Friday, September 26, 2008

How it Happened

After listening, reading and digesting information on the banking crisis, here's my simplified take on how this whole mess went down. There are only two components to the problem.

First off, banks were used as instruments of social equality, more specifically, the quasi-governmental Fannie Mae and Freddie Mac were used. The political sentiment was that we needed to help poor people own their own homes.
Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition, they held an enormous portfolio of mortgages themselves.

In the times that Fannie and Freddie couldn't make the market, they became the market. Over the years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments. Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.
The concept was that poor people were poor because they did not have access to credit. The truth is that poor people are poor because they're lousy money managers.

Second, mortgage brokers and managers were rewarded for profit, but not penalized for losses. I don't have a source for this on the web, it came from an interview I heard on the Dennis Prager show of a fellow who use to be a high level manager for one of the brokerage firms. This compensation scheme biased the market heavily towards risk. So long as the real estate market went up, the loans paid off and everyone in the chain made lots and lots of money. They may have known the bubble would burst, but individually they felt powerless to stop it and would have been penalized had they opted out of the bubble.

Here's a very succinct summation. Fannie and Freddie provided a market for lousy loans. Mortgage professionals were paid to make loans. They loaned the money to people who could not pay it back and dumped the risk off on Fannie and Freddie and then rushed out to make more loans. Eventually the whole house of cards fell in.

Update: This post from John Allison, President & CEO of BB&T, a South Carolina bank, is a must read. John is not in favor of the bailout, probably much to the delight of our good friend B-Daddy. Here's a tidbit:
Freddie Mac and Fannie Mae are the primary cause of the mortgage crisis. These government supported enterprises distorted normal market risk mechanisms. While individual private financial institutions have made serious mistakes, the problems in the financial system have been caused by government policies including, affordable housing (now sub-prime)...


Kelly the little black dog said...

So where you you lean on the bailout? I've heard reasonable arguments both ways - although it seems the no bailout folks have a slightly better argument. The problem being they've yet to suggest an alternative.

K T Cat said...

Kelly, the House Republicans' idea for an FDIC-like solution sounds like a good idea, but it seems to me that an insurance company needs a few good years of picking up premiums before it faces catastrophic losses that it has to cover.

The President's plan makes sense to me as it addresses the problems right now and uses the RTC model from the 80s. The S&L RTC actually made money from the government by buying assets cheap and selling them after they had appreciated.

Assuming that the price tag is double what they suggest, say $1.4T, this is still peanuts compared to the coming fiscal crisis from Medicare, Social Security and the rest. Those are at least an order of magnitude bigger.

Mathematical problems have an emotionless, inexorable nature to them. Borrowing endlessly is just such a problem. At some point in time, this will all stop and we'll have to pay the bills.

B-Daddy said...

KT, thanks for the link and for breaking this down.