The Credit Crisis Explained…. And Explained Again.

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Here is a video that wonderfully explains how we came to economic place we’re at now.

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

(Hat Tip: My Genius Friend – Salah Boukadoum)

I had been wanting to write a post on this subject for a while but kept putting it off. About a month ago, I was in a serious blargument with a commenter at Gay Patriot about the underlying cause of the current financial crisis. The Rush / Hannity talking points on this – and come to think of it, every problem in the world – is to lay blame solely at the feet of government and the Democrats for the whole mess. They love that simple answer, and will ignore and block out all information that contradicts or invalidates their rigid belief that business and the free markets, and Republican / Conservative policies are infallible and are also part of the mix. Trust me, there is plenty of blame to go around. Here is a comment from one of the more spirited participants. Note that the view of this commenter do not AFAIK reflect the views of my friends Dan and Patric who run Gay Patriot:

You mean the repeal of the Glass-Steagall Act Signed by President Gramm? OOOPS. Silly me, Gramm wasn’t the president, Bill Clinton was. President Bill Clinton signed the repeal into law in 1999, not any Republican. And the repeal was approved by all but 7 Democrats. That Glass Steagall Act? Why yes, that’s the only one.

But your lame attempt to blame Phil Gramm for legislation signed by a Democrat president and supported by all but 7 Democrats really does illustrate how dishonest liberals have to be to try and blame Republicans. Furthermore it illustrates your ignorance.

What is it the repeal of the Glass Steagall Act supposedly did to cause the sub-prime mortgage crisis? It allowed commercial banks to underwrite and buy up bundles of bad loans.

But why on Earth would they WANT to? Banks are not in business to make or buy bad debt.

Ah yes, because DEMOCRATS in congress, and DEMOCRATS at Fannie and Freddy were forcing banks to make loans to bad credit risks, and encouraging commercial banks to underwrite them by promising to buy them up. And the more bad loans to unqualified candidates Fannie and Freddy could get banks to make, the more millions of dollars Democrats Frank Raines(Obama adviser), Jim Johnson (Obama adviser), and Jamie Gorelick (Clinton crony also responsible for erecting the wall that prevented intelligence agencies from stopping the 9/11 attacks in order to hide illegal foreign campaign contributions to her boss) would reward themselves with.

And more from the same guy:

As if banks were actually eager to snap up bad debt without government incentive.

The only revisionism, as usual, is coming from liberals. Just like Senator Leahy who yesterday called for “truth commissions” to revise history on warrantless wiretapping (already settled as Constitutional by the FISA court), treatment of detainees (already settled by bipartisan investigation), and iraq intelligence (already settled by 5 separate bipartisan and non partisan investigations).

After reading some of this, I couldn’t keep silent. I had to respond, especially to the “As if banks were actually eager to snap up bad debt without government incentive.” bit.

Uhm, yes they were! The banks made tons of $$$ buying and reselling the debt in the form of collateralized debt obligations and credit default swaps, which were mixed in with hedge funds and money market accounts and polluted the entire financial system. Look I know everyone want to lay blame on the government alone, but, if we’re going to tackle the problem, we need to face the whole thing and not focus on bits and pieces that mesh with our political POV. Lets go back to the initial push to increase home ownership for lower income families – Carters Community Reinvestment Act of 1977 . Carter’s CRA is not to blame for the current economic malaise. The concept of the measure plays a part, but it is much more complicated than that.

Carter issued the CRA’s which were administered by Fannie and Freddie, then, later by mortgage banks. The CRA mandated that each banking institution be evaluated to determine if it has met the credit needs of its entire community. That record is taken into account when the federal government considers an institution’s application for deposit facilities, including mergers and acquisitions. Note that the housing market didn’t implode right after this was passed. Why? Because the banks found it easy to easily meet the requirements without making stupid loans. Yes some loans were more risky than regular loans, but through the years the default rates were about as much as expected, and so there was an equilibrium of sorts. And the mortgage banks made some money off the loans, got good PR, so all is well. You have an economic balance of sorts.

Then in the 1990’s Bill Clinton turned up the heat. He passed new regulations that not only allowed the relaxation of rules on writing loans, but also require more loans to be issued through Freddie and Fannie, and those govt backed lenders were allowed to hold just 2.5% of capital to back their investments, vs. 10% for banks. The number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent. By 2007, Fannie and Freddie owned or guaranteed nearly half of the $12 trillion U.S. mortgage market.

The new rules, implemented during a time when many banks were merging and needed to pass the CRA review process to do so, substantially increased the number and aggregate amount of loans to low- and moderate-income borrowers for home loans, some of which were “risky mortgages.”

