Credit Crisis: How Did We Get Here?

In a recent blog I discussed the reasons for the credit mess we are in. I want to now focus on the companies that failed and triggered this panic wave. Let's start with the Government Sponsored Entities, the GSE's, namely Fannie Mae and Freddie Mac. Those firms were chartered by Congress to buy mortgages and thus facilitate housing ownership to low income Americans. By serving as middlemen, buying mortgages from lenders and banks and then holding or reselling them, they allowed banks to make even more loans to even more homeowners, and the GSE's could book profits along the way. The risk was that borrowers might stop making their mortgage payments, and the GSE's would be left holding the bag.

Things went well for decades. Real estate prices were marching upwards. Management became confident the business model was sound. But then clients such as Countrywide Financial Corp., a major mortgage company, demanded that the GSE's buy more risky loans from them, lest Countrywide take its business elsewhere and make the GSE's irrelevant. Investors were also pressuring them to take greater risks to keep their stocks advancing. Democrats on the Hill, who lobbied for the GSE's for years, demanded that the companies buy more loans that had been made to low-income and minority home buyers. And Republicans, who were busy promoting lax regulations, are clearly not without fault either.

The GSE's started to fear that lenders would be selling products they weren't buying and Congress would decide they weren't fulfilling their mission. So between 2005 and 2008, Fannie Mae alone purchased or guaranteed about $270 billion in loans to risky borrowers, more than three times as much as in all its earlier years combined, according to an article the New York Times recently ran, detailing the GSE's demise.

The GSE's actually had lending standards that were much better than most other lending institutions, and their market share of risky loans was actually falling when everyone else were ramping up on them. Their problem, however, was gigantic leverage, which left no room for error. So when the steep decline in home prices started, something they never experienced before, it wiped them out. This is a clear case of management's greed and stupidity, but the blame also lies with homeowners, who wanted bigger homes than they could afford, and were happy to overpay for them and over-borrow to finance them.

Or take AIG, one of the largest insurance companies in the world and one of the most important financial institutions. AIG insured Credit Default Swaps (CDS), a financial security that allows you to bet on the credit worthiness of companies. Many companies had CDS's with outstanding values far exceeding the underlying bonds they insured, so the buyers of the CDS's had incentive to plunge those companies towards bankruptcy so that they can make a fortune on the insurance policy. That is tantamount to you being allowed to take a very large life insurance policy on your neighbor. You would have a financial incentive to run your neighbor over to collect the insurance money. This practice creates motivation for behavior that capital markets, and society, cannot tolerate. And the fact that the regulators allowed this to happen can only indicate either sheer stupidity or irresponsible cluelessness, not exactly inspiring confidence in the competence of our government officials and their negligent ways. Either way, and to simplify a bit, AIG was unwisely on the other side of these insurance contracts and when credit started to collapse, they ran out of money to cover their obligations.

Lehman Brothers owned risky mortgage loans with a 30:1 leverage. That means that for every $1,000 of capital that belonged to the firm, they had $30,000 worth of assets (and $29,000 of corresponding liabilities). It logically follows that a decline of 3.5% in the value of the assets more than wipes out all of the firm's capital. We now know that those risky loans had lost a lot more than 3.5% of their value. And when a firm has nearly $700 billion in assets, as Lehman had, everyone feels the repercussions of that collapse.

Merrill Lynch found its travails in much the same way, as did large commercial banks like Washington Mutual and Wachovia, that were recently brought to their knees.

The decisions of those companies and others like them are now threatening to drag down the housing market and the economy.

Treasury Secretary Henry Paulson now put together a $700 billion plan to bail out the financial sector. The Federal Reserve has pumped some $800 billion into the financial system. That figure doesn't include what the Fed still plans to spend buying short-term debt so that companies can survive and continue their daily operations. And it doesn't include any of the hundreds of billions the Treasury Department might spend propping up Fannie Mae, Freddie Mac or AIG.

After 14 months of crisis, the federal government -- meaning you and me -- has already put gigantic sums of money on the line. (For comparison, the entire annual federal budget is about $3 trillion). And I am very dubious about the idea that government bureaucrats working with our money can have better judgment about the value of complex financial instruments than private investors making decisions with their own money.

Even before this crisis, the Bush administration was on schedule to hand down a $550 billion deficit to the next administration. A new better estimate might be $750 billion, or 5 percent of gross domestic product. It isn't as big as our healthcare obligations, but serious nonetheless. There are about 100 million households in the United States. $750 billion is about $7,500 for every household in the country.

