Anatomy of a Crisis

Why are we in the mess we are in? Well, like most crises, the history goes back about 15 years with a couple of additions along the way making it what it is now.

In the wake of the Republican sweep of Congress in 1994, Mr. Clinton knew that he had to do something to revive his own base to ensure his reelection in 1996. He seized on a report that was published noting that minority home ownership was significantly lower than the white majority. This is due to the fact that a majority of minorities are poor and banks generally don’t give mortgages to poorer people who are unlikely to pay back the loans. Mr. Clinton authorized the Justice Department to lean on Freddy Mac and Fanny Mae to increase the quota of low-income mortgages, up to 50% of the total that they deal with. These quotas were eventually put into law in 1997, when Democrats made up some of their losses in the House and Senate.

One economist equated this type of lending as picking up nickels in front of a bulldozer. You make profits slowly, but as long and liquidity and credit hold out (i.e. as long as the bulldozer doesn’t move) you’re okay. God help you if there is a credit crunch.

Things were going along dangerously, but smoothly until a new piece of legislation was passed in wake of the Enron scandal. Congress passed a law stating that companies had to report asset holding at their current value than at the projected value. Now, for Enron, this makes sense. It does not make sense for mortgages. A mortgage means that a bank has shelled out a bunch of money for property and you are required to pay them back or the bank takes possession of the property. Banks look at the long term and would report that they spent $100,000 but would be gaining $200,000 (loan plus interest) over the course of 30 years. So a bank would often list the long term value of the mortgage. Now, they have to report what the current value of the mortgage is, which is based on the value of the property and the credit rating of the person paying the mortgage. In other words, banks are reporting much lower assets and these assets are heavily dependent on the housing demand outweighing the supply.

So, now we have a ton of risky mortgages out there with banks reporting much lower assets (thus hurting their own credit rating). But then the housing market bubble bursts and the value of property goes way down. People who had been putting off paying anything (even the interest on the mortgage) suddenly find themselves owing much more than their property is worth, so they bail and the house is foreclosed on. Now the bank has a bunch of properties that it can’t sell to even responsible buyers for the value that they shelled out for it. Thus bank credit dries up. Banks then have to lean on insurance firms to cover their assets (AIG, etc.). The sudden cashing in of insurance causes the insurance firms to crash because they don’t have enough capital to cover everything at once (as is traditional in most insurance firms). So now banks have no credit available to them, no assets, and no insurance capital to keep them solvent. Thus, firms go belly up.

So, what the government is now offering is to take all of these low value mortgages off the bank’s hands in exchange for a large influx of cash. So the government will now own a ton of mortgages and since they make the money, they don’t care about reporting assets. They can afford to wait things out, wait for demand to creep back up and sell the foreclosed houses and give the people who are in trouble (but haven’t been foreclosed on) more time to pay back their loans. Once things are stabilized, the government will then start slowly selling back solvent mortgages to banks and make a killing. One paper has estimated that the government stands to gain between $1 and 2.3 trillion on their $700 billion rescue operation. Of course, the politicians in Congress will not return that money to the taxpayer. They will simply report that as income, write off the $700 billion into the deficit and increase spending programs based on the projected spending.

If the package goes through, people should start lobbying the government to either take this mortgage revenue to either pay down the deficit or send us all nice big royalty checks of several thousand dollars per taxpayer that we should be owed for getting into this business in the first place.