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 to subsequent non-IPO companies was too high to sustain.

The growth outlasted the consumption. The supply exceeded the demand, and venture capitalists started running 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 challenging as companies sought funds to stay afloat. As uncertainty creped in, consumer confidence eroded, and bears took over the bull market. NASDAQ plunged from 5,048 points on March 10, 2000, to 1,423 points on September 21, 2001, wholly taken over by bears.

The dot-com Bust

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

Fed’s Intervention to Address Dot-Com Crisis

To revive the economy, Treasury lowered the interest rates. According to Bankrate.com, Treasury decreased the prime interest rates to 4% in 2003, and as interest rates started to decline, consumers began to buy homes. The technology sector continued to tank, and the real estate market flourished due to low-interest rates. As activity around real estate increased, so did home ownership. As per U.S. Census Bureau, 2003 to 2006 witnessed the highest home sales. Over 4.62 million homes were sold in those four 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 a record 7% during that period.

Most 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. They sold the loans to Freddie Mac and Fannie Mae, initially created by the government to create equal housing opportunities for all. Freddie Mac and Fannie Mae bought the loans without any checks assuming lenders had 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 homeowners could not make the payments on an ongoing basis. Salary did not support prices. Basic background checks and business ethics were violated.

Predatory lending is an unethical business practice approved and encouraged by the executive management to get more buyers. On the other hand, buyers started to treat real estate as a short-term investment. In many instances, people purchased homes with as little as a 1% down payment and bought multiple homes hoping they could dispose of one shortly to make profits. As homeowners’ stake in the market capital increased, the credit default swaps (CDS) programs expanded, and so did hedging around real estate. Many insurance companies like AIG operated heavily on CDS programs, and Citicorp was heavily into CDS and hedging.

Newton’s Law of Gravity states that “What goes up must also come down” and applies to the economy, not just objects. According to Newton, gravity constantly self asserts. Gravity, in this case, was equilibrium. 2007 witnessed tremendous GDP growth, a low unemployment rate of 4.5%, the DOW reaching 14,000 points, and consumer confidence at 100 points. When all was going exceptionally well, the demand for homes started to decline as the effects of predatory lending became visible. As the demand decreased, the prices of the houses began to fall. Homeowners 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 lost, 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 entered a correction phase. The correction was too much for the corporations to handle. The trend started to reverse in the middle of 2008. Lenders now had a lot of foreclosed homes in their balance sheets as assets that do not generate any revenues. Freddie Mac and Fannie Mae, who bought the loans without proper scrutiny, were becoming victims of their encouragement, predatory lending.

Banks were holding off to their foreclosed assets without buyers, and the credit flow ceased. They could no longer offer loans due to a shortage of credit. Companies like AIG, whose line of business was CDS, were losing billions due to homes losing value, and AIG posted a 10 billion dollar loss due to CDS (Cole, 2008). Some 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 billion in losses in 2008 and was hanging on a fine thread to survive. Automakers, retailers, financial corporations, homeowners, and all technology sectors were severely 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 lay off employees as part of a restructuring. Laid-off employees increased the foreclosures, increasing 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 markets 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; the government decided to intervene in the capitalistic market to infuse the required capital.

The government quickly and swiftly came out with bailouts, promptly asserted itself in the free market, took ownership of Freddie Mac and Fannie Mae, and owned 80% of AIG and 40% of Citicorp. Many economists questioned government intervention into the capitalistic market for 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. The government pursued the latter option to protect the economy and jobs.

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

A government that the citizens elect to carry out social programs for the welfare of the citizens was now in charge of the major financial institutions too. With the government fostering partnerships with significant corporations, the environment evolved into a socio-capitalistic climate where government officials oversaw the capitalistic environment. The government quickly contacted the corporations and failed to show the same urgency to troubled homeowners who had to foreclose due to no aid.

The economic data released by the U.S. Bureau of Labor Statistics showed no improvement in the economy and jobs despite the government’s two bailout programs, EESA and TARP. The Board of Directors, on the other hand, started to offer incentives to CEOs from the money received from the government as a bailout. The taxpayers’ money that the government provided to the struggling companies was supposed to have gone to building better programs and writing off losses so the economy could revive. But the greediness of the corporations had different agenda. Their agenda was to fulfill personal gains first and address corporation needs next. CEOs 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 a criterion to measure CEO performance. Many questions surround the interference of government in capitalistic markets and the efficiencies such interference might bring, if any. Transformational leaders like Jack Welch completely disappeared from the free market, and agency theory was fully violated. Anything and everything that could go wrong went wrong.

For the first time since free trade evolved, America never looked so weak in ethical management. Treasury and corporations were focusing on short-term gains instead of long-term vision. The crises that started domestically impacted countries worldwide, moving 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 issues: stocks lose weight, real estate loses value, and Dollar loses value.

References

Cole, M. (2008, February 18). AIG’s losses show swaps next domino. Financial Week. Retrieved from [http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080218/REG/794188688]

Kirchhoff, S. (2005, Aug 17). Home prices rise to ‘extremely overvalued’ levels in 53 cities. USA Today, p.

OFEK, E., & RICHARDSON, M. (2003). DotComMania: The Rise and Fall of Internet stock prices. THE JOURNAL OF FINANCE, LVIII(3), 1113-1137.

Varian, H. R. (2005, March 10). Economic Scene; Five years after the Nasdaq peaked, one answer to the question of what happened. New York Times, p. 2.

Praveen Kotha graduated with double Masters’s Degrees, a Master of Science from Mississippi State University and an M.B.A. from Stayer University. Praveen Kotha is currently leading the Enterprise Business Integration team at Magellan Healthcare and can be reached at

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