The Subprime Mortgage Crisis

Cause, Consequences, and Cure

The current subprime crisis. Who doesn't first of all think of greedy bankers who profit from the poor? Yet, the roots of today's financial crisis date back to the presidency of Lyndon B Johnson who started the avalanche with a little-known law: the Fair Housing Act.

The Avalanche Starts: Introduction to Structural Problems Causing the Current Crisis

Before we go into details of the current financial crisis (in the U.S.A.), it is very important to analyze its origin and the structure of the system that caused it. In the aftermath of the stock market crash of 1929, the US government spent a few years trying to contain the long-term adverse effects. Since speculation by banks was the root cause of the Great Depression, and one of the results was the loss of the deposits in the banks, the US government tried to protect the people who owned money in bank accounts from potential bankruptcies and also to reduce the influence of giant financial enterprises. This was accomplished 1933, four years after the start of the Great Depression, with the passage of the Glass-Steagall Act. The Glass-Steagall Act divided the banks who survived the 1929 stock market crash into investment banks and commercial banks. From then on, investment banks would be allowed to engage in high-risk trading but wouldn't be able to hold deposits, while commercial banks wouldn't be able to engage in high-risk trading but could hold deposits. The premise behind this law was to limit the size of banks, prevent collusion between investment and commercial banks, and if a bank failed, to protect consumers from losing the money in their bank's accounts. Another important federal government creation during the 1930's was Fannie Mae. At that time Fannie Mae was a government agency tasked with providing affordable mortgages to low-income people, who otherwise would not be able to do so. Since the US government stood behind Fannie Mae as its primary backer, the agency has been able to borrow money at lower interest rates, something no other bank in the US could have. In the 1960's Fannie Mae and Freddie Mac were "privatized", with the government retaining its oversight and serving as its primary backer. This allowed Fannie Mae and Freddie Mac to pass all profits to its shareholders without taking any risk (the risk was carried by the US government). In 1968, president L.B. Johnson signed the Fair Housing Act with intent to make homeownership more easily obtainable for underpriviliged communities. FHA criminalized practices such as redlining, and established the Fair Housing Agency to enforce the new rules. The Community Reinvestment Acts of 1977 and 1995 further expanded the government authority to steer banks towards offering mortgages to people who could not afford them.

The Avalanche Rolls: How and Why the Crisis Started

Credit rates at which the banks borrow money are regulated by the Federal Reserve, while credit ratings are regulated by the Federal Deposit Insurance Corporation (FDIC). The Community Reinvestment Act empowers regulators to monitor banks' compliance with the act, and this has been used as a tool to force the banks to go into neighborhoods and give loans without necessary preconditions to ensure their repayment. If banks are found to be in "violation" of CRA, then the regulators can impose upon them conditions powerful enough to drive them out of business. Under the pressure from the US government and the threat of closure, banks have been compelled to offer mortgages to people who couldn't afford them. These are often called NINJA subprime mortgages because they don't require proof of income, a job, or assets to obtain them. The banks know the risks associated with these practices, but the fear of the government lowering their credit ratings and the "encouragement" by the government forced them into providing those loans anyway. Commercial banks kept borrowing money due to low interest rates set by the FED (as shown in graph below, source: www.federalreserve.gov/releases/), and expanding the number of subprime mortgages.

As the number of subprime mortgages increased, investment banks bought them and expanded their CDO portfolios with subprime securities. Keeping these high risk CDOs is profitable as long as the investors have the confidence that they would make money in the future. Raising capital from investors is essential to keep investment banks running because of their high leverage ratio, and uneven profit cycle. Problems leading to the failure of investment banks started with the subsequent waves of foreclosures on homes whose mortgage holders could no longer make the payments (see graph below, source: economist.com).

Fissured foundations

As the number of foreclosures skyrocketed, the value of CDOs dropped drastically and risk increased astronomically. Since investment banks raise money from investors based on their assets, and CDOs are their primary assets, the constantly decreasing value of CDOs meant that the capital needed for day-to-day operations of investment banks could no longer be raised because no investors would invest money into something with constantly decreasing value. This unavailability of capital led to the bankruptcies of these investment banks.

In the Path of the Avalanche: The Consequences; Who Is To Blame; How To Prevent Its Reoccurence

As a consequence of the crisis, investment banks have ceased to exist in the USA:

Lehman Bros. has declared bankruptcy

Bear Sterns was acquired by JPMorgan with government subsidies and will no longer be an investment bank (will become a quasi-commercial bank)

Merrill Lynch was acquired by the Bank of America, and will no longer be an investment bank (will become a quasi-commercial bank)

Morgan Stanley will no longer be an investment bank (will become a quasi-commercial bank)

Goldman Sachs will probably follow the lead of Morgan Stanley and Merrill Lynch

The role of investment banks in the USA will be replaced with hedge funds and private equity funds, but unfortunately these entities cannot reach the potential and profitability of investment banks because of regulations governing their business conduct. Investment banks trade in highly profitable high risk securities, and when they make profit, so does the Federal government (via taxes). This is no longer an option, and the tax revenue coming from investment banks is about to dry out. Some foreign investment banks were also affected by this crisis, but will survive. New York City used to be the financial capital of the world, but this started shifting after the Sarbanes-Oxley Act, and this latest blow will ultimately put an end to its reign (source: nytimes.com). In simpler words: USA lost, Asia and UK won.

