If you really want to know what contributed to this mortgage meltdow, I've done the research, this is worth the read; and please, follow my links.
This content is prepared for those outside the current "sound bite" culture.
The Culprit: The Subprime Mortgage. Before we begin our detective work, let’s define some terms. Subprime means just what it sounds like, less than prime. A subprime loan, given to a subprime borrower, is for the person who does not qualify for a prime loan, either because of bad credit, or not enough credit, or high income to debt ratio. There have always been subprime loans, in all kinds of industries, like credit cards and auto loans, for instance. They are often necessary for people to repair their credit. They are risky loans, but lenders have built-in factors to offset their risks, like higher interest rates, and private mortgage insurance. The problem started when subprime lending began to grow to a very risky level. It is estimated that 21% of current loans are subprime loans, including the infamous ARM’s, and the Stated-Income loans, or “liar loans”. In 1994, the estimate was 5%.
The natural question is What would incent banks to overuse these risky loans? That's the $64K question, I'm glad you asked! Especially since we now know that in 2006, about 61% of the people who got subprime mortgages had credit scores high enough for conventional loans.
The Accesory to the Crime: The Political Climate. The Political Climate of our time repeats the mantra: "Affordable Housing", the highest and best outcome, even at the cost of common business sense. Echoing this mantra are several Willing Accomplices.
Willing Accomplice #1: The Real Estate Boom and Bust. In hindsight, we see many factors that contributed to the Boom, and inevitably caused the ensuing Bust. Low interest rates, easy credit, inflow of foreign investment, all lead to increased demand. As with any market, the higher the demand, the more the price is driven up. Builders increased new home building, to the point of overbuilding. Add to this the growing number of Speculators, those who bought homes to flip, and the growing number of 2nd home- buyers. This number reached 40% of the homes bought in 2005, and 36% of the homes bought in 2006. Eventually affordability went out the window, you can only reduce interest rates so much. ARM's came due, demand ceased, credit tightened, high inventory of new homes, as well as exhisting homes on the market, it all sent prices plummeting. And here we are today.
Willing Accomplice #2: Securitization. Securitization has been used in different forms since the middle ages. In this country, we've experienced crisis no less than 6 times because of securitzation between the Civil War and WWII. This time, securitization of mortgages started in 1970. It is the process of taking money-making assets or financial receivables, bundling them and selling them to thir-party investors. The process frees up more capital so that banks can make more loans. The default risk gets spread around to all the investors. The problem came when an increasingly growing number of subprime loans got bundled into those MBS's. In 2001, 54% of subprime mortgages were securitized, compared to 75% in 2006. According to Alan Greenspan, securitization of these loans, not necessarily the loans themselves, is what led to the current glogal credit crisis. Keep in mind that the third-party investors are all over the world; they are your mom & dad's pension fund, they are my kids' college fund. Bet I can guess what your next question is...Why would anybody with any business sense do that?! Good Question!
Willing Accomplice #3: Credit Rating Agencies. Credit rating agencies are now under scrutiny for giving investment grade ratings (BBB - AAA paper) to these MBS's with subprime loans (C paper). These higher ratings brought on more funds from foreign investors, helping to finance the housing boom. The unbelievable fact is that these rating agencies are paid by the companies that bundle and sell the debt to investors. Can you say "conflict of interest"? The really bad news is that in light of this, many companies have had their investments downgraded, lowering their stock prices, requiring them to come up with tremendous capital to maintain their capital ratios. But this still does't answer your first question: What would incent banks to overuse these risky subprime loans? We need 3 more accomplices to complete the picture.
Willing Accomplice #4: Fannie Mae and Freddie Mac: Fannie Mae buys loans from mortgage originators, repackages the loans and sells them on the secondary mortgage markets. Freddie Mac was created in 1970 to compete with Fannie Mae. Fannie may also hold some of the loans in its own portfolio. Fannie provides a guarantee to its MBS’s by setting guidelines for the loans that it will accept, called “conforming” loans. So, I’m sure you’re about to guess what happened…yes, the guidelines were lossened up over the previous years to allow for more subprime loans to be acceptable. Here's the timeline:
In 1999 the Clinton Administration pressured Fannie Mae to ease its credit requirements for the mortgages it purchased, all in order to promote “affordable housing”, or mortgages to borrowers with low to moderate incomes. Fannie Mae started receiving credits for meeting the new affordable housing goals set by HUD. Shareholders also pressured them to lower its conventional credit standards to maintain its record profits.
But in 2004, these rules were abandoned for new rules that allowed high-risk loans to be counted again. Fannie Mae is in the midst of scandal over the "cooking of the books."
Willing Accomplice #5: The Community Reinvestment Act: The Community Reinvestment Act, and I encourage you to google it, was passed in 1977, as a follow-up to the Fair Housing Act of 1964, in an effort to address some legitimate discrimination. Those who maintain that it had nothing to do with the current crises site that it has been around since 1977. But it was fairly dormant until the 90’s. The CRA gave ratings to banks based on the amount of loans they gave to create affordable housing.
In 1989, in response to the savings and loan crisis of the 80’s, Congress passed the FIRREA, and part of the reform of the banking industry was to increase the oversight of the process of issuing CRA ratings to banks. This gave teeth to the Community Reinvestment Act, which made a huge difference to the dormant 1977 Act. It in essence, gave advocacy groups, like Acorn, power to influence the lending policies of banks. It’s unintended consequences: politicizing the bank’s lending practices.
This discussion brings me to my last
Willing Accomplice #6: Congress. The Real Culprits, who should have done something, could have done something, but wouldn’t. It’s always interesting to me that the general public blames the administration for most things, when it is Congress who actually spends our tax dollars, and Congress who had oversight of Fannie Mae, Freddie Mac, and who imposed the Community Reinvestment Act on us. Congress is the entity that votes on laws to regulate and deregulate. The Bush Administration proposed more regulation of Fannie Mae and Freddie Mac 17 times, (in 2008 alone) but were blocked by democrats in Congress. Congress only acted when it was too late, the house in 2007 and finally the senate in 2008. My intention is not to make this article partisan, so I encourage you to follow the links and decide for yourself.
So what now?
Let the Litigation Begin! In Feb. 2008, there were 278 civil lawsuits in federal courts related to the subprime crisis. The lawsuits in state courts haven’t been numbered.
Thankyou to all who made it to the end of the article, I hope you found it informative. I welcome critiques and comments. I also hope that the facts have made you, like they have me, a little angry, and a little more willing to dig for truth. I believe that the moral of the story doesn't get lost in the rhetoric: When political agendas and social engineering mess with tried and true common sense business, we the people always get screwed. Thanks for reading.
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