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How Did We Get to This Point?

by: Scott Brown September 23, 2008 | about stocks: FNM / FRE    
Scott Brown

Dr. Scott Brown

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Excerpt from Raymond James Economist Dr. Scott Brown's latest economic commentary:

First, let’s take a step back and think about what got us to this point. The root cause was excessive lending in the mortgage market. With a political bent, some have placed the start of the problems with the Community Reinvestment Act of 1977, which was meant to provide credit to undeserved populations, improving home ownership in inner cities and providing loans to small businesses. However, the CRA impact, while typically seen as a drag on business earnings, is tiny compared to the recent expansion of mortgage debt. Subprime mortgage lending had a small, but justified niche in the credit markets. For example, a recent MBA grad with a limited credit history and starting a family might not qualify for a prime mortgage loan, but would after a few years of working. The subprime mortgage market provided such people an opportunity for home ownership sooner rather than later. The excesses came as subprime lending expanded well beyond its scope. Mortgage originators, interested only in a fee, had little incentive to make sure that the borrower would be able to pay if, for example, adjustable-rate mortgages were to reset at higher levels. Easy credit, fueled partly by a global savings glut, and lax supervision in the industry helped create the bubble. Speculators played a part too, especially toward the end of the housing boom.

Mortgage securitization has been an important success over the years, expanding homeownership and providing opportunities for investors worldwide. The problem was leverage. Fannie and Freddie got greedy. Investment banks levered up, borrowing to buy higher-yielding securities backed by subprime debt. As anyone familiar with the real estate market knows, leverage is great on the way up, but deadly on the way down. If you put 10% down and the asset price increases by 10%, you’ve doubled your money. If the price falls 10%, you’re out of luck. And if the price falls 20%, then you’re in serious trouble. In the U.S., distressed homeowners can simply walk away, leaving the lender with the asset.

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This article has 15 comments:

  •  
    Sep 23 04:30 PM
    worthless blog....anyone who doesn't know this isn't breathing.
    Reply
  •  
    Sep 23 04:53 PM
    Yep. Securitization's been a great opportunity. Well, it was when we had GNMA pass throughs. But once Fannie and Freddie got together with Congress and decided that subprime lending would be a key goal, and once the SEC decided in 1995 that derivatives were OK with them, and once Glass-Steagall got repealed in 1999, then the perfect storm just kept building and building. And then we were in it. And so we are.
    Reply
  •  
    Sep 23 05:55 PM
    It's EASY to look back at where you've been, and much HARDER to see where you're going.
    Reply
  •  
    Sep 23 08:01 PM
    There been numerous commentators talking about the Community Reinvestment Act. I don't understand what is driving this. Yes, the CRA probably results in some loans that default, but have you folks looked at the volume of CRA loans? They are minuscule compared to the current problem. See www.ffiec.gov/cra/defa...

    The mess we're in now includes $700 Billion (big B) for loan purchase authorization, plus the AIG bailout of more than $85 Billion, and assuming Fannie plus Freddie's $1.5 Trillion (really Big T) of mortgages. The failure of every loan ever made through the CRA wouldn't make much of a blip in all this pile of money.

    There’s lots of blame for this mess to go around:

    (1) Phil Gramm’s [R-TX] Commodity Futures Modernization Act, passed during Bush’s first year in office, specifically excluded these instruments from regulation or oversight by the government. This was in keeping with the Republican agenda of keeping the government out of business regulation.
    (2) Investment houses and mortgage brokers discovered that they could make lots of money making home loans, packaging them as mortgage-backed bonds, and selling them into the bond market as high-yield, low-risk securities. As a result, they virtually gave away mortgages to anyone willing to take one, knowing that if the loan defaulted, the bond holder – not them – would be hit with the loss.
    (3) The bond rating agencies and bond insurers (ie. AIG), paid by the investment houses, did the investment houses a favor instead of doing their job, and approved and insured the bonds.
    (4) Speculators, house flippers, and the financially naive took advantage of the almost free money by buying homes that they either couldn’t afford, or planned to resell. Like musical chairs, the speculators are walking away now that the music has stopped. The poor and dumb are once again getting kicked onto the street, and thanks to falling home values, the plain unlucky are getting financially destroyed.

    My children and probably grandchildren will be stuck paying for this mess. The investment industry CEO's will take their millions from prior year bonuses and move to the south of France. Some folks will get a deal on their homes at taxpayer expense, if they can hang on long enough.

    Hopefully the good thing that will come out of this mess is the death of the Republican belief in unfettered free markets.
    Reply
  •  
    Sep 23 08:08 PM
    Einhorn: soft-spoken swindler?
    Reply
  •  
    Sep 23 08:41 PM
    Nothing in this article to see...move along,please..
    Reply
  •  
    Sep 23 08:53 PM
    Are you sure it was the GSE's got greedy? Remember the are federally regulated by congressional mandates. There's a lot of people in the loop that would have to turn a blind eye for Fannie and Freddie to get greedy.

    Something is not right with this whole mess. A government takeover when the stock was going up and the interest spreads coming down? The takeover infused 1 Billion in each company but shareholder value dropped by 36 Billion? Seems way too convenient to point a finger at a company that has a government gag on.
    Reply
  •  
    Sep 23 08:54 PM
    Dr. Brown,
    I believe you meant to say "underserved populations" rather than "undeserved ppulations". A Freudian slip perhaps?
    Reply
  •  
    Sep 23 10:24 PM
    My 9th grader could've written this.
    Reply
  •  
    Sep 24 01:10 AM
    This is bullshit. The "root cause" is America's addiction to debt.
    Reply
  •  
    Sep 24 09:30 AM
    when i see rude comments with no point other than being rude posted to these articles, i think i could be at a yahoo message board. when someone takes the time to post, argue with the points or compliment the points . . but making a comment with no other intent that rudeness, is what is truly worthless.
    Reply
  •  
    Sep 24 10:04 AM
    I think Americans in the future should do like our grandfathers did; If you can't afford to buy something, save your money until you can.
    Reply
  •  
    Sep 24 11:51 AM
    I feel someone should be in jail! Am I wrong?
    Reply
  •  
    Sep 24 02:44 PM
    If this was written in late 2005 I would have been impressed.
    Reply
  •  
    Sep 24 07:53 PM
    Fannie and Freddie drove lax lending with loans for those who could not afford to pay and held off regulation by giving huge campaign contributions to their partners in Congress: LIBERAL DEMOCRATS. This totally liberal democrat agenda made Fannie and Freddie assets grow to justify huge compensation packages for Franklin Raines and other executives at Fannie and Freddie. This requires a totally unbiased report to expose the truth, which we may never get. The democrats are frantically trying to find specific Republicans to blame it on and would be screaming for an investigation if they could find any (even walking by in the parking lot).
    Reply
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