Laypeople who want to keep up to date have been reading much about the situation but I have yet to see a narrative explaining each significant step of the way. I do not pretend to know everything about this very complex set of facts and may err in some details but this is what happened.
The role of Freddie Mac, Fannie Mae and others you haven't heard of yet expanded in the 1960s because of the first rule of banking. That rules states "Don't lend long and borrow short". That means don't lend money on a mortgage for 30 years at, say 5%, and borrow money, mostly from savings accounts. The savings accounts could start out at 2% and escalate, because of market conditions, to 8%. This was the cause of Savings and Loan difficulties in the 60s. Savings and Loans had traditionally offered 30 year fixed rate mortgages from their depositors checking and savings accounts. Most bank failures were caused not by bad loans but failure to abide by this rule.
It appeared that the US was going to go to the same system that every other country, then and now, uses - namely Adjustable Rate Mortgages (ARMs). Then some genius pointed out that there was an almost unlimited market for fixed rate, high quality bonds. Pension funds, wealthy individuals, Mutual Funds, retirement accounts and foreign governments needed safe securities with a guaranteed return. Why not convert the mortgages into high grade securities, rated AAA by a bond rating agency, guaranteed by FHA in some cases, guaranteed by Freddie and Fanny which everyone knew to be the US Government? High standards of documentation were implemented to assure the bond rating agencies and the end buyers of the bonds that they were buying well documented and safe securities. This was done and the banks got rid of their exposure to changes in interest rates and had a lot more money to invest in mortgages. Typically $100,000,000 of mortgages were bundled together to be sold on Wall Street. The bundles are called collateralized debt obligations (CDOs). Investors in securities had a lot more product to choose from, home buyers kept their 30 year fixed rate mortgages and Wall Street generated very large fees for selling the new securities. This was truly one of the great win-wins of the century.
How did we get from there to here?
In 2002 we saw our first Nehemiah loan followed closely by Ameridream. This was an FHA program to get more buyers into their fist house. For a house listed and to be sold at $100,000 (for example) the offer would be written at $108,000 with the owner undertaking to give $8000 to Nehemiah/Ameridream. N/A would keep $1000 and donate $7000 towards the buyer's down payment and closing costs. FHA appraisers were encouraged to support this program with relaxed standards.
Experienced Realtors were, of course, horrified. Prices were driven artificially high and we could see trouble ahead with barely qualified buyers defaulting. We didn't know the half of it!
2003 to 2005 saw a general relaxation of mortgage lending standards. It turned out that Nehemiah/Ameridream were the thin end of the wedge. Banks and lending institutions didn't have to worry about foreclosures because it was only their money until they sold the loan. Realtors did their job getting the most money for their sellers and negotiating the best deal they could for their buyers. Some Mortgage Brokers were fraudulent in their dealings with unsophisticated buyers but, in general, did their job professionally. These professionals had to work with ever looser mortgage standards. The flood of buyers coming into the market escalated prices and new construction far beyond their natural levels to the increasing concern of the responsible members of these professions.
Why were mortgage lending standards relaxed?
In my opinion we need to look to Wall Street and Fannie and Freddie. All three invested huge amounts in lobbying to prevent regulators stepping in. Their companies were making large amounts of money from the selling of these collateralized mortgages. Twice as much profit can be made from selling twice as many CDOs. Further, look at the obscene numbers generated for the benefit of the most senior management of these companies. Basically dozens to hundreds of millions of dollars were taken in short term profits; money stolen from the future. This was the largest Ponzi scheme in history wrapped up in free market rhetoric.
How do you keep the bond ratings at AAA when half the mortgages in your CDO bundle are an accident waiting to happen?
You chop them up and mix them with the good stuff that's how. Then you make a deal with the Bond rating agencies that they only get paid if they come up with an AAA rating. This part was made easier because the Bond rating agencies only rate the technical aspects of the final bond, not the value of the underlying security - in this case the sub prime mortgages.
This still does not explain the depth of the crisis. If these CDOs are sold off the resulting foreclosures are someone else's problem, right? Some of the following is speculation on my part.
Why did so many of these institutions keep many of their fraudulently constructed CDOs?
- Sub Prime (Bad) mortgages were written at higher interest rates so the resulting CDOs showed higher returns while still rated AAA. The more money you borrow at less that the rate on the CDO the larger your leveraged return on is on your investment. Simply they forgot their own lies and invested in their own garbage. Eg $1000 CDO returning 10% = $100pa. Investment bank borrows $950 @ 8% and pays $76 interest to the investor. The bank makes $100-$76 = $24 but only has $50 of its own money invested. A $24 return on a $50 investment is 48%pa. The trouble is that if the CDO is only worth $925 the investment bank or Freddie and Fanny have to pay their investor back and make a $25 loss on top of it. Additionally, the CDO is a fixed rate and the money borrowed by the Investment Bank is short term variable rate money. See the first rule of banking. Since I wrote this I have had a further thought. If you keep the garbage CDOs your nominal rate of return remains high and you can go to the market and borrow still more money! Even more cynical than I first imagined!
