A Brief History of the Credit Debacle
I can't say that I'm an expert in credit markets, the Fed, or subprime lending, but I've been frustrated by what's happened recently in the credit-subprime-mortgage world and have been trying to figure out what's really going on. Here's my breezy, oversimplified brief history of the credit debacle.
For a while now, the big banks and lending companies have lent money with ridiculous terms and conditions to poor and working class Americans who the lenders knew wouldn't be able to make their payments. These same lenders also argued that government shouldn't regulate this incredibly risky lending scheme and protect poor and working people. Political leaders did nothing because the lenders are a powerful lobbying force and because our political culture is pervaded by an antiregulatory ideology.
Thus the situation was just as lenders should have expected. People couldn't make their payments. Credit became constrained. And financial markets grew volatile. The lenders reaped the volatility that their risky investments had sown.
This placed the Fed in an awkward position: Either they lower rates and create a moral hazard – knowing they'll get bailed out, lenders would have no incentive to improve their behavior in the future – Or they do nothing as the world's markets remain chaotic, potentially creating a huge economic disaster.
Now the antiregulation, anti-government lenders argued for the Federal Reserve (a government organization) to save them from themselves by lowering rates. And the Fed, last week, lowered rates – perhaps not because they think the lenders deserve to be saved but simply because the consequences of inaction could be terrible.
And this week we find out, courtesy of the Wall Street Journal, that Lehman Brothers and Capital One have closed their subprime-lending and mortgage businesses, and that Bank of America has bought Countrywide to "dispel[] a crisis of confidence among creditors and investors in the nation's largest mortgage company."
To recap, here's where we stand:
The lenders acted irresponsibly, created havoc in the financial markets, and then were bailed out. The have every incentive to act irresponsibly again.
The Fed was stuck in a terrible position and acted to prevent further chaos, but in the process created incentives for future bad behavior that they likely won't prevent through tighter rate controls.
Elected officials did nothing to address this crisis, and will likely still do nothing to regulate this industry and prevent future crises.
And working families are left to fend for themselves.
This seems to me a great case for what our own Professor Warren has called a Financial Products Safety Commission. We should be preventing these crises before they happen, not (barely) addressing them after the fact.
As always, Warren Reports readers, your comments are much appreciated. Have I gotten the facts wrong? Would you characterize these decisions differently? What do you think lawmakers should do?
Comments (33)
Sounds about right, although I wouldn't overlook the corporate/shareholder obsession with quarterly profits as the root cause of all of this. All things being equal, most investment managers would prefer a non-volatile marketplace. But, the pressure on returns is just too great not to roll the dice and then let the fed save you from your own undoing.
However, I still think Democrats--if they were truly the party of the future and not the past--would spend as much time addressing the implications of this overpriced housing market for prospective homebuyers as well as the fools (both lenders and consumers) who knowingly pumped it up.
--
Empire of Liberty
August 24, 2007 5:36 AM | Reply | Permalink
Much of the problem stems from borrowers with ARM's who took out loans a few years ago when rates were low. I do not recall anyone at the time suggesting that the Fed would then go on to raise the Fed Funds rate for 17 straight quarters, but that is precicesly what they did. This increase in turn raised the prime rate, to which most ARM's are pegged, and up they went.
August 24, 2007 7:02 AM | Reply | Permalink
Re: For a while now, the big banks and lending companies have lent money with ridiculous terms and conditions to poor and working class Americans
A lot of the subprime loans went to speculators were were neither poor nor middle class.
re; ...who the lenders knew wouldn't be able to make their payments.
The lenders assumed (as did the borrowers) that the borrowers would either be flipping the houses be the payments reset (see speculators, above) or would refi when the reset came due.
Re: The lenders acted irresponsibly, created havoc in the financial markets, and then were bailed out.
while I agree there was certainly irresponsible lending, for every act of irresponsible lending there was also an act of irresposnible borrowing. And left out of your analysis is the role played by spceulation, which, IMO, was crucial: without speculators driving the price of housing sky high we would not have had so many borrowers of modest means forced into the subprime market.
