With the bail-out passed and action being pursued to "fix" our economy with the $700B infusion, we should be only weeks away from growth, prosperity and success! Or perhaps not.
The history making bail-out of 2008 will be a piece of legislation that will be reviewed, analyzed and critiqued for many years to come. While much debate as to the cause of the financial condition within our country will be continue to be debated, it is my contention that there are several relavent causes that have lead us to where we are today.
These causes can be reduced to several key actions pursued by our Government, Financial Institutions, the American Consumer, greed and risk. No single entity is entirely at fault, but there are those that bear much more of the burden than others.
First up is the Government of the United States and legislation enacted in the early to mid 1990s. The passage of the Community Reinvestment Act was intended to provide every American with the opportunity to live the American dream of home ownership. This legislation opened the door and many would say, strongly encouraged the banking and mortgage industry to participate (in some cases, or else!). With the ease for low income people and families to get mortgages, they would then have the ability to fullfill the American dream. However, the elected Government officials seemed to fail to recognize that with a mortgage comes mortgage payments and the need to have the ability to pay the monthly debt.
Then the concept of the sub-prime mortgage became a reality. The sub-prime mortgage made good business sense for the lender. They were being asked to take a higher risk with a borrower who had questionable credit history, questionable income history, and wanted to finance 100% or more of a home they were buying. The concept of the sub-prime mortgage was actually promoted by the Fed and in the perfect world, which we were encountering at the time, it was not such an awful concept - theoretically at least. Never mind that it completely ignored the long-term proven principles of financial soundness.
Early on, this was irrelevant due to the new and greatly increased demand for homes. Supply could not keep pace with the demand of new home purchases. As is typical, when demand exceeds supply, prices increase. With the increased value of homes growing at unprecedented levels, it was not much of an issue that a person borrowed $100,000 for a house on a mortgage that only required interest payments for the first five years. While this new homeowner could afford the interest only payments, they would not be able to afford the adjusted payments at the end of the five year period. Again, this was irrelevant for many years. With home values commonly growing at rates of 10%+ per year, that $100,000 home could then be sold for $160,000 five years later. The new home owner would then sell this house without ever having to pay down the principle and walk away with a $50,000-$60,000 profit. Many early adopters greatly benefitted by doing this.
Everybody seems to win and nobody was complaining.
Just like the Dotcom spree of the 1990s and subsequent crash, home values stopped growing at an out of control pace. This should have been predictable, and in fact, many did predict this would eventually happen. Once it did, then the practice of financing 100+% of a home on an interest only payment for five years with the plan to sell it for a nice little profit stopped working. All of a sudden, people were having a tough time selling their houses and they were getting less and less money. Supply had caught up to and even surpassed housing demand in many markets. Interest rates started increasing and those home owners holding adjustable rate mortgages saw their rates increase. Whether on a mortgage at interest only or a more standard interest and principle mortgage, these high-risk borrowers were rapidly falling behind on their payments. This lead to price drops in the markets due to short sales, distressed homeowner sales, excess supply and eventually increased foreclosures. The stone had begun to roll and it was rapidly picking up speed.
Eventually this impacted the mortgage companies as more and more homeowners realized they could no longer afford to pay their monthly mortgage and that their home was worth less than what they owed. Combine this with the American Public's inability to save and their need to finance everything they purchase with credit cards, unsecured loans and a new car every three years and many irresponsible people found themselves unable to make ends meet. As everyone would guess, this lead to increased bankruptcy filings, foreclosures and a further decreases in home values as the supply well exceeded demand.
With this, the banks/mortgage companies found themselves sitting on notes written against overvalued security (the house). Unfortunately, during this whole spiral, it was determined that packaging these mortgages into groups and selling them was both a good protection for the initial note holder, was good cash management and proved to be profitable. However, as the values of these notes fell and ended up with an undetermined value or low, things became further complicated. With the Mark-to-Market accounting principle in play, it meant that the holding companies had to cover the difference between the book value against the current day market value. This needed to be done on a monthly basis and with cash to balance the books. The market value, had become so low as it was basically based on the lowest selling price of like instruments, that the holders of these instruments needed more and more cash to finance the holdings. This forced grave cash position situations and the failures started to become evident. As a result, a spiraling mortgage company (note holder - which in many cases had eventually become financial companies that consumers invested in) was forced to liquidate these holdings, sending the values even lower, which further exacerbated the problem, pushing more financial institutions to the brink of insolvency. Finally, it became difficult, even impossible for the note holders to borrow money for the mark-to-market accounting principle requirements as the holders of cash became leary of the inability to be paid back.
This resulted in the credit market semi-freeze on lending that really trickled down to unrelated industries and even consumers (to a much lesser extent). Once the mark-to-market make-up loans were no longer available then everything pretty much fell apart and puts us where we are today.
The $700B Bail-out was/is designed to address the credit market with the concept being that between the infussion of available cash for credit, combined with the side feature of trying to partially addressing the sub-prime loans, that a slow but steady recovery will be possible.
Did our elected officials act wisely? There are too many opinions on this and nobody knows as only time will tell. My contention is that they acted too quickly without considering all options. It is my opinion that instead of a cash bail-out, it would have been both more economical to have offered government backed insurance for bank-to-bank loans that address the mortgage holding needs in the mark-to-market practice requirements. Secondly, I do not get the impression that the plan to auction off the sub-prime mortgage notes can be done with the full protection of the taxpayer while also being fair and reasonable to the borrowers. While I do not yet know and understand all of the details of the UK plan (10/7/08), what I do understand seems like a more plausible solution which costs less and protects the tax payers more completely. The UK plan is a combination of an insurance plan and an infussion of funds via government backed loans into the credit market designed to increase the amount a credit capitol and provide protection at the same time. Additionally, part of this plan provides for the acquisition of stock ownership in banks participating in this program. This plan to me, on the face, seems like it is a more thought-out plan that provides significantly better protection for the tax payer while at the same time providing a badly needed infussion of capitol into the credit market with insured protection.