Just how are we going to pay for all this?

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment partnership.

Comments

[SteveMDFP]

Some lack of insight here:

1. The bulk of sub-prime loans were made by UNREGULATED companies. They created a feeding frenzy of real estate transactions because they knew they wouldn't be the ones left holding the bag. Such rampant speculation was the driving force behind the real estate bubble. Freddie and Fannie and ACOR and Mthe CRA have very little responsibility for the crisis. Instead, look up The Gramm-Leach-Bliley Act, the Commodity Modernization Act, and other Phil Gramm-authored legislation. Championed by McCain, of course. For excruciating detail, see:
http://bigpicture.typepad.com/comments/2008/10/misunderstandin.html

2. All major investments and commodities are falling in price, rapidly. Thus, the dollar is gaining value. The is a DEFLATIONARY CRISIS. Reversing this explosive process requires previously unimaginable amounts of "inflationary" stimulus. There really is no problem with how to pay for any proposed program. The challenge is how to convince the body politic that the federal govenment MUST run massive budget deficits and run the printing presses at high speed.

Steve

[Bobrobert]

Answer...

These questions tell all...

How many of you own your car/cars?

How many of you never use a credit card for anything?

How many of you have never obtained and used an equity line of credit on your home?

How many of you own your home or at least have it 3/4 paid for?

How many of you have 6 monthes pay in cash on hand for any type of emergency that may pop up?

My guess is less than 5%.... hee hee ... actually less than 1% is my guess.

That is why this country is in the mess it is in!!!!!

Everyone has used their credit to the limit... and cannot keep up their payments... that equals a major crash because we can NO LONGER buy goods... the governments answer... GIVE US MORE CREDIT!

[frynpan]

My neighbor almost fainted when I told her we have always paid cash for our cars.... and never carried credit card debt. I am glad I was raised by my grandparents who experienced the depression, and am voting for "that one" who was also raised by grandparents.

[ThankGodforAtheists]

I am fortunate enough to do what you have laid out. Many, many people are not. Credit is not a bad thing, in fact it is very important to the economy, especially now.

I know people that view the credit lines as a source of income. Mostly they live paycheck to paycheck. It is very sad. But they keep getting offers for new cards!! Why? Why are banks allowed to continue to send card offers to people whose credit reports must look horrible.

It wasn't that long ago that lenders would reel in desperate people with usery interest rates and when they couldn't pay they would go to debtors prison. How far we have come.

[Ricktay]

Here is the smoking gun. Below is the link to the 46-page HUD report that explains in great and entertaining detail exactly how the Bush administration partnered with lenders to create the credit crisis. You'll love how Bush had Fannie Mae commit exactly $700 billion dollars for this initiative (bottom of page 41 of the pdf, numbered as page 39 in the document). The document is called "Blueprint for the American Dream". Bush is quoted in it, and it lays out how credit worthiness standards were to be lowered.
Enjoy this, and everyone please disseminate as widely as possible. This completely refutes the GOP arguments that the Bush administration was not only complicit, but led the way.
http://www.hud.gov/news/releasedocs/blueprint.pdf
I had to use the Archive.org website to locate this, as HUD has apparently hidden it from their search and all existing links to the online document that I could find were broken.

[Poboy]

Good job, Ricktay.

You're right. It is the smoking gun, because it is the blueprint for the housing fiasco.

[laocoon]

I admit I know little about this topic but I only hear about new purchases of homes. Werent a lot of the bad mortgages from people taking presumed equity out of their homes to buy other things or to take care of other debt? It is always easy to criticize the consumer. what happens to a relatively poor person who sees their wages stagnant and then is hit with an unexpected crisis. they have little choice but to accept those loans which are available. the question of whether or not they can afford the loans takes a back seat when your only transportation needs a $5T repair or you have an uncovered medical need etc. this is why nations have usually regulated loans and their terms. the people selling the debt have a large incentive when unregulated to assure the borrower that they will be ok.

[tyrussell]

I live in CA and worked at a top Escrow and Title Co. and one thing I noticed was the lack of education about these products that the lower income people were obtaining. The excitement of getting a home outweighed the risk for them. I would sign loan papers with a borrower who would not read them. Had I not been involved in the lender side of the business I don't know how much I would have known. The bottom line is we need to educate home buyers about the risk they take before signing on the dotted line.

[gemcando06]

Hey, it wasn't the government calling on the phone to urge me to get an equity loan on my house even three times a day. I refused all of them.
And the mail - I must have thrown out pounds of equity loan offers and refinance offers. None of those were from the government either.

