Thursday, September 18, 2008

The Current Crisis in the Financial Markets: What Caused it?

I am personally very uncomfortable with the recent federal bailouts of investment bank Bear-Sterns and Insurance company AIG, with the quasi-independent Fannie Mae-Freddie Mac intervention the possible exception. Fannie and Freddie are only partly independent anyway, and are called Government Sponsored Enterprises. They have (had—all have been fired and replaced) their own boards and CEO’s and their stock can be purchased on the open market. They are regulated and overseen by Congress and the administration, but they are technically private corporations, or were, anyway.

Their role in the mortgage industry is to expand home ownership by buying mortgages on the secondary markets, then bundling and repackaging them into “mortgage backed securities” (MBS). The idea behind the MBS’s is to bundle higher risk mortgages (with higher rates of return) with lower risk mortgages (lower rates of return) to balance and mitigate risk to investors while maintaining a decent composite return on their investment (in the MBS’s).
In the days of the Great Depression—when Fannie was born—no other entity would or could (by law) create MBS’s. Freddie was created in the 1970s to offer some competition to Fannie.

Legislation in the late 1990’s allowed commercial banks and investment banks to merge and consolidate their operations. The objective was to introduce even more competition to the financial services industry, and to offer consumers more choice and bring innovation. This allowed the investment banks to package their own loans from their commercial banking operations into so-called ‘private label’ MBS’s, and then sell them on the open market.

Couple this new competitive landscape with other legislation in the 1990’s that required lending institutions to offer mortgages to all areas and customers they served, eliminating what was called “red lining”, and you have a recipe for disaster. The banks were required by GOVERNMENT REGULATION to offer loans to people with poor credit or no credit. To mitigate their risk, the banks came up with, and regulators allowed new sub-prime lending rules, and then could repackage these sub-prime loans with high quality loans and then sell them off as MBS’s. The profits from these MBS turned out to be incredibly lucrative.

All of a sudden more people could buy houses, then the housing bubble began to build, then it popped, sub-prime mortgages began to go into default, and now blood runs down Wall Street.

As is so often the case, (and as I fear it will be again with the “solutions” to anthropogenic global warming) the good intentions of the Clinton Administration and the Republican-controlled Congress (at the time) ended up delivering a crushing blow to many low-income people. They will feel the brunt of this crisis, not anyone on Wall Street.

As my dad always used to say, ‘the road to Hell is paved with good intentions’.