Saturday, September 20, 2008

Origins of the Subprime Crisis

Over the past few months, America’s financial sector has been hit with its largest crisis since the Great Depression. The crisis began with a rise in foreclosures and the failure of some small banks. The problem spread to investment company Bear Stearns failed in May 2008. Liquidation was avoided by a government-orchestrated takeover of the company by JP Morgan. Bailouts of Fannie Mae and Freddie Mac followed. Over the past week, two prominent companies failed. Lehman Brothers, another investment bank, was liquidated, while American International Group (AIG), an insurance conglomerate, was judged by the Federal Reserve to be too big to fail. This prompted the government to bail out AIG by purchasing an 80% interest in the company with taxpayer dollars.

As the crisis grows, there are more and more calls for increased regulation on Wall Street. To determine whether regulation will solve the problem, the cause of the problem must first be determined. If the source of the problem is not simply short selling, fraud, or basic greed, then new regulation might cause further problems instead of resolving our current ones.

When we delve deeply into the causes of the crisis, it is soon apparent that lack of regulation is not necessarily the problem. Along with healthcare and commercial aviation, finance is one of the most heavily regulated sectors of the US economy. The law of unintended consequences states that any purposeful action will produce unintended consequences. An example of unintended consequences is the passage of the Renewable Fuels Standard in 2007. This law was intended to lower fuel prices by mandating increased production of ethanol. Instead, the net result was that food prices almost doubled while oil prices kept rising. With that in mind, we should look at some of the regulations that the government has enacted on the banking industry.

Many point to the Community Reinvestment Act of 1977. This Carter-era law was intended to combat the practice of “redlining,” denying credit to people who live in certain areas. The law’s language was originally so vague that it only required banks to show a good faith effort. This began to change when the law was strengthened in amended in 1989 to grade banks on a four-point scale and to make these reviews public. In 1991, Congress passed the FDIC Improvement Act, allow regulators to consider a bank’s CRA performance when processing applications for FDIC services.

The law was strengthened yet again by President Clinton in 1995. The Clinton Administration changed compliance of the law from a matter of making an effort to one based on hard numbers of specific loans and specific levels of service. It also significantly stepped up enforcement of the law.

Since the passage of the CRA, the purchase of mortgages by minorities and in minority neighborhoods has risen sharply. The problem is that the underlying assumption that minority loans were denied on the basis of racism rather than credit turned out to be erroneous. According to a 1999 report by Freddie Mac, one of the mortgage companies now in dire straits, revealed that African-Americans have disproportionately large number of credit problems. For example, the report states that on average blacks with incomes of $65-70,000 per year have more credit problems than whites with an income of under $25,000. Consequently, as banks were pressured to make more loans to minorities and low-income borrowers, they were also making more loans to people who were poor credit risks.

A second possible root of the current crisis is the repeal of the Glass-Steagall Act. The Glass-Steagall Act was passed in 1933 during the height of the Great Depression. The banks of the era were accused of speculating in unsound investments. Banks would make loans to companies that were shaky, and would then recommend the same company’s stocks for their investment clients. The GSA established a wall between investment banks and commercial banks. The law was intended to prevent the use of deposit accounts to cover a bank’s investment losses.

In 1999, President Clinton signed the Gramm-Leach-Billey Act into law and repealed the GSA. This was done to make banks more competitive with foreign companies that offered a broader range of financial services. In addition to removing the barriers between banking and investing, the GLBA also allowed banks to offer insurance-related services. The predictable result of an increase in the number of sellers in the marketplace was more competition for the available investors.

At the same time, the United States was experiencing an economic boom. The Federal Reserve under Alan Greenspan was aggressively cutting interest rates. The inexpensive cost of borrowing money combined federal pressure for banks to lend to low-income borrowers. As the competition among lenders became fierce, banks began issuing loans that were more and more risky. Loans were made to borrowers without down payments, without income verification, or with poor credit records.

Borrowers who wanted more house than they could afford were sold Adjustable Rate Mortgages (ARMs). These loans had low interest rates and payments at inception, but since interest rates were at historic lows, both the rate on the mortgage and the mortgage payment had nowhere to go but up. In some loans, teaser rates were artificially low at first, and then adjusted sharply upward. In any case, as payments rose, borrowers found that they could no longer afford their homes. Tightening credit made it impossible to refinance into a fixed rate loan and falling real estate prices made it impossible to sell the home for enough money to pay off the loan. For many, the result was foreclosure.

