The meltdown and the bailout: why, how, and what they mean
By John Silveira
Issue #115 • January/February, 2009
To understand how the recent meltdown and bailout came about, you have to know what brought them on. According to some, there are PhDs who have problems grasping what happened. I don't know if that's true, but I don't think it has to be made that difficult.
If you're unfamiliar with some of the terms and the entities that are spoken of when discussing the issue, let's start here:
subprime This refers to borrowers with income levels that are too low, or who made extremely small down payments when buying a home (or no down payments at all), or have poor credit histories, or shaky employment (or none at all). They're the kind of borrowers traditional bankers do not want. Hence, they're less than prime.
Fannie Mae the Federal National Mortgage Association founded in 1938 under FDR, but made a "private" corporation in 1968, under Lyndon Johnson, as a Government Sponsored Enterprise (GSE). What you have to know about Fannie is that it's a quasi-government enterprise and that it doesn't grant mortgages. It buys mortgages from banks and other lending institutions, thereby creating a fluid "mortgage market." This is thought to be important for ensuring the availability of money for mortgages.
Freddie Mac Federal Home Loan Mortgage Corporation, another GSE. Other institutions couldn't compete with Fannie, so the government "invented" Freddie to compete with it.
Something else you must know about Fannie and Freddie is that they are the only two corporations in the Fortune 500 that, by government "regulation," do not have to make their accounting public to either the public or investors. This would eventually create problems.
You should also understand that in the "old days," when you got a mortgage it was almost always through a local bank. The bank loaned out the depositors' money and charged the mortgager interest. The bank held the "paper" or deed to the property and took the risk. It then used the interest paid against the mortgage to pay the depositors interest on their savings and took a portion of it to run the bank and make a profit. It worked.
But, nowadays, the bank is more likely to sell your mortgage and take the money it receives and loan it out, again. To whom is the mortgage sold? Often, it's Fannie or Freddie.
Under the old arrangement the local bank was responsible and accountable and the type of meltdown we so recently witnessed could not have happened.
Seeds of the meltdown
The seeds of the meltdown and bailout were planted with the Community Reinvestment Act (CRA) of 1977, passed into law under Jimmy Carter. The intent of the CRA was to ensure banks gave housing loans to low-income families. The Act wasn't just to encourage the banks, it actually created penalties with stiff fines for banks that didn't commit to making those loans, even if the bankers were convinced those loans were risky.
On the heels of the Act's passing came activist groups, such as the Association of Community Organizers for Reform Now (ACORN) which began to ensureand often bullybanks into making nontraditional loans. If banks didn't comply, the activists took them to court contending the loans were denied because of racist policies, not sound financial policies. The result was that banks, to avoid harassment and fines, began to lower credit standardseverywhere. They began granting mortgages to subprime borrowers.
Then, in 1993, under Bill Clinton, Fannie and Freddie were directed to increase the number of subprime loans they were carrying. Though there was initially some resistance, legislation was passed by a Republican-controlled Congress so the loans were ultimately guaranteed by...are you ready...you and me, the taxpayers. With pressure from regulators and the guarantee the taxpayers would bail them out, Fannie and Freddie understandably gave in and bought even more of these mortgages.
Finally, just months before Clinton left office, Fannie and Freddie were told they had to increase the number of subprime loans until they equalled half of what they carried in their portfolios. No prudent lender would have taken these risks, but Clinton felt Fannie and Freddie, both GSEs and both backed by the taxpayer, could "afford" to.
By 2004, many lending institutions realized Fannie and Freddie would buy up these mortgages, so they too could afford to grant these risky loans and "sell" them, along with their risks, to Fannie and Freddie. Hey, it wasn't just legal, it was what the Congress and community activists wanted. In all fairness, although the problem originated with Democratic Party policies, when the Republicans had a chance to correct it...well, they weren't going to be the bad guys who turned off the mortgage spigot.