The Banks and Mortgage companies who called sounded so friendly, so generous, so interested in my interest.

[ProudAmerican23]

His article only goes 1/2 way into the cause. Yes, they did buy up those risky mortgages... What he didnt mention is why the banks granted those risky mortgages in the first place- lobbyist groups (like Acorn) pushed for "a home for everyone" and well they got it. those banks crumbled under the pressure of being accused of being called racist if they didnt grant those risky loans. Race had nothing to do with it - Risk and bad credit isnt a race issue but just like the current voter fraud investigations people are crying racism. what a bunch of B.S. I am certain that for the next several years banks will only loan to people with good credit (wow what a concept!) But Im also certain that in a couple years someone will cry foul and lobby congress to force them to loan anyone or they will claim that its racist and has nothing to do with credit... and we will start the whole mess over again.

[Henry]

And here I thought it was George Bush Jr who was taking credit becasue his administration wanted an "ownership" society. Tell us, was little George a member of the Acorn like groups or did he just argue their agenda?

[bannorhill]

There is a difference between ownership and over your head. Barnie Frank made sure you could get a loan even if you could not afford it.

[CCverve]

Further YOU fail to mention those loans coupled with CDS allowed Wall Street to sell those loans worldwide to pension funds,hedge funds and the like as much as 90 basis points over par value...Ever wonder why COUNTRYWIDE must repay 8 billion to borrowers? Sorrry Pal your argument of the good doers at ACORN being at the root cause doesn't hold water.. This was a perfect storm for predatory lending
1. Bush intros new society of ownership...equally welcomed by all
2. In the backoffices of Wall Street one Bylthe Masters of JP Morgan the inventor of the CDS says hmm..
3.People got suckered by some vaccuum cleaner salesmen who found new homes in the mortgage industry
4. Those loans were rapped with credit enhancers CDS (Credit Default Swaps)
5. Wall Street makes billions by infecting sick loans into the world economy
6. Tax payer gets stuck paying while losing 25% FMV of his home and 401k

[bellrich]

A Question to all you well educated people out there especially in the Free Market. What is free about the Free Market? Manufactures and Farmers limit production to drive up prices, fix prices to maximize profits and keeping any one company from becoming a Monopoly there by bring down the government Sherman Antitrust Act on them. Plus the many rules put on both Banks and the Stock Market to keep people from losing too much of their money there by damaging the economy. So with all this in mind should the government have more control over the Financial Systems to protect the working and middle classes?

[JPHR]

I am not sure if I am from the well educated category, but I will try:
Free markets are an illusion. Ideology invariably succeeds in producing frightening train wrecks. Any market needs some oversight or regulation if only to prevent for instance a oligo/monopoly. Although corporations are efficient organizational mechanisms, they are also narrow minded sometimes near sociopaths motivated by self interest only. So society has to define the framework within both markets and corporations operate.
This event will probably mean both the end of the extreme free market ideology and of of a financial system dominated by the USA. The USA will have to accept more that GAAP to IFRS, because the rest of the world will not willingly accept any more of such events.

[Henry]

Here is a big problem for the free market: It is the monopoly of the state that controls the interest rate floor(above which competititon exists) and has the authority to flood the market with money. The theory of free enterprise market capitalism argues that supply and demand are the governors of price. This theory assumes that the equilibrium price of money (int rates) would be determined by the market place. This is not true now. It has never been true. The simple point is how do you have a market equilibrium when the state has the monopoly of money. Just does not quite wash. Think for a second...if fed funds were 15.0% and not 1.5%... would there be more or less money. There would actually be less contrary to the theory, the higher the price the less supply. It is a gaping hole in the theory of free market capitalism.

[sposton]

You can zoom in onto any part of this financial meltdown and find plenty of local culprits but what are the true root causes? Martin Wolf's of Financial Times paints on a larger canvas so that we can see the broader reaches of this failure. Read

http://www.ft.com/cms/s/0/fba32c1e-9565-11dd-aedd-000077b07658.html

(make sure you look at the charts)

We cannot fix our financial mess without fixing the problems related to global trade and its consequences. But the financial interests and the MSM do not want you to think about that because you just might rebel against the whole rotten system they have devised to enrich themselves on the backs of the rest of us. We just might start thinking like socialists! ;-)

[the-lexicon]

I take issue with the author's statement that :

"...the blame also lies with homeowners, ...."

