Sub-prime mortgages were not the result of unworthy deadbeats fraudulently obtaining credit they did not deserve. It was the industry which engaged in fraudlent predatory lending practices. They neglected to explain to elderly or unsophisticated investors how negative amortization could eat up all their equity and turn them out of their homes before they could do anything about it. Loan agents, in hustling people to sign up for what they touted as this easy credit, neglected to explain how you are supposed to prepare for when your baloon payment comes due. They neglected to explain just how much the borrower might have to pay if their adjustable rate mortgage maxed out. The original lenders neglected to mention that these loans could be resold to unscrupulous companies who might lay a trap for the borrower by sending him a statements that requested only a minimum payment, allowing the unpaid interest to quietly accumulate until it hit a threshold which suddenly triggered the whole note coming due, at which point you would be hustled into refinancing on less favorable terms. When people inevitably got behind in their payments, instead of working things out with them, they reported these “lates” to credit bureaus, ruining their FICO scores and virtually insuring that they could not be able to obtain refinancing.
Once the trap was sprung, the company aggressively rushed to foreclosure in order to capture a windfall in any remaining equity. Why? Because the industry has successfully gotten the laws concerning writing off bad debts rewritten in their favor. Instead of deducting the loss as a cost of doing business, they are able to take a tax credit against future earnings. This makes a write-off suddenly worth several times more lucrative than carrying it to term and being taxed on the profit. Plus they get it all instantly (well, within the year).
Unfortunately, this created an avalanch of nonperforming loans which hollowed out the value of the securities that repackaged them. The owners of these securities, being unable to accurately assess their true value began selling them off, starting a panicked rush for the door that destroyed any remaining value they might have represented. Treasury Secretary Paulson’s first proposal was to use the bailout money to buy up these worthless securities, sticking the taxpayer with the whole mess. But that proved a non-starter as the firestorm of public protest over the bailout forced cooler heads to consider things like replenishing the bank’s capital in exchange for an equity position. This would allow the banks to write off these losses and distribute some of the burden to stock holders. Replenishing bank capital would provide the reserves necessary to stake for bank lending at 12 times the amount put in. That would restore liquidity and confidence to the markets.
It needs to be said that it was the Bush Administration which provided the original impetus for this sub-prime lending debacle, since it was part of Bush’s “ownership society” initiative. This was based on the observation that homeowners tend to become more conservative and vote Republican as the equity in their house increases. The industry was explicitly encouraged to target blacks in the hope that home ownership would co-opt them and lure them away from the Democratic base. While the Bush Administration didn’t exactly endorse the predatory practices of the industry, he did send them clear signals that the door to the candy store would be unguarded by cutting back staff and funding for the SEC, the Office of the Comptroller, and the other regulatory agencies. To be fair, in 1996, it was the Democrats under the Clinton Administration that dismantled the Glass-Steagall act, and removed the restriction on banks from speculating in the securities markets, so when paper money suddenly vanishes from a bank’s portfolio it parralyzes the bank’s ability to lend until they know how much money thay actually have.
The industry entheusiastically responded by aggressively marketing sub-prime loans to marginal borrowers with low teaser rates and other gimmicks that tended to gloss over the fact that that the adjustable rate mortgages will not always remain low. These loans were presented the loans as an easy hassle free way to get capital necessary to realize the American dream. According to a New York Times study, the industry did target blacks, minorities, and other unsophisticated first time home buyers. The borrowers were told not worry, any weakness in their credit would eventually be erased by the equity they would accumulate in an ever-rising real estate market. Borrowers had no reason to question this “blue sky forever” assumption since the agent was supposed to be an expert on these matters, and real estate prices had in fact done nothing but increase in living memory.
What really set the stage for the current meltdown was that banks and brokerage houses went out hired rocket scientists to work out the the advanced math underlying extremely exotic instruments which were sold to investors who did not understand well enough to correctly value and reglators did not understand well enough to regulate. They relied on securities rating companies, who rated them AAA without really understanding them either. Some of these instruments contained provided a kind of insurance and a hedge against adversity. And no less than Alan Greenspan praised them as instruments that they would spread the risk and lead to a more stable system. The people who bought these instruments more or less took all this on faith and loaded up on them. In order get around the statutory requirement of setting aside a prudent reserve to cover the risks inherent in insurance instruments, they decided to call them “swap” instruments instead, and leaveraged themselves to the hilt. Had regulators been actively monitoring the situation, this whole crisis might have been avoided.
Since October 9, 2007, the Dow has lost 5,585 points, or 39.4 percent, in the past year. That’s $8.33 trillion in paper wealth disappearing out of a $14.175 trillion securities market, the bulk of it in the last 20 days. The $850 billion bailout seems a drop in the bucket compared to what has been lost, but (we hope) it was enough to restore confidence in the system and get banks to start lending again. Unfortunately, this $850 billion is as yet unfunded obligation, meaning that although we have commited ourselves to paying for it, we haven’t yet specified in any budget exactly how we are going to pay for it out of a real economy that produces $13.3 trillion GDP per year. This, by the way, is added to several trillion in unfunded Social Security and Medicare obligations, in an economy that is already in debt to the tune of $56 trillion due to a 25-year run-up in credit card and mortgage debt which has grown, and continues to grow, twice as fast as the real economy.
If there is another round of foreclosures, it will set off another devaluation of real estate-backed securities, another panicked rush to unload them, and a run on all dollar-denominated securities. The only reason we are afloat to the extent we are is that the rest of the world still believes we will honor the “full faith and credit” of dollar denominated securities. Should they decide that this is not the case, they will start a panicked sell off of our securities, tens of trillions of dollars will disappear from the world economy bringing not just us down but the whole world economy.
So, when you hear that this could be “really big” and that we are tetering on the “edge of an abyss,” this is what they are talking about. Once the world economy implodes it will be much worse than 1929. If you recall it was extremely difficult to reinflate the national economy after 1929 (it took WWII to do it). It will be incomparably harder to prime the pumps with the world economy in a slump.
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