CRY-SIS

I remember the thrill of buying my first home and the anticipation of waiting for the bank’s decision on our mortgage application. In that long forgotten era, the 1970s, buyers were required to put down 20 percent of the total loan and complete a myriad of paperwork proving their ability to pay.

During the last few years, buyers with no money, no job, no documents or no credit history received home mortgages without the kind of vetting we experienced. The most serious investment most of us ever made had evolved into an entitlement.

There are many things that converged to create the current financial crisis. We can start with the modification of The Community Reinvestment Act. This law forces banks to lower mortgage standards in depressed areas in exchange for favorable reviews by the Federal Reserve. In 1995 a sweeping change reduced the paperwork and verification process allowing less creditworthy buyers to obtain mortgages.

Sub-prime financing was off and running.

In 1999, The Gramm-Leach-Bliley Act set the stage to allow banks, insurance companies, brokerage and investment firms to cross the boundaries of mortgage limits created during the depression. This was another vital component in creating the drama unfolding today.

Following the dot-com crash and 9/11, the only part of the economy that thrived was housing and a number of people set out to make it even better. The prospect of easy money combined with easy loans propelled the housing boom. In any market, too much cash chasing too few assets will cause prices to rise.

It has been disclosed that over 60 percent of mortgage applicants lied on their applications either about their incomes or their intentions for the property. Many of these mortgages ended up covering investments and the purchases of second homes—not primary residences. Bizarre loan products allowed borrowers to pay almost nothing for a few years, allowing speculators to purchase multiple properties. The result: About one of every six homes in America has a mortgage in excess of its actual property value.

Mortgage lenders can be called predatory, and the real estate brokers criminal, but how many of us would refuse a virtually free house with the anticipation of appreciation as high as 15 to 20 percent each year?

Enter the investment banks unshackled by previous regulations. Investment banks took these sub-prime mortgages bundled them and then sold, split and resold new bundles; a derivatives market developed and credit default swaps became money-printing machines. We politely call a garbage dump a landfill, and now we have, ‘toxic assets,’ another euphemism for bad bundles that smell.

People assumed that Fannie Mae and Freddie Mac, the purchasers of many of these bad mortgages–to the tune of more than a trillion dollars during 2005-2007–carried an implicit government guarantee.

What caused this bubble to burst?

• • Greed on the part of everyone involved from the homebuyer to the investment bank on Wall Street.
• • The use of Fannie Mae and Freddie Mac by Congress as politically motivated money-laundering machines. Alan Greenspan and several departmental auditors warned the American public four years ago of improper bookkeeping and insane debt-equity ratios.
• • The failure by banks and investment firms to accurately report their real asset base and the incompetence of the bond-rating agencies.
• • Unrealistic pricing in the derivatives market based on computer models using archaic default ratios in an environment where actual defaults proved well above historic averages.

Now we will be footing the bill for idiotic legislation that lead to excesses that government chose to overlook instead of overseeing.

Here’s another bleak thought: Many sub-prime homeowners that got in early have gone on to take home equity loans and purchase cars with subsidized financing. Additionally, there are 1.5 billion credit cards currently issued in America or about nine for each family; credit card debt averages about $12,000/household. As the credit crunch becomes more acute, default will become widespread in the consumer credit market. This will affect insurance companies, banks and managed retirement plans.

On a more macro scale, states and municipalities will receive less income due to a huge drop in property tax collections and this year the federal government will receive little capital gains revenue. The $700 billion band-aid is miniscule compared to the unregulated $62 trillion derivatives markets that touches every financial institution in the world. However, it should be sufficient to allow Mr. Paulson to leave his post with dignity and foster the re-election of incumbent Congress people.

In a few weeks we will be choosing a new president. Neither candidate has any governing or global financial experience. Neither candidate has any experience running a business for profit as opposed to running a government in deficit. Neither has ever created private-sector jobs. I doubt if either candidate really understands the interlocking relationships within the global economy. Unfortunately, one of them will win, and more than likely, most of us will lose.