Wednesday, February 25, 2009

Top 3: Most Responsible Parties for Economic Crisis

Over the last few months, we’ve all been watching as the economy has made like the body of a European runway model: fed on itself and slowly disintegrated. I’ve seen and heard quite a bit in the papers and on television about the causes of this crisis and who is to blame. It appears that many blame Wall Street. I cannot totally disagree with that. Much of the proliferation of the economic downturn was caused by the investment banks and their “greed is good” philosophies; however I would not be so quick to make Wall Street such a convenient scapegoat. With an economic crisis so widespread it’s impossible for the blame to go to one group. Many are responsible for this problem, and by my estimation, the most culpable might have even lived next door to you:

3) The Clinton Administration: You remember these folks don’t you? They can hardly escape this list. Before they were caught stealing the silverware on their way out of the White House in 2000, they spent the better part of the 90’s pushing housing policies that made home ownership more affordable to lower income Americans. These policies helped create such conditions as: increased lending to people with poor credit history, borrowing with little or no down payment, adjustable rate mortgages with irresponsibly low teaser rates.

The Clinton administration pushed housing policies (with Fannie Mae and Freddie Mac as an accessory) that helped create a sector of the population that a)simply could not afford the homes they lived in or b) could only afford the homes they lived in based on favorable market and interest rate conditions (which were allowed to get to recklessly low levels under Alan Greenspan). This faction of homeowners might as well have acted as the pin that eventually popped the housing bubble.

2) Wall Street: If you think of the economic crisis as a breakout of poison ivy, Wall Street’s influence would not be involved in the initial infection, but rather the scratching that makes it ten times worse. Investment banks, hedge funds, brokerage houses, and most all financial institutions were guilty of not seeing the inherent risks in betting the house in financial instruments tied to the housing market.

Individual home mortgages do not exist in vacuums. They are often sold off and packaged into securitized and collateralized bundles that can be bought and sold in the markets. A bundle might include thousands of individual mortgages. Without going into too much detail here, the common wisdom was that an individual mortgage is riskier than a package of them. Basically, because your exposure to delinquent payments is mitigated averaged out many mortgages. Agencies that rate financial instruments failed to see the danger of the interconnectedness of the housing market (a potential wide-spread reason/cause that would have mortgages going bad) and rated the mortgage packages based on historical mortgage repayment levels. They were given high ratings. Many even as high as AAA.

Even though they were rated as high as AAA, these mortgage securities often “paid off” slightly higher most AAA securities. Historically Wall Street smells a potential arbitrage like this like a shark smells blood in the water. They threw huge sums of money at the opportunity to make small percentage points on a single trade. It was not uncommon to risk something like $1 Billion, on a securitized mortgage related trade, with the hopes of making like $10 million….which sounds like a lot, until you realize that’s only 1%.

When the housing market started to fail these financial instruments failed, these banks were left open to hundreds of billions of dollars worth of exposure. Moreover, each Wall Street firm is/was so heavily invested in the other banks and funds, as one failed they all failed….like a house of cards.

1) Your friends and FORMER neighbors: Conventional wisdom had once held that the housing market would always go up and was an impregnable investment. However, blood-letting was also once conventional wisdom as well.

People bought houses that were way out of their means. Don’t want to stomp on the American dream, but it’s very simple: people with bad credit and 30K yearly income should not own $3 million dollar homes. What’s more people knew that they couldn’t afford these homes, but because of the low “teaser” rate mortgages and nearly zero-down loans they were allowed to enter in mortgages. The thinking was, “Well, I can afford the mortgage payments for right now….when the rates go up and I can’t make the payments anymore I’ll just sell the house. By that time it will have appreciated in value and I’ll just make ten grand or so off the difference. No harm no foul.”

Little thing happened on the way to the bank: the housing market back-tracked. The impregnable investment became pregnable. People failed on their mortgage payments and sold their homes at a loss (if they were able to sell at all). This happened at widespread levels and (with aforementioned help of financial institutions) permeated the entire economy.

Lack of controls in the credit market was a problem….super low interest rates didn’t help…politicians grandstanding for more home ownership wasn’t the greatest either….but individual people should have been more responsible in buying homes and entering into mortgages that they could reasonably afford.

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