In 2000, Bill Clinton signed the omnibus spending bill for that year, which contained the “Commodity Futures Modernization Act of 2000?. The measure, authored by Phil Gramm, deregulated the investment option know as derivatives, which includes credit default swaps, a favorite mode of new investment highly endorsed by, among others, Alan Greenspan and Larry Summers (yes the Obama economic advisor). Derivatives, CDO’s and CDS’s are way to complicated to explain (even if I could) but the are not unlike selling your long term lottery payment contract, say $1 mil over twenty years, to a financial institution for a lump sum of lesser value, $700 thousand dollars now. You get your money, and the bank gets the $300 thousand profit over time. This enabled banks and financial institutions to sell the long term unregulated contracts (debt collections) to other institutions, and those debts included the sub-prime mortgages.

But why would a bank want to buy these more risky loans you ask? Why did Lehman Bros. go belly up?

In business accounting, you can count the entire value of a long term payment package as a lump sum of profit on the books. When you buy a car, they look at how much money you make annually, and not how much you have on hand. Kinda the same thing. So, through an accounting quirk, the more debt collection accounts you have, the better your books look. Investment banks are in the business of long term debt, so it is only natural that they acquire much of this debt.

Keep in mind that, although the government is wanting, pressuring mortgage banks to issue more loans at lower interest rates to lower income families, there are no requirements, NONE, to disregard basic sound accounting principles, like making sure the applicant has a steady income and such.

Now that they can make an immediate profit from these risky loans, mortgage banks now go wild! Suddenly, they can sell these more risky contracts easy as pie to investment firms, with no government strings attached. And there are plenty of buyers. As more contracts get sold, there is more and more pressure by the bosses of the mortgage banks to make more loans. The bosses of the banks, not the government, are the ones who induce the loan officers to issue mortgages to any warm body that walks in off the street. Through the CDO’s, CDS’s and derivatives, each contract mean $$$ for the mortgage bank.

The conditions for the crash are set. The system is just waiting for a trigger. Enter Lehman Bros., Wachovia, and everyone else. They buy the mortgages, and then repackage and resell the risky loans as mortgage backed securities, derivatives, and other money market type investments. As the housing market declines, investors complain that they can’t make heads or tails of some of the packages that contain mortgages, so the government changes the accounting of mortgage backed assets to mark to market value, instead of long term. Suddenly, these packages that had worth based on long term projections, were worth much less overnight. Everything came to a screeching halt.

And the problem is compounded, because so much of the mortgage debt has been split up, and resold, and injected into various investment packages, via the CDS, that no one is sure exactly where all the poison debt is.

That, my friends, is the crux of the financial mess we have today.

In short, the really bad sub-prime mortgages were like a virus. If this debt based pathogen would have stayed within the bodies of the mortgage banks, the eventual problems caused by the bad debt would have been isolated to that segment of the financial organ. But Collateralized Debt Obligations, Credit Default Swaps, Derivatives and other investment schemes became a vector on which the bad debt virus was able to spread throughout the body economic and into the entire financial population. And, like many serious illnesses, the long incubation period and ease of contamination allowed the disease to spread far and wide throughout the economic population, so that the infection is truly an epidemic. Unfortunately, the doctors currently on duty seem to be no more competent than those doctors of the eighteenth century who would perform bloodletting as a cure all manner of ailments. They seem to have know idea what to do, and have put the nation on a Hodge-Podge of treatments, including a heavy ration of super-expensive homeopathic and holistic tax, borrow and spend remedies, treatments not shown to cure the problem in the past severe economic downturn, treatments which even contain the same type of virus – debt. So who pays for this expensive treatment? Why, the already infected tax payers and their children, of course!

No Comments to “The Credit Crisis Explained…. And Explained Again.”

  1. By Dotar Sojat, March 5, 2009 @ 10:04 pm

    Leaving out the CRA and Dodd/Frank/Raines makes this an amusing but incomplete cartoon. Chris and Barney demanded that Franklin buy crap sandwich loans, and he happily obliged. All attempts to reign this in were blocked.

  2. By sonicfrog, March 6, 2009 @ 6:37 am

    Look, I’m not denying they are not part of it, but if the banks did not split off the bad loans into all sorts of investment vehicles, this would not infect the whole financial system, and we would not be have this global financial meltdown. Bad mortgages in the US should not be affecting the global markets. But if you want to remain ignorant of all the facts, hyper-partisan and blind to the big picture, then by all means don’t let me stop you.

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