Tuesday, April 01, 2008

Some Truths About the Housing Bubble and the Credit Crisis

Both contenders for the Democratic nomination for president, Hillary Clinton and Barack Obama, have made statements about the efforts of the federal government to combat the problems caused by the collapse of the housing bubble. To paraphrase both of them, what they are saying is that it is somehow immoral to take steps to protect the financial system without bailing out individuals who, through their stupidity and/or their selfishness, are in danger of losing their homes. Both would turn over the tax money of working Americans to people who overreached themselves or are the victims of their own greed.

It is the responsibility of the federal government to protect all of us from a complete meltdown of our credit markets; it is not the responsibility of the federal government to save greedy and stupid borrowers UNLESS IN SOME CASES THIS IS AN UNAVOIDABLE BYPRODUCT OF EFFORTS TO PROTECT THE FINANCIAL SYSTEM. Clearly some irresponsible lenders will benefit from the bailout efforts; this is unfortunate, but the system must be saved. Clearly also, more regulation and closer supervision is necessary to prevent certain practices from being repeated in the future.

One measure that absolutely must be taken is once again to keep the ownership of commercial banks completely separate from the ownership of investment banks and insurance companies – a practice that was made illegal in 1933 during the Great Depression, but was overturned during the Clinton Presidency.

Some understanding of the reasons for the current crisis can be gained by reading the following excerpts from an excellent article published by

“Traditional vs. Modern Banking
Banks traditionally operated by taking deposits from their customers and lending money to those seeking loans. The difference between the interest rate paid on deposits and the higher one charged on loans (the “spread”) was their profit. If customers defaulted on their loans, banks were liable to depositors for payment—the banks held the risk “on the books,” 100% their responsibility. It was therefore in a bank’s best interest to carefully screen customers’ ability to repay before providing loans. The customer needed to have a good job, adequate assets, and was required to make a sizable down-payment. This conservative approach to lending enabled banks to make tidy profits for decades, while staying financially sound….

However, the 1990s saw banks change their traditional way of operating. Seeking higher and higher profits to satisfy shareholders and to secure executive performance-pay bonuses, banks decided they could make even higher profits if they loaned out more money. To do this, they used other people’s money through “securitization,” a process that allows banks to convert hundreds, even thousands, of mortgages into bonds and then sell the bonds to investors, such as pension funds, mutual funds, insurance companies and other banks. Banks did not make a profit through the “spread” anymore, but instead made a fee for having put together (“originated”) the loan, now owned by other investors.

Further, the bonds were insured by specialized insurance companies (so-called “monoline” insurers), and were rated as safe investments by the rating agencies (i.e., Standard & Poor’s, Moody’s, and Fitch).

Since the loans were now “off the books” and insured, the banks felt comfortable about “originating” even more loans. Through their new fee-based income, banks made much higher profits than ever before.

Reckless Lending
In their quest for higher profits, banks no longer felt the need to carefully screen loan applicants, as they once did. Customers who did not qualify for loans under the banks’ standard lending procedures (i.e., “subprime” customers) were now targeted as a lucrative source of income, and marketed aggressively to. Loans were provided to people with no income, no job and no assets (so-called NINJA loans).

Additional “sweetener” incentives were also provided, such as no down payment required and interest-only payments. Those who initiated the loans and approved them were no longer attached to the risk, and were paid handsomely for their efforts.
The subprime mortgage market became a ticking bomb, ready to explode at any time…….

Two developments have played a significant role in the development of modern banking and the current crisis:

The first was deregulation of the U.S. financial services industry with the 1999 repeal of the Glass-Steagall Act, after years of lobbying by the banks. Carefully crafted during the Great Depression to control speculation in the stock market, Glass-Steagall prevented retail banks, insurance companies and investment banks from owning each other. With the repeal of Glass-Steagall, massive financial services conglomerates were suddenly formed, combining these three types of financial institutions. Industry behemoths such as Citigroup and JP Morgan quickly came into being. This meant that retail banks seeking higher and higher profits could now dive headlong into high-risk speculative ventures through ownership of (or being owned by) investment banks, which led to disastrous consequences during the Stock Market Crash of 1929.

The second was the low interest rate policy pursued by the Federal Reserve. Low interest rates encouraged banks to target subprime customers with variable rate mortgages. Banks offered initially low interest rates (“teaser” rates), to be increased two or three years later. Because of rising house prices, customers took the bait believing they could refinance their homes at an affordable rate when the time for the reset arrived.”

Many of these homeowners facing foreclosure purchased homes they could not afford or thought that they could use their home as a source of easy credit or expected to flip their houses in a never-ending climate of increasing prices. They ignored completely the bursting of the housing bubble that occurred as recently as the 1990’s. As happens over and over in life, when the experiences of the ages are ignored and “cool” behavior becomes the norm, disaster strikes, whether it be the loss of a home, the destruction of a family or the spread of a dread disease.


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At 2:43 PM, Anonymous Anonymous said...

I absolutely agree. Lack of regulation caused this crisis. Capatalism is the best economic system around, but without regulation it invites manipulation that can lead to disaster.


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