August 24, 2007 11:43 AM | Reply | Permalink
The blame for this fiasco lies entirely with the lenders. The sub-prime lenders know when they were making these loans that 10 to 15 % of the borrowers would be unable to maintain their payments. That is known. What happened recently, was that the appreciation on housing values was so high, that even if the loans were forced into foreclosure, the houses would sell for more than the mortgage. Thus in those conditions the loans were 'secure'.
Cynics in the subprime business called these 'neutron loans' since at the end all of the people were blown up but the property was still intact. As the housing bubble grew the lenders became more and more reckless. At the same time the finance houses were inventing new ways to package these mortgages into securities, finding buyers for them and therefore pouring even more capital into the mortgage market. The thing worked great as long as housing prices appreciated. As with all bubbles, this one finally went pop. The shock is not that it went pop, the shock is that so many apparently conservative finance houses were seriously exposed to the reversal.
August 24, 2007 12:28 PM | Reply | Permalink
Here's an excellent article in last week's Economist which gives a global breakdown on what happened with inter-bank lending, and how the sub-prime mortgages affected credit.
http://www.economist.com/finance/displaystory.cfm?story_id=9660039
~~~~~~~~~~~
Quidquid latine dictum sit, altum videtur.
Come visit PROJECT: Lucidity
Where everybody knows your name...
unless you use a pseudonym
August 24, 2007 12:29 PM | Reply | Permalink
What "crisis"? What "debacle"?
Some investors in MBSs and CDOs -- mostly wealthy ones -- are going to lose some money. Some housing speculators are going to lose some money. Some subprime borrowers will have to put their dreams of home ownership on hold and resume their prior status as renters.
Big deal!
August 24, 2007 12:47 PM | Reply | Permalink
Your basic statement is accurate as far as it goes, but the problem is quite a bit bigger and more complex, which is why the financial markets are so much on edge. At the consumer level, the problem is poorly informed, poorly protected home-buyers being sold loans they couldn't possibly afford.
This problem was exacerbated by the Fed-driven housing bubble and legislators like Joe Biden (Sen., MBNA), who had lots of interest in protecting the financial industry and none in protecting working Americans. But the reasons for the major ripple effects are much more complex. The crummy loans were sold, packaged and securitized, leveraged, repackaged and resecuritized, releveraged, .....
So, the combination that caused the problem includes:
And on, and on. The failure of the market to price risk over the last few years, along with easy money have helped to fuel all the leveraged buy-outs of companies, which have buoyed the financial folks who create the structured financial instruments, and which also create larger entities that can be portrayed as too large to allow to fail.
I'm not saying that there are not major economic advantages to structured finance, which can be used to reduce risk and to smooth economic cycles. If it were properly regulated (not an easy task -- not even a possible one in the current U.S. political climate) it would be a fine thing. Unregulated, it is an automatic moral hazard generator.
August 24, 2007 12:54 PM | Reply | Permalink
Exactly.
If anything, the Fed and ECB did an amazing job (after the fact... I have my own opinions on Greenspan prior to the housing/lending boom) in minimizing the impact on inter-bank exchanges by infusing TONS of cash. The only thing I would have liked to have seen differently would be punitive rates on banks for those money infusions.
And, as I've read more on the situation, it really does seem like the securities rating agencies were the ones dropping the ball on this.
~~~~~~~~~~~
Quidquid latine dictum sit, altum videtur.
Come visit PROJECT: Lucidity
Where everybody knows your name...
unless you use a pseudonym
August 24, 2007 1:02 PM | Reply | Permalink
snooker or be snookered
the american huckster business ethic.
greed blinds people even to transparency.
like all bullies, the big boys on wall street strut about their self-made success until their ponzi scheme flops and they cry to daddy fed for a bailout.
remember the short happy life of
"long term capital management"
V A N I T A S
August 24, 2007 1:05 PM | Reply | Permalink
I would add the complicity of the rating agencies. They became addicted to the fees associated with the securitization deals and failed to make accurate risk assesments. Investors need to do their own risk assessments but if an A rating doesn't mean anything, what's the point of ratings?
August 24, 2007 1:12 PM | Reply | Permalink
Perhaps it will turn out to be no big deal. But the potential is that housing prices at the upper end of the market will continue to fall. When a point arrives when housing value declines below mortgage value it is in the home owners best financial interest to give the house back to the bank. This can be true even for people who can afford their mortgage payments. When that point arrives then the crisis will spread to even the prime mortgage markets. It was this fear that rippled through the markets last week that caused problems even for funds with no exposure to subprimes.