- CEOs in the financial industry are largely paid on the same basis as manufacturing companies. If they get the stock price up, by increasing profits through any means including acquisitions, they are generously rewarded with stock options and bonuses. This model is totally unsuitable for financial institutions where security is paramount
- The market was probably wising up to the value of the later CDOs.
- Very few people and institutions protected themselves because everyone else was doing the same thing. This shows that these people aren't as smart as we thought they were and, further, it shows lack of character through willing to be a follower than a leader.
What are the Consequences for ordinary citizens?
Those who are losing their homes and those who are faced with escalating and unaffordable payments will do the best they can. Families will be living with lower living standards, children will wonder why they have to change schools and friends, and resentment and bitterness will run rampant until America's natural optimism reasserts itself.
Reduced spending brought about by caution, reduced capacity through increased payments; a likely recession will touch all our lives.
What are the consequences for the US?
This could well overshadow all the other consequences. The details of this fiasco are well known all over the world. All diplomatic, trade and military relationships with other countries, investors and institutions will be affected. We've been lecturing the world directly and through the World Bank on how to run their affairs and now we've created a much bigger mess that anyone else ever has.
Immense damage has been done to national prestige.
Where has the money gone?
It went to land owners who received too much for their property. It went to home owners who sold and decided to rent afterward, it went to CEOs and senior financial institution officers. It went to Bond rating agencies. It went to Wall Street insiders. It went to Lobbyists. It went to Realtors and Mortgage Brokers who got too much then and are paying for it now.
As explained previously the money was borrowed from the future by a relatively small number of people.
Whose Fault is it?
There is lots of blame to go round. I have arranged this part from most responsible to least. My opinion, of course, is from my position at near the bottom of the food chain.
- Wall Street and Fannie and Freddie. They have very smart people working for them. It's obvious that senior managers increased their huge income and bonuses by reducing mortgage standards. The result was predictable by the lowliest Realtors and Mortgage Brokers. However the efforts of Lobbyists headed off action by Congress. This was the most cynical action in our lifetime and the most damaging.
- Bond Rating Agencies. They created the gold standard for American securities and now they've destroyed it for the sake of quick profits and keeping customers. They knew what they were doing.
- Alan Greenspan and the Fed. Rates were lowered at the time of the High Tech bust (2001/2) but not brought back up when the economy recovered. At that time there was a huge pool of cash in the international market with little to invest in. Low short term borrowing rates with the availability of high long term CDO investment rates were irresistible. Greenspan was warned and ignored the problem.
- Big Banks. I believe some of the CEOs fall into the same category as #1. While it did as much damage I believe most of the rest simple did not have the guts to go against the flow.
- The Current Administration. With their attitude that big business is good they had no chance of grasping the problem.
- Congress. Too much attention to minor issues. Too easily distracted by Lobbyists.
- The Clinton Administration. Encouraged no down payment a la Nehemiah. Actually implemented later but started under Clinton.
- Realtors and Mortgage Brokers. At the later stages of the run-up many customers were completely out of their depth. Being honest would have cost them a commission. Higher mortgage standards would have saved these situations from becoming a moral challenge.
- Buyers. For many of the buyers committing to complicated mortgages they were simply acting irresponsibly. "I want it." Is not a good enough reason to make an irresponsible commitment. Please note that is not true for all those in trouble now.
- All of us. We want that new TV, car, boat, house NOW. We demand that our stocks show gains each quarter and will pay handsomely to make that happen. Slow and steady is not rewarded. But slow and steady, in the form of Warren Buffett, will profit hugely from this crisis encouraged by our impatience.
Who should be punished?
Those in #1 and #2 should be in jail for fraud. Those smash and grab CEOs from #3 should be prosecuted but it will be more difficult to prove.
Is the Bailout the right thing to do?
After the 1929 market crash it took the US three years to act. At that time it was believed that Government should never interfere in the working of the market. The Smoot Hartley Act placed tariffs on 21,000 imported items. International trade, imports and exports, plummeted. Unemployment reached 25% and homeowners lost paid off houses because they couldn't pay the property taxes.
When Franklin Roosevelt was elected he acted decisively. While it was slow - much damage had been done - the economy recovered. $700 billion is cheaper than 25% unemployment in my opinion.
Comments from my customer Jeff Fisher at The Origins of the Bank Bailout Part 2