In 2001, and now in control of both the Congress and the White House, many Republicans pretended that the CRA, Fannie, and Freddie were not problems just as the Democrats had done before them. Part of the reason seems to be that many Republicans, just as were many Democrats, were taking substantial campaign contributions from the two GSEs, and there was also the danger at that time that if you spoke out against the lending practices that today we know were unsound, you would be vilified by the press and castigated by community groupsaccused of being anti-poor, racist, or both. It was better to lay low, ignore the problem, and hope it would go away. And if it didn't go away, you hoped at least you wouldn't get blamed.
Housing takes off
The inevitable result of "easy" mortgages was that developers, conventional lending institutions, and borrowers started having a field day. Developers rushed to build, banks were eager to make loans to both the developers and home buyers, and high-risk borrowers were eager to get in on the "American Dream" of home ownership.
Increased demand in housing made the cost of houses rise faster than ever and also created the illusion that the price of housing had nowhere to go but up and would continue no matter how fast it was risingor how high it got.
Remember I said banks used to hold your mortgage? It's different, today. Nowadays the institutions originating the loans don't have to keep them. Banks and other lending institutions were now more willing to grant mortgages when they could quickly get rid of them, along with their risks. This is where the CRA met Fannie and Freddie and disaster came looming.
Buyers of the mortgages resold them. They bundled them together and each bundle is now called a mortgage backed security (MBS). Investment firms in turn bought these MBSs, pooled the mortgages from them, then "graded" and separated them into what are called "tranches." Tranche is just a French word meaning "slice." Some "slices" were the really good mortgages, owed by people you could expect to pay them off. Other slices were not so good and got a lower grade and so on down the line. The really good tranches paid very low returns because they carried the least risk. Lesser grades paid higher returns because they carried more risk. These graded tranches were called collateralized mortgage obligations, or CMOs, and they were sold as investments to pension plans, life insurance companies, investment firms, and others who bought them up because they're supposed to be safe investments and they were backed by you and me. And what did the financial institutions who sold these CMOs do with the funds they got from selling them? They used them to make loans for even more subprimes mortgages.
This availability of more mortgage money, of course, drove housing prices even higher. It seemed like the perfect plan to make everyone rich and happyas long as the housing market didn't tank. But now many pension plans, insurance companies, and other financial institutions that had invested heavily in the MBSs and CMOs began to depend on the worst part of the economy: the subprime borrowerspeople with shaky credit and living in overpriced houses. If those people stopped paying their mortgages, the whole system was going to be in danger.
What caused the meltdown?
And the price of housing was the proverbial fly in the ointment. From about 1980 until 2001, median housing costs had averaged between 2.9 and 3.1 times the median household income. By 2006 it had gone up to a high of 4.0 times the median household income. This meant that, in traditional markets, housing was now overpriced. Yet, peopleborrowers, banks, Fannie, Freddie, and Congresswanted to believe it still had nowhere to go but up. So, new housing starts, house refinancing, and the number of subprime loans all increased and demand made the "values" keep climbing. But like any other commodity, housing has no intrinsic value, i.e., you can only get for a product what another person is willing to pay, and new buyers began getting priced out of the market. Suddenly, buyers were in short supply. When that happens, prices dropand they did. As a result, many homeowners suddenly discovered:
- they owed more on their mortgages than their houses were worth
- there was no equity in their houses, so they couldn't refinance
- many who had taken the mortgages or refinancing at "teaser" rates found they couldn't make their new, larger payments and, with their houses worth less than they paid for them, they couldn't refinance them to get a fixed rate, and they couldn't sell them without losing money.
The net result was that, predictably, the housing bubble burst and people began to default on their mortgages.