August 24, 2007 1:15 PM | Reply | Permalink
.
Now, if the decline at the low end creates a recession, and the people in the midrange start losing their jobs, that could be another story.
sPh
August 24, 2007 1:51 PM | Reply | Permalink
The laws vary from state to state but in none is one's credit rating destroyed for the rest of their life. As a practical matter, one could approach the lender, plead hardship and negotiate either a new mortgage or giving up the house. In some states this is a fairly simple process. It will be the book-to-loan ratio that determines whether this becomes widespread.
August 24, 2007 3:04 PM | Reply | Permalink
"Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision." S&P's standard disclaimer.
It looks like you and Standard & Poor are on the same page. :-)
August 24, 2007 5:20 PM | Reply | Permalink
. . . punitive rates . . . .
I haven't seen a discussion anywhere of why the Fed lowered the discount rate -- to 5.75% from 6.25%. Or indeed, why the central banks needed to "pump" money into the financial system.
As I read the news short term money was available at very high but not obviously prohibitive rates. Now, had the central banks not acted maybe the rates for short term loans would have gone hyperbolic. But we don't know that.
Has anyone got an idea of 1) why the central banks thought they had to step in and 2) why the Fed thought it necessary to lower the discount rate?
N.B. That a banker who wants the Fed to loan him cheap money whines and caterwauls about there being "no money out there" doesn't mean that there is, in fact, "no money out there."
August 24, 2007 5:26 PM | Reply | Permalink
Thats the beauty of a fiat currency, the FED can print more money whenever they need it. You don't have to get permission to tax the citizens, they will pay for it later in inflation and never make the connection. You can keep playing the bailout game for years before anyone notices. Then by the time the citizens begin to figure out what is going on, it is too late, and their currency falls into hyperinflation and all their money is worthless. But, the politicians are heros because they appeared to save the day. Then they can come and save the day again cleaning up the problem they created, and blame it on those irresponsible borrowers the lenders bilked with tricky contracts with high interest rates and fees to pay for their executive's multi-million dollar salaries. Good plan! The rich are richer and the middle class and poor are poorer. Those lazy irresponsible middle class scumbags don't know any better, it is their own fault.
If you study economics, you should read a book titled "The Creature From Jekyll Island" and follow the bibliography references to the original sources. Even if you don't agree with it, you might find it very educational.
Jim Anderson
The Truth About Credit
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Ministry WebsiteAugust 24, 2007 6:12 PM | Reply | Permalink
"Some subprime borrowers will have to put their dreams of home ownership on hold and resume their prior status as renters."
Okay, SOME of those borrowers can get back to life as it was before. But please think about what I suspect is more than "some": By the time it gets so bad that a home buyer defaults on a mortgage, that borrower has done everything possible to keep that house. That probably includes other bad decisions, such as maxing out credit cards and taking out a second mortgage or other loan. It's a "robbing Peter to pay Paul" cycle that results not only in mortgage default but often bankruptcy. (Except, of course, it's way more difficult now for the average person to apply for and receive bankruptcy protection. There's the credit counseling first. That counseling might have been nice when there was still some way out of the abyss.)
I wish I didn't, but I know a bit about this personally. I lost my house, not in this debacle but in 2004. It was a manufactured home in a CA mobile home park, and my loan was for $63K. However, because manufactured home buyers can't get an actual mortgage, the loans to buy them aren't much regulated. My loan from 2000 was at 10% for 30 years.
When I became ill in 2001, I tried to sell my home to avoid what even then I saw as inevitable. Since I would never be able to earn what I did before my illness, I would never be able to keep up with not only the loan payments but also the park's space rent, which increased 6% per year. The space rent was so high, however (something else not regulated), that I couldn't sell the home.
Ultimately I exhausted all my savings and retirement accounts, sold everything of value I owned, went through bankruptcy, and then lost my home.
So I was back where I was many years before: I needed to rent an apartment. But that becomes a pretty tricky thing to do when your credit has been trashed by all these events. I couldn't find a place I could afford that would rent to me.