In the end, the markets will recover. Some will say as a result of the government intervention (in the USA) and others will say despite the government intervention. As a strong believer in capitalism and the free-market ideology, I have a partial belief that more failure and losses were needed for a lesson to be learned - by the financial institutions, the Government and yes, even the taxpayers and homeowners. The idea that our Government bails us out, both businesses and individuals sets another bad precedent. There were many participants in this nightmare who all decided to take very high risks that were contrary to the long term principles and practices of mortgage lending. I don't like the idea that those who willingly and knowingly take high risk and fail then get the benefit of a bail-out funded by those individuals (taxpayers) who took the responsible route. This, in my opinion, is what is happening.
So, who is to blame you ask? The blame needs to start with the Government first, with the enactments of the Community Reinvestment Act in the 1990s. Under pressure from various civil rights groups, political organizations and other entities claiming to represent the best interests of lower income Americans to live the "American Dream", our elected officials traded solid financial practices with decades of proven success for votes by forcing the banking industry to participate in their plan for the equal distribution of wealth via home ownership.
Second, the American consumer is to blame. Too many people decided to pursue the risky venture of getting a sub-prime loan. It is elementary education math, nothing more, to determine if one can afford to buy something. If one earns $2,000 per month and decides to borrow money which requires a monthly payment in excess of their ability to pay, in the case of a mortgage, this should be no more than 25% or $500, then one is taking a huge risk with a very high potential for failure.
After ignoring the simple math, these people then tried to predict the future value of a commodity (in this case a house) with the hope and belief that the value would continue to increase at levels well beyond long terms averages and this would compensate their risky borrowing. There are some who argue that these inexperienced borrowers were taken advantage of by the loan/mortgage officer. While I would agree that some of these people and companies are sleezy, this does not provide a valid excuse for ignorance or stupidity. It is similar to your teenage child blaming peer pressure for using drugs, drinking or behaving in irresponsibly. As parents, this doesn't fly with us with our kids, so it shouldn't with a lender either. The fact that the typical American has virtually no savings and significant debt from credit cards, car loans and other financing decisions; it should come as no surprise that these people eventually failed. Murphy always finds a way into your house and there were just too many financial house of cards that we consumers were living.
The lenders need to participate in the blame game as well. It was the lenders who disregarded years of proven lending based on a borrowers credit history, job history and proven ability to pay back the loan (income to debt ratios). The lenders should have fought the government legislation harder, the lenders should be more knowledgeable than the politicians in this area and should have showed the Government that the Community Reinvestment Act principles were not based on reality but purely on ideology. Such practices were destined to fail, as they surely did.
While it would be nice that we look at our bank, mortgage company or lender as the experts, it is also important to recognize that they are out for their best interests first - to make money. Every legitimate real estate professional will tell you to have your mortgage reviewed by an attorney. Doing so will help point out the weeknesses in said mortgage that could hurt you in the long run. Additionally, for those individuals considering purchasing a home, perhaps discussing their ability to afford the costs should be considered up front as well. In the end, we need to recognize that reading the small print is important and when we don't understand it, we need to pay a professional to work on our behalf (not the lenders) to provide us with the pros and cons.
In the end, most of the blame belongs on the borrower for not performing their due diligence and perhaps for not even being honest with themselves. We as taxpayers should also be suspicious of our elected officials. Elected officials are for the most part out for themselves first and even when they claim to be acting on the best interests of the tax payer, are typically undereducated in most areas that the results of their actions are nothing more than a guess.
Many people state that this is a result of under regulation by the government, when in fact, it was regulation by the government with the Community Reinvestment Act that is one of the key causes of our present situation. It must be remember that regulation for the sake of regulation is not always good. The same can be said for reduced or no regulations. In the end, regulations need to be carefully weighed, studied and are best left to be written and determined by experts outside of the political arena. Regulations should not be written by people within the industry in which they are designed to regulate, though their input should be considered. Politics needs to be taken out of regulations and all regulations must be written and practiced for a common good. They must protect and/or provide a playing field that is fair and reasonable to all. Most important of all they should be able to stand up to long term logical and practical examination and consideration.
Three regulations I would like to see enacted: mortgages cannot exceed 80% of the value of the collateral (ie. a loan max of $80,000 for a purchase price of $100,000). Residential monthly mortgage payments cannot exceed 30% of monthly income, unless additional cash deposits or real estate collateral is part of the mortgage. And finally, no mortgage can be written with a pre-payment penalty (pre-payment penalties have helped to prevent people with bad mortgages from refinancing with better terms when their credit history has improved or market conditions have changed).
My final comment on this topic is geared toward greed and risk. People and institutions take increased risks when the result of success is increased profits. There is nothing wrong with this and it is what our country and economy is based on. This is why people start businesses, which is necessary for the growth and expansion of our economy. However, anybody or any organization choosing to pursue a higher degree of risk must be honest and aware of the potential for total or partial loss. The amount of loss must be weighed against the investment and the ability to sustain such a loss. If one cannot afford to sustain the loss, then one should not pursue the risk. Buying a house with a traditional mortgage and a 20% downpayment still involves the potential for risk. The house may decrease in value for any number of reasons. However, historically this risk has been low and the losses, when they do occur, are generally manageable.
Okay, I better understand why we are in the condition we are in. But what should I do now? The answer to this question is fairly simple, but the topic of another article.