When too many people started defaulting on their mortgagesand mortgages were the very heart of these CMOsno one any longer knew how much the CMOs were really worth. And because so many institutions, such as Lehman Brothers, Washington Mutual, and others including pension plans, insurance companies, had large investments in the CMOs, no one knew, anymore, what those institutions were worth. The result was that the stock values of the institutions began dropping. At the same time, no one wanted to give credit to those institutions because they had started looking like bad credit risks. In other words, those institutions were beginning to look like subprime borrowers themselves. It's that simple.
Now, involved in this were also credit insurers who were supposed to cover the CMOs if they went bad. But credit insurance is like hurricane insurance. It's only viable if it's a payout here and a payout there. But, when there are too many claimants in a hurricane, the insurer can't pay off. And that's what happened in the credit industry. The number of borrowers defaulting were like a massive hurricane moving through the financial markets. The credit insurers went broke trying to cover the bad debts, and markets began to free-fall.
Could it have been prevented?
Not everyone was blind to the dangers of subprime lending. As early as 2000 there were articles in financial publications such as the Wall Street Journal forecasting the dangers many saw on the horizon. And just a few years later the Republicans in the Senate sponsored the Federal Housing Enterprise Regulatory Reform Act of 2005 (S. 190), which would have capped the subprime holdings of Fannie and Freddie in an attempt to reduce those dangers. But it never made it to the Senate floor for a vote of the whole Senate because the Democratic minority found enough Republicans, at least some of whom were indebted to Fannie and Freddie, to block the vote. So it died and Freddie and Fannie went on with business as usual.
Had the bill come to a vote, and had it passed, would it have saved us from this mess? Would blocking more subprime mortgages and forcing the government-controlled Fannie and Freddie to divest themselves of many of them so they weren't carrying the burden of so much bad debt have stopped the meltdown? There are many who believe it would have. Had Fannie and Freddie stopped buying up the subprime loans, the subprime market would have started drying up and fewer irresponsible loans would have been made. But we can't go back in time to find that out. However, it was one of the last best hopes.
Then, in 2006, a similar bill to bring Fannie and Freddie under control was introduced but blocked by what was now a Democratic majority on the Committee. Perhaps their hearts were in the right place and the Democrats were not going to give up their dreams of affordable housing for the poor, no matter how unrealistic it was.
In the meantime, from 2005 to 2007, Fannie and Freddie added over a trillion dollars in bad mortgages to their portfolios. But, come 2007, the housing bubble was beginning to pop and the entire Senate was coming around to the fact that the two GSEs were a problem. But it was too late. Come January 2008, four percent of the subprime mortgages were in default and the delinquency rate was rising every day. This meant the CMOs continued dropping in value and the institutions holding them were beginning to falter. The whole stock market began to falter. By September the Dow-Jones Industrial Average had plunged over 3,000 points and several of the largest investment firms that were holding the subprime debt in the form of securities, such as Lehman Brothers, went into bankruptcy while others, such as Washington Mutual, were gobbled up by competitors.
This has been described as a failure of the free-market system and leaders from both parties, including John McCain and Barack Obama, made the charge that the meltdown came about because of corporate greed. Both refused to acknowledge that the seeds of the meltdown began in Washington, D.C., and, when measures could have been implemented that would have started undoing the bad government decision, members of Congress got in the way.
Many congressmen have proclaimed the meltdown occurred because there wasn't enough oversight and that it was preventablebut they had fought against any changes for years.
President Bush said recently, "The market is not functioning properly." Of course it wasn't; it was being regulated by people who were trying to force markets to do things no prudent man would or should do. The regulators allowed Fannie and Freddie to operate without opening up their books, twisted them for political ends, and forced them to make unsound fiscal moves. The one thing you will not see is the Democrats admit they screwed up. The one thing you won't hear the Republicans say is that they lost their courage when they had a chance to correct it.
One of the problems, according to many market critics, is that the industry wasn't regulated enough. In truth it was regulated too much. It was manipulated by politicians. It was the push of politicians to make more risky mortgages available while allowing the two largest mortgage buyers, Fannie and Freddie, to keep their books closed to the public. The regulators were not only aware of the risky loans, they mandated them. And because Fannie and Freddie are backed by the government, they can and do take risks no private company can take and stay in businessor even escape the scrutiny of regulators. And take risks they did.