And this brings me to what's really behind the sub-prime lending situation's getting so bad before anyone noticed or decided something should be done. Those poor and working people don't matter to policymakers until it's advantageous--to the policymakers--to help them.
Before they bought homes, those poor and working people paid rents that they saw going up faster than their incomes year after year. When those poor and working people--including me--saw a way of getting a piece of what isn't just their dream but what we've always known as "The American Dream," by buying a home that seemed no more expensive per month than renting, they and I jumped at it.
How can owning a house ever be a bad thing? All those people who buy a house, sell it, and move up the chain over and over again are proof that owning something (even while still buying it) is always better than paying someone else rent.
Many of us didn't look far enough ahead to anticipate what might happen. Most of us, I suspect, could never have anticipated increases in monthly payments that reached the heights they did once those adjustable rates hit. There was no example to warn us.
Even in my situation, owning a nice manufactured home was still generally seen as a positive change from renting in 2000(according to people who advised me), because all housing was at such a premium in California.
In my case, I became disablingly ill. For others, all it might take would be a longish illness in a job with few or no benefits to undo even the most careful plans.
But then factor in nowhere to turn for help: Local governments, state governments, and the federal government (before it became too pervasive to ignore) told those losing their homes that there was nothing that could be done. Lenders have the right to take back their property if borrowers can't pay their loans.
Is it possible that these lending practices--high interest because of no other options or misleading loan terms leading to extortionate rates and defaults--could have any parallel in the upper-middle and upper classes? Never. And the reason is that unless there is some kind of advocacy for the poor and working people (and even advocacy is no guarantee of help), what happens to them is politically irrelevant. And this is because to those who have power, poor and working people, if they have relevance at all, are merely commodities.
So "big deal" about those borrowers? To me, yes.
Nothing worse could happen to one than to be completely understood. — Carl
Gustav Jung, psychiatrist (1875-1961)
August 24, 2007 7:42 PM | Reply | Permalink
There's no need for anything so elaborate as a commission. Just a few simple rules.
Borrowers should be required to truthfully document their income for 12 months before origination. Lenders should be required to specify a maximum monthly payment over a maximum of 30 years. The maximum payment should be the basis for loan qualification, and it shouldn't be more than a third of the borrower's median monthly income.
A borrower's income would limit the size of house they can buy and builders would build smaller houses that people can really afford.
Most importantly, the global economy wouldn't be threatened by runaway lending that creates too much money and causes massive asset inflation that feeds back into itself and creates a bubble.
August 24, 2007 10:34 PM | Reply | Permalink
.
However, today credit reports are used for employment screening, setting insurance rates, and running terrorist screens among many other things. And AFAIK there is no expiration date for the negative effect that a credit event will have on these, 7 years or otherwise.
sPh
August 25, 2007 6:55 AM | Reply | Permalink
Let me start by making two comments: "breezy" and "oversimplified". And add a third: "pretty much worthless".
This was the cartoon version. To get a serious discussion we would need to take some steps. First we would need to define 'lender'. Or you talking the originator, the lender, or the funder? Because the Fed didn't take a single action to directly benefit the actual lending companies, indeed they continue to drop like flies. Second this totally ignores the roles of speculators in sub-prime. Not every borrower in sub-prime was in fact poor and working class, some were taking advantage of the terms and specifically the possibilities for 100% leverage and were willing to tolerate the rates, and the more bubbly the local market the more likely this was. In fact the more outlandish the apparent terms of the loan the more likely it was actually fraudulent, taken out by a speculator/investor looking for a quick profit. Third the notion that this liquidity crisis was led by defaults is to an extent true but once again drastically oversimplified. The reaction of the end investors in the securities and then the banks ('lenders' in your terminology) was in my view way out of line with the actual volume of the defaults. Defaults will always spike on the downslope of any housing market. That is a structural feature that is related to the probability of being in a negative equity situation. Certainly the increased availability of 100% LTV (Loan to Value) loans will increase the percentage of loans subject to default, and ideally this is priced into the rate. In fact I have seen little evidence that this wasn't the case even today. End investors in these securities seem to have missed that day in Investing 101 when they discussed 'risk/reward'.
