Economy & Trade

The news is bad.  I won’t cite the litany of economic statistics here proving this is the worst economic crisis the world has faced since the Great Depression.  We all feel it.

When the only thriving businesses are pawn shops, and the only thriving professionals are bankruptcy attorneys, you know something is very wrong in the economy.

The news is filled with pundits explaining what went wrong.  Their explanations are filled with jargon.  What I’d like to do is explain, in layman’s terms, how we got here and how the problem spread.  A separate article will discuss how Congress and President Obama have dealt with the problem.  I think Obama’s massive stimulus plan is a mistake, and will just make a future day of reckoning even worse.

Our current prices stem from the collapse in housing prices, which then detonated a larger economic slowdown.  So here goes the sequence of events that landed us in our current predicament:

HOW WE GOT HERE

Problem #1.The Community Reinvestment Act of 1977 (“CRA”), and the Clinton Administration’s expanded rules:

The 1977 CRA was a vague mandate for regulators to “consider” whether a bank was serving the needs of the whole community it was supposed to serve.  Banks were “encouraged” to meet community needs.  There were no explicit quotas or mandates.  During the Clinton administration, this changed for the worse.   New rules were adopted in 1995 that effectively mandated banks meet quotas for loans to “underserved” populations.  Banks were pressured into making loans to people they normally would not make loans to.  

The CRA rule changes under President Clinton led to the birth of the “subprime” mortgage market – loans to people with poor credit who previously would not have qualified for a loan.

This government intrusion – meant with all good intentions to help minorities and poorer Americans – was the spark that eventually became today’s wildfire.  

Problem #2: Fannie Mae and Freddie Mac lowered their guidelines so they could accept the loans made under the CRA

Fannie Mae and Freddie Mac were government-sponsored entities (you may have seen them referred to as “GSE”s).  Their mission is to buy mortgage loans from banks.  Some of the mortgages they keep as investments, and some they sell to investors.  The sold mortgages carry a guarantee from the GSEs to the buyer that the principal and interest will be paid – whether or not the homeowner paid his mortgage.  The buyers of the debt believed in the guarantee from the GSEs because the US government implicitly backed the promise, earning them the “government-sponsored enterprise” moniker.

Fannie and Freddie own or guarantee roughly half the mortgages in America.  They are gigantic entities at the heart of the housing market.  

Many banks only made mortgage loans because they knew they could immediately sell the loans to Fannie and Freddie.  If Fannie and Freddie did not lower their standards, then banks would not have been able to lower their standards also.

Problem #3: Loan standards were loosened for all borrowers, not just for “underserved” populations

If banks and the GSEs lowered their standards for people with poor credit histories, it certainly made sense (or so they thought) to lower standards for people with stronger credit histories as well.

Problem #4: People bought homes they could not afford

Many subprime borrowers purchased homes with a mortgage incorporating a low initial “teaser” interest rate.  This enabled them to buy a more expensive home than traditionally they could have afforded.  Many figured that home prices would continue to rise, so when the teaser rate expired, they could simply refinance into a more traditional mortgage, or sell the home at a hefty profit.  This theory works well when home prices are rising.  It works horribly when home prices are falling.

Simply put, many homeowners voluntarily took on mortgages they could not afford once the teaser rate expired.

Problem #5 The Securitization Market (the “newfangled Wall Street product”)

Traditionally, banks and the GSEs held onto the mortgage loans made to homeowners. There was no opportunity for other investors to provide mortgage loans.  However, in the 1990s, Wall Street financiers developed a new product that greatly expanded the mortgage market.  This product allowed banks to bundle a group of mortgage loans into a single security and sell it to investors. Pieces of these securities were then purchased and re-bundled into yet more securities.  This process became known as “securitization”.

There is nothing inherently wrong with securitization. It allowed outside investors to provide mortgage funds to homeowners, which increased the supply of available mortgage funds, which lowered its cost.  On the whole, it lowered mortgage rates for homeowners.   