Yet another commonly cited source of financial problems for companies is a change to arcane accounting rules that occurred over the past fifteen years. In the past, companies used cost accounting, which applies historical costs to a company’s their assets. More recently, the SEC and the Financial Accounting Standards Board have changed accounting rules to a method known as Fair Value Accounting. Assets are now valued at their market price. In other words, assets are valued not by their true economic value, but by what they can be bought or sold for on the current market.

The obvious problem is that when a market suffers a sharp decline, so does the value of the company’s assets. It doesn’t matter that the decline may only be temporary or that the company had planned to hold the assets for the long term. In effect a company’s holdings are required to be valued at an unrealistically low price. When the market was high, fair value accounting was one of the tools used to artificially inflate Enron’s bottom line.

In aviation, there is the concept of an accident chain. There are few instances in which an accident is caused by only factor. In most cases, there are multiple factors that link together to form an accident chain. If any of the factors are missing, the chain is broken and the accident does not occur.

The subprime mortgage crisis is also the result of numerous factors. Government pressure convinced banks to make risky loans. Low interest rates, deregulation, and increased competition all combined to fuel a housing bubble that eventually burst in 2007. When the bubble burst, fair value accounting principles exacerbated the problem by magnifying the decrease in value of the securities held by banks.

Old-fashioned greed also undoubtedly played a role. Some companies, such as Countrywide Financial, focused almost exclusively on the subprime market. Many of these companies did not service their loans, but instead immediately bundled them into mortgage-backed securities and sold them to other companies, such as Fannie Mae and Freddie Mac. In this way, the cancer of failing mortgages was metastasized throughout the financial community.

Some lenders engaged in predatory lending practices. Likewise some borrowers defrauded banks. For whatever reason, many borrowers were either misinformed or failed to care about the terms of the loans that they obtained. Bad loans were either sold off to other companies or the homeowner simply walked away from the house, leaving the bank to foreclose.

Hedge funds, aggressive funds that catered to limited numbers of ultra-wealthy clients, snapped up risky financial products in their attempt to boost returns. Naked shorting, selling short without having stocks to cover the position, occurred even though the SEC considered the practice fraud and attempted to rein it in.

The greed and fraud did not stop within the bounds of the financial community. Countrywide made loans with generous terms to VIP borrowers. The list of Friends of Anthony (Mozilo, Countrywide’s founder and CEO) is long and distinguished. Democratic Senators Chris Dodd, chairman of the Senate Banking Committee, and Kent Conrad received favorable loans from Countrywide. So did numerous members of the Clinton Administration such as cabinet members Alphonso Jackson and Donna Shalala, staffer Paul Begala, and Postmaster General John Potter. Henry Cisneros, Clinton’s secretary of Housing and Urban Development was a former Countrywide director. Franklin Raines and Jim Johnson, former CEOs of Fannie Mae as well as fundraisers and advisors to Barack Obama, also received preferential loans from Countrywide.

In 2003, three years before the crisis broke; President Bush did make an attempt at reforming Fannie Mae and Freddie Mac. The housing industry and realtors opposed the plan, which went nowhere.

Representative Barney Frank of Massachusetts, now chairman of the House Financial Services Committee said, “These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

In 2005, John McCain sponsored the Federal Housing Enterprise Regulatory Reform Act. This law would have established a new independent regulatory agency to oversee Fannie Mae and Freddie Mac. Unfortunately, the bill was allowed to die in committee; the same committee headed by Friend of Anthony Chris Dodd.

There is another saying in aviation: “Don’t just do something. Sit there.” Hastily doing the wrong thing is often worse than doing nothing at all. Government pressures and corruption were largely responsible for the unfolding financial crisis. Hasty and ill-advised additional regulation is more likely to make the problem worse instead of resolving it.

“How To Save the Financial System,” William M. Isaac, Wall St. Journal, September 19, 2008


Dave Keys said...

You've described me to the nth degree. I was one of those who thought they'd buy a spec home on a 5 yr ARM. This forced the sale of my primary residence in a declining market to get the little equity out and try to get out of the loan on the spec home that became our new primary. The strategy looked good on paper but the house took a year to sell and the spec home went upside-down. Now it's a matter of time before that chicken comes home to roost.

Dave Keys | Temecula Photography

CaptainKudzu said...

After posting this article, I found that Barack Obama was the second highest recipient of campaign contributions from Fannie Mae and Freddie Mac. Obama received more than $125,000 between 1989 and 2008, in spite of the fact that he only entered Congress in 2005. In three years, Obama amassed more money from Fannie and Freddie than most members of congress did in twenty years.