I am sorry to be so harsh but this post seems like just another in the ongoing attempt to turn this whole story into a morality play instead of what it really is, which is a market failure in weighing and allocating risk in a housing market at the bend point between strong surge up and flat to down.
The following may be just as useful for understanding the psychology of the current crisis:
"Little Miss Muffet
Sat on a tuffet,
Eating her curds and whey.
Along came a spider,
Who sat down beside her,
And frightened Miss Muffet away!"
Miss Muffet, it is just a foreclosure! This whole thing may in fact spiral out of control, but that has more to do with the shaping of the narrative as the fundamentals. This can be seen by the focus in the reporting on percentage of change in foreclosures (up 266% year over year) as if they actually had any information content. The real focus should be on the actual ratio of performing to non-performing mortgages and keeping the actual volume of sub-prime loans within the context of the overall mortage pool. Why don't we see reporting like that? Because it sucks much of the drama out.
People who are a lot smarter than me on this subject see more significance here. People who are way more influential than me are sounding more alarm here. People who are way, way, way more rich than me are moving millions and billions of dollars around reacting to this. I may be totally off base. But frankly I see a ratio of Miss Muffets to Hard Eyed Analysts that is skewing the fundamental narrative.
August 25, 2007 7:37 AM | Reply | Permalink
I would suggest reading the Economist story that I linked above:
http://www.economist.com/finance/displaystory.cfm? story_id=9660039
It explains pretty well the inter-bank issues, and just how important it is for banks to loan against each other.
~~~~~~~~~~~
Quidquid latine dictum sit, altum videtur.
Come visit PROJECT: Lucidity
Where everybody knows your name...
unless you use a pseudonym
August 25, 2007 9:52 AM | Reply | Permalink
Re: And AFAIK there is no expiration date for the negative effect that a credit event will have on these, 7 years or otherwise.
Except for bankruptcies, which remain on a credit report for 10 years all credit issues drop off the credit report after seven years, so if you paid some bills late 12 years back no one looking at your credit report today would be able see that fact. Besides which not all employers use credit reports to determine hirability; in fact, most do not. And if they really want to hire you because they see you as a perfect fit for a job, a few late bill payments, even a bankruptcy, several years back in the past will not stop them. For example, I work for a major investment bank (and they do pull credit reports when hiring). My first boss at this job confessed quite candidly to a bankruptcy due to a failed business start-up. Obviously this did not prevent him from getting his job.
August 25, 2007 2:09 PM | Reply | Permalink
Yes; I had read that article earlier this week -- and noted the report of rising overnight interest rates:
So ---
Doesn't look like a "crisis" to me. Doesn't look like "there's no money out there" to me. To me doesn't look like the article answers my questions, at all. Am I overlooking something?
August 25, 2007 6:03 PM | Reply | Permalink
The ratings agencies did not drop the ball on this one, they were complicit, to the level of advising their clients (that they were rating) as to how much of these marginal loans they could bundle in their paper.
The second part is, due to the ratings and returns, how this problemn was exported and became a world problem. No free pass here either as returns are directly linked to risk so AA ratings and high returns broadcast a level of risk not applicable to the rating. But the f'rnrs sure bought in, too.
Was everyone complicit? The borrower$, lender$, rater$, bond $eller$, investor$? You bet. And the overseers and government, too. Predictable and predicted. Who looses? The originator who can't pay the monthly, and the greedy bastard left holding the parcel at the end of this grown-up's version of Pass-the-Parcel.
The reason I gave a "marginal" rating to "Ellen" at 3:47 p.m. is because this event met those definitions. Look 'em up.
Crisis: turning point in sequence of events, condition of instability or danger, etc.
Debacle: [débâcle, in French, means collapse] general break-up or rout, sudden downfall, complete collapse or failure, etc.
Individuals were suckered into both in significant numbers. Buyer beware says Ellen. I say government and oversight has to be better than that. How safe is your food, Ellen?
The central banks intervened in a way rarely seen because exactly why? There was a crisis of credit confidence that caused a drop in the stock market of 8-10% in days, and there was a debacle of the AA-rated mortgage bonds and we've yet to actually measure the damage.
This domestic idiocy caused problems world-wide.
Yes, marginal. A "2".