What's the bailout for?
The reason Washington said we need the bailout is to prevent the implosion of the credit markets and shore them up so there will still be a free flow of credit and stave off a full-blown depression.
The politicians are using scare tactics and they keep harking back to the Great Depression, telling us that without the bailout we're going to see another depression that will rival that one. What they don't tell you is that starting with Hoover in 1929, and then accelerating under Roosevelt, the President who followed him, the U.S. Government tried to spend its way out of the Great Depressionand failed. We not only wound up with a depression that was the longest in American history, but in 1937 we got a depression within the Great Depression. All despite Washington's fixes.
Many economists now feel that had Washington stayed out of it, not have tried to spend the country's way out, the markets would have self-corrected and what became an unfathomable depression would have been an economic downturn that would have lasted just a few years.
This bailout is just another attempt to throw money at economic trouble, and the danger is that, like the Great Depression, the problem will go on, get worse and worse, and there will be more bailouts until we do have another depression.
Quite frankly, we're hearing all this from the people who created the problem, and didn't see it coming, but who now know the "fix." Meanwhile, the free-market people had been warning us for years that what we have now was inevitable, but are members of Congress or Wall Street-types asking them for any input? No!
The purpose of the free market is to let the consumer speak directly through his money. As a result, those who serve the free market get rewarded, while those who don't get punished.
The bailout is not bailing out the American public; it's bailing out the people who caused this mess, including the politicians who had a hand in it. It isn't to save poor people with mortgages, but to save the investors who made bad choices and bought those mortgages. It is to save the stock holders who made bad investments. Half the actual bailout money goes to foreigners, most notably Arabs and the Chinese who made bad investments. But it will not make the bad mortgages good.
The bailout is punishing those who have acted responsibly while rewarding those who didn't.
We could have taken the bailout money and have paid off or paid down to manageable sizes all of the bad mortgages. But why should you and I, who pay our bills on time, have to do that? Why do we have to bail out Wall Street?
Where's the money from the bailout coming from? Actually, there is no money. Congress and the Federal Reserve are simply "creating" the money. But that extra money dilutes the money in existenceinflation. If you don't understand that inflation is really another way of taxing us, you haven't been paying attention to how government works. You're paying for the bailout.
So, what did the bailout accomplish? It pulled the butts of the creditors and investors out of the fire. In other words, people who had made bad loans and investments are the ones being saved, not the homeowners. It saves the money of foreign investors, mostly notably the Chinese and Arabs.
What would have happened without the bailout? Banks would have failed. That is, they'd have gone bankrupt. The owners of the banks, the stockholders, would have had to sell off their assets. The banks would then have new owners. And those who owe on their mortgages would still have to either pay their mortgages or be foreclosed on. That is, from the borrower's point of view, nothing would have changed.
In the meantime, housing prices would have dropped further and the irony is they would have become more affordable to the poor and to other people who previously could not afford them but had shown restraint.
We don't yet know if the bailout is going to work. And it most likely won't. We don't even know if there are going to be more bailouts, though there are already stirrings in Washington that there will not only be more money needed for the subprime mess, but there's already talk abut bailing out the auto industry, student loans, credit card companies, various states, and who knows who else is asking to be "saved."
But this bailout and and future bailouts are clear signals from Washington that it's okay to engage in risky economic behavior because you and I will pick up the tab when they fail. Those who get bailed out are always grateful, while those who pay for the bailout usually don't understand that they're the ones paying for it either directly through their taxes or by having their money eroded by inflation. And the politicians and bureaucrats are grateful for it because there are always strings attached to these bailouts and they aggrandize more power. This bailout is actually more socialization of the banking industry; future bailouts will be for the socialization of America, creating more centralized control of America from Washington.
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