I don't know what kind of rock you were living under during the last 7 years, but home prices have risen so much that it makes your "bigger homes" statement ludicrous.

In the northeast, a 1200 square foot simple ranch house on a city lot went from being, say, $65,000, to being a quarter million dollars. And of course, everything up-market went up in price proportionately.

Meanwhile, wages were flat.

The guy gets a new job out of state. He has to sell his existing home, which is a 1200 sq ft ranch on a city lot. He bought it for $70,000, owes $65,000 on it, he can sell for $200,000, because the market's crazy. So he sells, and nets something like $120,000. He moves, and buys a comparable house. That 2 bedroom 1200 sq ft ranch in the new state is now $220,000, and let's say he puts down his whole $120,000. Same size house, but he's got a mortgage that's almost twice the size...$100,000

Today, the market sinks, so that house that he bought for $220,000 is now worth $165,000,

But, that doesn't really matter, because he lost his job today. In 4 months, the house will be foreclosed on,
I submit that this is the TYPICAL scenario, and the right-wing frame of the "buy myself a big bling bling house" guy is very much the myth.

lexicon

[ProudAmerican23]

Lexi - the scenerio you laid out is STILL the fault of the homeowner! He took an new job and moved... his choice. 4 years ago the stock market broke the 10,000 limit for the first time, everyone cheered. 4 years ago you never heard of "house flipping" and now there are 2 TV shows about it. If people didnt see that the market was being inflated faster then the reality then the fool and his money got parted!

[Rule Of Law]

When our President tells us to go shopping as he begins his second war, and His VP says in 2004 that Deficits Don't Matter, and the corporate owned media--both print and air--are filled with the blue sky bought and paid for Real Estate Brokers of America bs, about the booming market and profit to be made there and how rosy the economy is, did most average working Americans of average intelligence really stand a chance? No.

This was a con--plain and simple. Pump it up, then dump it, and go begging to the FED for even more money. The incentive for business was to churn cash and create as much debt as possible.

When Greenspan slammed rates to the floor back in 2003 and encouraged the bankers to sell "creative" mortgage products so that the churn would prop up the GDP and hide the fact that Bush's wars and tax cuts were bankrupting the country, we should have known the fix was in. But in this era of instant communication, we also have instant censorship!

And I'm still getting mortgage junk mail every single day!

[cqyates]

Thanks for the post. I lived in the SF Bay as a renter and you would have to prove that you made 3x the rent to get a place. Since rent on a decent place (esspecially if you are living as a family) is about 2000.00 a month, I would have to prove that I made 6,000.00 a month....or live in the Ghetto where my landlord didn't care that I was spending 80% of my income on rent. I think this mirrors the experience of most people i knew there.

[JPHR]

When putting blame on the homeowner Mr. Schram ignores the fact that a consumer/citizen/taxpayer/aspiring homeowner is definitely not an equal to the financial (self)services industry. Late 90' the financial services industry in te Netherlands started to offer mortgages with an investment component. So most of the premium was supposed to be invested in shares. That scam however hid the cost of the life insurance premium, the management fee for the investments etc. In the end government forced the companies involved to reimburse the consumer. Compare that to the practice in the US and especially with that outdated legal system dropping contracts with hundreds of pages on the doorstep of the consumer. Class action suit are no replacement for good consumer protection taking into account the very unequal position of the individual consumer versus the industry.
As a matter of fact McCain health plan is doing that again: putting the individual consumer versus the industry with overwhelming resources.

[1pappy]

I have to disagree with your statement "ignores the fact that a consumer/citizen/taxpayer/aspiring homeowner is definitely not an equal to the financial (self)services industry."
While it is true that the average Joe homeowner is not as well versed about home financing as someone in the financial services industry, Joe homeowner should know elementary addition and subtraction. Joe should be able to add income and subtract expenditures thus arriving at a budget. Belief in unlimited appreciation on Joes' home set Joe up to withdraw "equity" in the form of loans, or to "invest" in more house than he needed, and the finanical industry was eager to facilitate Joe. Where Joe went wrong was buying into the media hype of a lifestyle that he could not afford.

[WmC]

The problem with your analysis, pappy, is that it fails to take into consideration the rising re-sale price of homes. As long as prices continued to rise, the affordability of monthly payments was--to a certain extent--irrelevant. If you had trouble making the monthly payments you could turn around and sell and realize an immediate windfall.

Should mortgagees realized that prices could not continue to rise? Maybe. But lenders DEFINITELY should have known. Yet they continued to make loans based in income info that they knew was false.