However, the rise of the securitization market led to two additional problems.

A.    It diffused the risk of mortgage loans throughout the entire financial world.  When problems arose from falling mortgage loan values, instead of being concentrated in a few big banks, the problem was spread out among many institutions around the globe.

B.    A single mortgage loan was no longer owned by a single bank.  Instead that loan could be chopped up into several different securities, all with different owners.  So if the homeowner wanted to renegotiate the terms of his mortgage, there was no one person with whom he could negotiate.  This has made renegotiating the terms of mortgage loans difficult if not impossible.



Problem #6 Rating agencies blundered and Investors did not do their own homework

All the mortgage securities sold to investors carried “safety” ratings from at least two of the big three rating agencies (S&P, Moody’s and Fitch).  These ratings indicated how safe the rating agency judged the security to be.  Since there are so many issuers of debt and many thousands of debt securities available for purchase, investors have come to rely upon the rating agencies’ judgment rather than doing their own homework.

The majority of mortgage securities carried the “safest” rating from the rating agencies.  Thus, investors believed there was little risk in the mortgage securities they were buying.  So they bought lots of them.

Historically, the rating agencies’ judgment has been very accurate.  This time, they were way off the mark (and that’s being kind).

Problem #7: Investment Banks owned the riskiest pieces of mortgage backed securities

The investment banks of Wall Street, who securitized the mortgages, often kept the riskiest piece of each mortgage security they sold.  These pieces were the hardest to sell.

Thus, when the value of mortgage securities began to fall, all the investment banks began to suffer massive losses on these “toxic” assets.

Commercial banks have two main activities: loan-making and investing.  In addition to making loans, banks also purchase investment securities for their investment portfolios.  Many banks sold the mortgage loans they made to homeowners to the GSEs, but then purchased mortgage securities from Wall Street firms for the banks’ investment portfolio.  Thus they too are suffering losses from the mortgage crisis, not from the original mortgage loans they made but from the declining value of mortgage securities in their investment portfolios.  And of course some banks did not sell the mortgage loans they made and are suffering losses on those.

Problem #8: A Housing Bubble Developed – Prices of homes skyrocketed

As a result of #1-#9, during the period 2001 – 2006 more Americans then ever bought homes, and could afford higher prices.  So the prices of homes shot upwards at appreciation rates not before seen.   

Historically, home prices rose 3-5% per year.  For the period 2000-2006, home prices rose an average of 15% per year.  For many, the value of their homes doubled or tripled in six short years.


Problem #9:  As Americans felt wealthy from rising home values, they began to borrow more money and save less

Americans felt wealthy.  The most valuable asset for most American families is their home and it was skyrocketing in value.  Many began using the rising value of their homes to withdraw cash via home equity loans. In essence, homes became like an ATM that spewed out cash whenever the homeowner desired.  This additional cash was spent on cars, televisions and other consumer items.  The economy grew.  

Americans began to borrow increasing sums and saved less.  Here are some startling numbers:

1960 - 1990:   Debt grew at 1.5x the growth rate of the economy, and Americans saved     9.0% of their disposable income.
1991 - 2000:    Debt grew at 1.8x the growth rate of the economy, and we saved 4.6% of income.
2001 – 2007:   Debt grew at 2.0x the growth rate of the economy, and we saved 1.4% of income.

In other words, feeling wealthy from our rising home values, we Americans borrowed lots of money and went on a spending binge.  This further propelled the economy.


HOW THE HOUSING CRISIS SPREAD TO THE REST OF THE ECONOMY:
“AND IT ALL CAME TUMBLING DOWN”

Consequence #1: The Subprime Bubble Burst
Most subprime loans featured a 2 year teaser interest rate.  The first big wave of “resets” in which the interest rate on a mortgage loan is reset higher as the teaser rate expires began in early 2007.  Many subprime homeowners could not make the new mortgage payment.  Thus, many subprime homeowners began to default on the loans.