August 25, 2007 6:15 PM | Reply | Permalink
I forgot my point that this happened before. S&Ls anyone? They got rescued as well but it cost us tax payers a whole lot more.
Oh, and Ellen, "Big Deal" to have your already poorish or faked credit trashed becuase you're not as smart as the arses that ripped you off?
And then, as renters, to go through years of difficult (if you're marginal) credit rehab (if ever), or just wait for the next round of exploitation and try to outplay the players?
I think we know which side you're on.
The whole thing smells of used car sales drifting up through the community.
August 25, 2007 6:36 PM | Reply | Permalink
As Crocodile Dundee would say, "That's not a crisis. This is a crisis. That wasn't a debacle. This is a debacle."
When you get a little more experience under your belt, notthere, you'll be able to recognize August 8-9, 2007 for what it was -- just another media carnival, sound and fury signifying nothing.
Oh, and just so you know, this is what counts as a real crisis.
August 25, 2007 9:25 PM | Reply | Permalink
Ellen, I'll match my market experiences against anyone's. That may go back more than a decade.
You?
My point was about definitions and that one you can't win. Ganesh's statements fully fell within those.
Your point is what, exactly?
August 25, 2007 9:47 PM | Reply | Permalink
That might be a crisis. Hard to tell from one photograph. Certainly is for the child. Maybe the parents, too. Or is it abuse? Is the community affected? This and this was a crisis. And a debacle.
You remember that one?
And, of course, similar events have been going on for centuries. No excuses.
Man's inhumanity to man, and all that. Women to women, too.
August 26, 2007 9:51 PM | Reply | Permalink
Your (great) comment got me thinking: but don't all those bulls and bears count on the chicken littles always being around?
August 27, 2007 6:03 AM | Reply | Permalink
Agree with Bruce Webb. The first paragraph of this post pretty much tells us that the rest of it, however sincerly felt, is useless to read. All you've done is velcro the latest events to your preconceptions and proclaim that they stick to each other. To the extent you are on the left, you certainly don't help your side by publishing admittedly ignorant opinions which can be held up by the right as evidence of your side's bias and lack of objective analysis. Sometimes discretion is the better part of valor. Spend your tiem finding someone knowledgeable who shares your views and give the space over to them.
August 27, 2007 10:29 AM | Reply | Permalink
You haven't missed anything.
Does anyone around here remember 1981 and prime rates around 18%?
Now that was a crisis.
What is going on today is nothing more than protecting wealthy investors.
August 27, 2007 6:48 PM | Reply | Permalink
Yep, and you know what, I'm not sure I would label that as a crisis, either.
I strongly recall it as the first time in my boomer lifetime when every Tom, Dick, Harry, Aunt Mabel, Grandma, Joe Blow and Suzie the waitress got into "investing" mentality, that they could play some games with money. If you had a savings account, you got into CD's, switching them every week for a few bucks profit. If you didn't, you went hunting for old silver coins or spoons to get the melt price from a coin dealer. You started looking at your family heirlooms as something to buy and sell. If you didn't have any of that, you starting thinking that if you saw toothpaste on sale, maybe you should buy 20 tubes of it because having it was future savings.
Texans, not Wall Street, were the big bourgeois pigs then, they were making tons of money, excessively exuberant conspicuous consumers.
My parents bought their first house on a relatively high interest rate (compared to recent history) mortgage in the early 70's, as they could never scratch up a down payment until their middle years. It was brand new, they had it built, but they simply decided against the garage that went with the plans until they could afford it. The garage got built then with the rising equity, just like what went on now.
P.S. The gas lines and rationing in many places threw a loop into all the fun, I would describe that as a "crisis." The continual neverending high unemployment, that was very scary and depressing, but it seemed eternal as if it were something a huge generation would have to deal with until we died--no hope there, hence no sense of "crisis."
August 28, 2007 4:52 AM | Reply | Permalink
I second that. I was torn as to whether to respond. I just didn't know where to begin. The oversimplification is profound and disturbing.
These are complicated topics that are helped along by subject matter experts. There are clear problems that led up to the current situation. Passing out the white and black hats, however, turns the matter into rank propaganda and leads nowhere.
/c
In the blogosphere every one is an expert, so no one is an expert.
August 29, 2007 7:49 AM | Reply | Permalink