[JPHR]

Tell that to that 90 year old who shot herself when evicted

[Robertx5]

The writer touches on the issue of credit default swaps, Am I right in believing that in respect of subprime mortgages you have the stupid position that there may be a total of say 2 trillion in value securitised, but there may be perhaps 20 trillion of credit default swaps outstanding on them, with Alt A and prime securitised mortgages leveraged up in the same way.?
If so surely the Government can at a stroke of the pen introduce 'insurable interest' legislation.
If you don't own the bonds you can't take out insurance (CDS) on them.
The unwinding of positions would be relatively easy, those betting on default will only have the premium that they have paid to worry about. I feel sure that the Insurance companies will be only too happy to return those in exchange for the cancellation of the insurance.
Perhaps at the same time the lawmakers can look at all those derivative contracts outstanding which exceed world GDP by a huge multipleand apply some common sense legislation too that as well.

[vox populi]

If unfettered self-interest and mono-manical greed (lassie-fare capitalism) were truly inevitable as claimed, that is , an undeniable "force of nature" like electricity, we should be very interested indeed in learning to control it, constrain it, and micro-regulate it and its application in society to the greatest extent possible.

But people are not psychotically self-centered, greedy, obsessives whose only goal is to maximize their own wealth at any given moment and whose only tool to achieve this is purely rational calculation of an infinite amount of perfect information (this is what classical econ models require) .

4 of 4
Our problem is nothing more mysterious and deep than market fundmentalist ideologues in high places subverting the carefully crafted system through look-aways.

There are no simple social systems. Social systems are lot less like gravity and motion and more like a carefully crafted computer program, or a carefully crafted scientific experiment. Each little thing has to be considered and accommodated and its the accumulation of a million of such little bits that makes the machine work.

Considered in this way, we're suffering from a market ideology whose proponents are impervious to real-world results and data just as much as the Communists did.

[Overd0g]

Unfortunately, using the government to try to control greed is like using nuclear weapons to control weeds.

[vox populi]

3 of 4
Regulation wasn't outfoxed by the Master of the Universe and quants on Wall Street. Rather, regulation wasn't DONE and existing laws weren't enforced.

We can live in a complex society if we check the worst impulses of people through laws and enforcement. The fact that this IS an extraordinary event tells the tale- the more severely your actions could effect people, the tighter regulation needs to be.

Since Reagan, the received wisdom has been to deregulate everything. This is based on a quasi-mystical notion that markets are "perfect" and always allocate resources in the most efficient ways, through a force called, anthropomorphically, "Adam Smith's invisible hand."

There are many problems with this notion of laisse fare capitalism. First and foremost is based on a theory of economics that is anti-scientific in its methods. Suffice it to say that real scientists, physicists for one, laugh out loud at the axioms of "classical economics. But read the award-winning book, "The Origin Of Wealth" for details.

Further, even if classical economic theory and laisse-fare DID allocate resources as its proponents claim (it does not), there's no reason to think that human happiness should in anyway be served by such a process, (although adherents are naturally constrained to claim the opposite).

For instance, evolution, a truly natural and real process, has no goal to create a better world for people. So it is with all other "real" natural systems- human happiness is not factored in.

[Overd0g]

Congress was bought and paid for by Fannie and Freddie.

[Rule Of Law]

No, the investment banks, recently liberated from oversight by Republican sponsored Deregulation, used Fannie and Freddie as a clearing house for their toxic mortgages.

[vox populi]

2 of 3

What happened here is the enforcement and regulation legs of this process simply did not do its job- exactly

1)
they permitted a debt instrument a "credit default swap" to come into existence which was in reality, an insurance policy . Companies issuing them were, in effect, in the insurance business. This should not have been permitted, since insurance companies are tightly regulated in exactly the manner needed so as to prevent their defaulting on their claims.

2)
the securitization of home loans exactly incentivized a "pass the trash" system of fraud on the part of bankers whereby they used all the techniques of Madison Avenue to bait people into risky mortgages. The practice of banks permitting falsification of required (by law) financial data was wide-spread and well known. This is a failure of enforcement of extant law- they knowingly looked the other way.
3)
The creation of perverse incentives (via securitization of home loans) was a clear failure of regulators to do their job. No such securitization should be permitted by law or be permitted by practice. You issue the loan, you live with the fall-out. Securitization should have been stopped and the possible consequences, (which were not obscure, hypothetical ones requiring great cleverness to foresee), should have been cited as the reason why they aren't permitted.

(con't)