Starting with L.B. Johnson, the blame for this financial meltdown lies primarily with liberal politicians in Washington DC, who have refused to reform Fannie Mae and Freddie Mac in time (namely Barney Franks(D-MA) and Chris Dodd (D-CT) ), and have pushed for an expansion of subprime mortgages to people who couldn't afford them. Barney Franks, chair of the House Financial Services committee, refused to investigate Fannie Mae for improprieties, as long as Fannie Mae continued to expand its "affordable" housing program (source: businessandmedia.org). Members of the Republican party actually warned about the looming problem for years and have tried to reform Fannie Mae and Freddie Mac, most recently in 2003 (source: nytimes.com), and in 2005 when their proposal was defeated in the US Senate Committee Banking , Housing and Urban affairs (source: online.wsj.com).

Nowadays, it seems as if most politicians see more regulations as the solution to prevent this catastrophe from happening again. They blame investment banks for trading in high risk securities, but they fail to address the reasons for existence of these securities in the first place. These high risk securities for subprime mortgages exist because of politicians who urged and supported the creation of subprime mortgages. More regulations will potentially kill the rest of financial transaction firms in the USA.

Moreover, the $700 billion bailout will have no benefit in the long run. Although the bailout may help many people in the immediate future, the federal treasury will have to be replenished by exactly those $700 billion - by means of higher taxation. In the end, therefore, nobody will have more money than before.

If more regulations are to be considered, then they should be used to self-regulate DC politicians. In other words, banks should not be told how to run their business, influence of politicans in overseeing and regulating their conduct should be severely curtailed, Fannie Mae and Freddie Mac privatized, Sarbanes-Oxley , CRA, and FHA repealed.

More on the subprime crisis

The analysis continues here.

For a short entertaining version of this aricle, check out this video.

Another summary of the events is provided by Director Blue's blog, and a hilarious and entertaining variation of the theme by the same author: Director Blue's Obamanopoly.

Last, but not least, there are still those who claim that the CRA had nothing to do with the subprime crisis. Click here for the analysis of the anatomy of a typical article in that category.

And if you really want to know more, this article by the Heartland institute provides an overview of the consequences of the CRA and als provides several excellent links to further reading.

Glossary

COLLATERALIZED DEBT OBLIGATIONS (CDOs)- bundles of high risk securities backed by assets. Held by investment banks

COMMERCIAL BANK (or BANK HOLDING COMPANY)-A bank that requires a deposit, has limited trading abilities (doesn't trade securities), characterized by low leverage ratio (approx. 10:1) Examples: Bank of America, Wachovia....

COMMUNITY REINVESTMENT ACT (1977 & 1995)- Pushes banks into offering loans in poor neighborhoods. First passed in 1977, then another (tougher) version passed in 1995, and signed into law by President Clinton. For the purpose of this article, the 1995 Act is the most consequential one. If banks fail to follow this act, federal regulators have the power to severely curtail their activities.

Federal Deposit Insurance Corporation (FDIC)- decides bank credit ratings

FAIR HOUSING ACT (1968)- Forbids banks from engaging in redlining and discrimination against people who ask for loans with respect to their gender, race, origin....

FANNIE MAE & FANNIE MAC- These are two different companies, but since they do the almost exact same thing, I'll use the same description for both of them. Started during the Great Depression to help poor people get mortgages. Today they own about 60-65 % of all mortgages in the USA. Initially, they were started and run by US government, but have since become private companies run by shareholders. The difference between them and other mortgage issuing banks in the USA is that Fannie Mae & Freddie Mac can get loans at lower interest rates because their survival is guaranteed by the US government. In plain terms, they can't fail, because the US government will always bail them out with taxpayer's money, and when Fannie or Freddie make a profit, it all goes to shareholders. Today, US Congress still has the power to regulate their conduct, but this is used for partisan goals. The most astounding fact: Fannie Mae has leverage ratio of only about 50:1.

GLASS-STEAGALL ACT (1933)- Separated banks into investment banks and commercial banks, and imposed regulations on the business conduct of both.

GRAMM-LEACH-BLILEY ACT(1999)- Repealed the Glass- Steagall Act, original intention was to deregulate banking and allow for more investment - related activities, but these days most often used to allow commercial banks to acquire failing investment banks

INVESTMENT BANK- Trades securities (on a large scale), doesn't require deposits, trades at high risks, needs to raise extremely large amounts of capital to stay in business, characterized by high Leverage Ratio (approx. 30:1), has an uneven profit cycle (sometimes makes a lot of money, and sometimes makes modest money). Examples: Lehman Bros. , Bear Sterns, Morgan Stanley, Merrill Lynch (pre-2008)

LEVERAGE RATIO- This is the ratio of a bank's total loan volume to its asset (equity) volume.

NINJA - No Income No Job nor Assets. Most current subprime mortgages are NINJA mortgages.

REDLINING- Practice used by banks to deny loans to people in certain neighborhoods. Banks would draw a red line around the borders of a neighborhood to whose inhabitants they wouldn't loan the money to.

SARBANES-OXLEY ACT (2002)- regulations enacted in the wake of Enrons's collapse with intent to make accounting practices more transparent. Also established an oversight agency. Its regulations are numerous and comprehensive, and full compliance extremely hard. Because of those issues, many companies have found it easier and more profitable to move to less regulated countries (countries in Asia and some countries in Europe don't have them).

SECURITIES AND EXCHANGE COMMISSION (SEC)- Regulates the trade of securities.

SECURITY- Esentially a piece of paper indicating ownership of assets (equity), this is what investment banks trade in.