Consequence #2: Housing Inventory Rises Ominously
At first, the foreclosure problem was limited to very low-end homes.  But the looser loan standards and homeowners buying above their means soon affected all types of homes.  Many people lost their homes.  In neighborhoods across America, empty homes today are listed for sale.

Consequence #3: Home Prices Begin To Fall
A glut of homes for sale is found in every major city in America.  And there are fewer buyers for these homes, as lenders have dramatically tightened their standards.  The increase in homes for sale, coupled with fewer buyers who can get financing, has caused home prices to plummet.

Consequence #4: Mortgage Security Values Begin to Fall
As many homeowners stopped making their mortgage payments, the value of the mortgage securities owned by banks and investors began to tumble.

Consequence #5: Banks Start Experiencing Losses
The owners of the mortgage debt – banks and institutional investors – must absorb the losses.  Several large banks fail or get taken over (Washington Mutual, Wachovia, IndyMac) or get emergency government assistance (Citibank and Bank of America).  All the major investment banks either fail (Lehman), get sold at a fire sale price (Bear Stearns, Merrill Lynch), or raise emergency capital from outside sources and become commercial banks (Goldman Sachs, Morgan Stanley).  All these investment banks survived the Great Depression and World Wars, but do not survive this crisis.

Consequence #6: Banks stop lending to each other
Traditionally, banks lend each other money every night.  If a bank needs cash, say to make a large loan or if depositors withdraw cash, the bank can easily borrow the money from other banks.  And if banks have excess cash, they are happy to lend it to other banks.

This came to a crashing halt.  No bank today knows what toxic assets are held by another bank, so getting a loan paid back becomes questionable.  And every bank fears “a run on the bank” in which depositors demand their money bank.  For these reasons, banks hoard their cash, and don’t lend to other banks.  Recent government actions have loosened the spigot somewhat, but the intra-bank lending still remains fragile.

Consequence #7: Banks stop lending to businesses
Banks can’t borrow from other banks at reasonable rates, and fear needing their cash to meet customer withdrawals.  So banks greatly curtail lending.

Businesses can’t get the loans they need to keep growing and hiring.

Consequence #8: The stock market plummets

Consequence #9: Consumers feel pinched
a.    Home values are declining
b.    Stock market values are declining
c.    Everyone worries about keeping their job

So consumers cut back their spending.  This makes sense for the individual consumer, but is bad for the overall economy.


Consequence #10: Companies feel pinched
a.    Consumers not buying
b.    Businesses can’t get credit

Consequence #11: Recession deepens!
Layoffs soar.  Bankruptcies soar.  Business leaders head to Washington to get bailout money.  Recently unemployed people – and everyone else – cut back spending, which hurts the businesses from which they used to shop.  This causes those businesses to lay off more workers, and the downward cycle repeats.

To state it simply, the current crisis has two overriding themes:
1.    The law of unintended consequences: Congress had good intentions in passing CRA and loosening standards for Fannie and Freddie.  However, they focused on the short term benefits without any consideration for the likely long-term effects of their actions.  It’s now thirteen years after the CRA rules were loosened, and we’re feeling the brunt of our past legislators’ ignorance.
2.    Too Much Debt: As a society – both individuals and government – we have lived beyond our means, especially the last few years.  Now we must tighten our belt, and it is a painful exercise.

Recessions must run their course.  We’ve had recessions before, and as painful as they are, the always eventually end.  Our new Democratic Congress and President do not seem to realize this.  With passage of the Stimulus Package, they are repeating mistakes 1 and 2 above – they are taking on too much debt, and there will be unintended negative long-term consequences that will likely outweigh any short-term positives.  Though they are well-meaning, Congress and the President are simply repeating the mistakes that got us into this problem in the first place.  We will all be worse off because of it.


The author, Rich Sokol, graduated with a Degree with Distinction in Economics from Yale University.