I’ve spoken to lots of people in the recent months about the banks and investment companies, and the massive bailout they are receiving from you and me through the Congress of the United States. I have yet to find even one person who can explain the reasons for the bank and brokerage failures.
So, I’m writing this article as a simplified explanation of the reasons for the banking collapse and the bailouts.
First, let me say that my perception of most Americans is that they do not care much about the bailout. I feel that the biggest reason is that Congress simply authorized the printing of $700 billion paper dollars, and that did not affect Americans directly. If they would have been required to write checks to the Treasury to cover this amount, the bailout would not have occurred.
But, here is why the banks failed.
One of the biggest causes is the Community Reinvestment Act of 1977. That Carter Administration legislation forced banks and mortgage lenders to lend money to low-income borrowers despite their lack of credit worthiness. The government promoted “affordable housing,” and accused the lenders of “redlining”, which was refusing to lend to those in non-white low-income areas. The law had teeth, and banks who did not comply could lose their charter to operate a bank. So, bad loans were written to meet government quotas.
Pseudo-government bodies like Freddie Mac and Fannie Mae subsidized mortgages for people who would not have qualified for traditional mortgages.
So, gigantic amounts of money began chasing a limited supply of housing. When demand is greater than supply, prices rise. In that housing and lending climate, home values increased every year. With cheap, easy money, consumers looked at housing as a low-risk way to make money. And, people believed that housing prices would continue to appreciate each year. That created phantom house value that could be borrowed, using the home as collateral for the refinance or second mortgage.
Meanwhile, builders sprang into action and created a boom in new housing to meet the demand.
Banks and lenders created Structured Investment Vehicles (SIV) by gathering mortgages into large packages and selling them to unwitting investors. The banks and lenders earned big closing fees on the first mortgages. Then they sold the mortgage-backed securities and took another fee while getting the mortgages off their books. The mortgage-backed securities were sold to pension funds, big investors, money market funds and other banks all over the world.
Everything worked great as long as people paid their mortgages on time, housing values continued to increase, and demand for housing exceeded supply. But, the default rate began to climb as those un-creditworthy borrowers began to fall behind, and foreclosures skyrocketed. At the same time, the supply of homes exceeded demand, forcing home values to drop. Then, even creditworthy borrowers got caught in Adjustable Rate Mortgage resets that sometimes doubled their payments, forcing them into foreclosure.
The SIVs that were secured by mortgages were now in desperate trouble because the underlying mortgages were defaulting. The mortgages were the assets of the SIV, and they were vanishing. The financial institutions who held the SIVs now had investments that were losing money, and there was no market to re-sell the SIVs to anyone else.
The financial institutions were screwed. The borrowers were screwed. The housing industry was screwed.
Big financial companies began to post huge losses in 2008, and market value and share prices went into free-fall. The financial institutions cried to the politicians, and the politicians did what they always do…blame the wrong parties, and certainly not themselves. But they also did not fix any of the underlying causes of the debacle.
They just threw money at the problem. Your money.
It will take many years for housing and banking to recover. The only thing that would accelerate the recovery is to return to the failed policies that destroyed the markets. Housing values must regain sanity, and lending practices must become traditionally conservative again.