Free Market + Liberal Entitlement=Disaster

CT

To us at PCT it has become imperative that the people of the United States know the truth about the Subprime Bust and what "REALLY" got us here. Opie and myself both agree that the economy is to sophisticated and intricate to be demolished by one group, one bad decision, or one person. This was more about an intermingling of two philosophies that are polar opposites and the effect was devastating to our economy. All of the information we drew from seems to point to that conclusion, minus all of the nuances of macroeconomics.

The Basics of the Bust:

In the mid-90's mortgage lenders relaxed strict credit standards thereby allowing people who would not normally qualify for home loans to be able to obtain them. Interest rates on these loans were greatly increased to compensate for the greater risk involved. Mortgage companies contributed more risk to the market by further lowering underwriting standards to increase the availability of the sub prime loans. Here are some numbers via the Heritage Foundation showing the percentage changes form late 90's-2006 due to the availability of subprime loans.

As a consequence, the availability of risky loans soared from the late 1990s through 2006. In 2001, newly originated subprime, Alt-A, and home equity lines (seconds) totaled $330 billion and amounted to 15 percent of all residential mortgages. Just three years later, in 2004, these mortgages accounted for almost $1.1 trillion in new loans, equal to 37 percent of the total. Their volume peaked in 2006 when they reached $1.4 trillion and 48 percent of the total. Over a similar period, the volume of mortgage-backed securities (MBS) collateralized by subprime mortgages increased from $18.5 billion in 1995 to $507.9 billion in 2005. [1]

Here is how Wall Street fits in to this scenario, enter a little "financial engineering." Large banks like Goldman Sachs or Lehman Brothers would buy hundreds of millions of dollars of these low quality loans from a mortgage underwriter and then bundle them together. They were organized by risk level into "tranches". This worked out well because analysts and rating agencies believed that by bundling up these loans you lowered your risks by depending on thousands of people paying the interest and principal rather than a single entity. The danger of everyone defaulting was minimal and since housing value was on the rise and interest rates were lowering. Even if someone defaulted on their loan you could re-structure the debt and still make a profit. This worked out great for everyone until there were a large number of defaults on the subprime loans which sent everything into a tail spin.

This is the mechanics of the bubble and the bust but this is the how and why, It started with the Community Reinvestment Act of 1977. Here is the definition provided by the Federal Reserve Board.

The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound operations. It was enacted by the Congress in 1977 (12 U.S.C. 2901) and is implemented by Regulation BB (12 CFR 228). The regulation was substantially revised in May 1995, and was most recently amended in August 2005.
[2]

Now, we jump ahead to 1999 and the Financial Services Modernization Act of 1999, it is defined as this,

Allowing firms to transform themselves into financial holding companies that can engage in a wide range of financial services will give rise to more competition, and consumers will benefit from lower prices, onestop financial services, and innovation leading to more products. U.S. firms will be better able to compete globally. [3]

The FSMA was created to allow banks that loan to you and I to become financial holding companies as well. They could deal in insurance, security underwriting, portfolio investments, etc. But in order to get this legislation passed through Senator Phil Gramm had to accept CRA amendments to the FSMA in order to get it passed through the Clinton White House.

There are two things about the CRA amendments and its accountability measures that draw my suspicions to it contributing to the subprime bust.

Information collected for CRA ratings does create a database for class-action lawyers to use in suing banks servicing low-income areas.
[3]

An unsatisfactory CRA rating does prevent a bank from merging or being acquired. [3]

If banks did not fulfill their obligations to the CRA amendments they could be lined up for a class action lawsuit from any number of "community activist groups". Also if they did not have a history of lending to low income consumers then they would not be allowed to reap the financial potential provided by the FSMA. I believe they saw an opportunity through the FSMA and its CRA amendments to really open up the market for subprime loans through some disastrously creative "financial engineering". This kept groups like ACORN at bay, allowed them to meet regulatory guidelines, and make a healthy profit in the meantime.

The CRA also imposes a larger cost on society by misallocating capital. In the absence of government intervention, credit markets efficiently allocate funds on the basis of risk and return. High-risk borrowers are charged higher interest rates to compensate lenders for the increased likelihood of nonpayment. Borrowers with a low probability of default borrow on more advantageous terms. To remain competitive, banks have devised sophisticated models for rating borrowers and allocating funds. That does not mean that low-income or high-risk borrowers are excluded from credit markets. Banks are willing to extend credit to any group if such loans,on average, are profitable. [3]

As noted above the credit markets could have regulated themselves through the profitability of the loans they were issuing. None of this was necessary, the FSMA and CRA should never have been coupled, it created a market with high octane potential for calamity. Simply this venue was used as a tool by the financial market. They were motivated by, ironically, regulatory fears and simple greed to reap a profit with some less than lustrous effects. I have asked this question before, "How do you regulate an attempt a deregulation?"

Now onto President Bush and the 2003-04 Congress's complicity. Welcome to the American Dream Downpayment & Zero Dwonpayment Acts.

American Dream Downpayment Act,

That chance will arise when the House is asked to approve by unanimous consent the American Dream Downpayment Act -- a bill that would require the U. S. taxpayers to provide $200 million per year to fund cash grants of as much as $10,000 to individuals and families wanting to buy a house, but without subjecting themselves to the burden of having to save for the downpayment. [4]

Zero Downpayment Act,

The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH), would require the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. Although the bill could lead to a very modest increase in the homeownership rate, it would do so by exposing the FHA—and ultimately taxpayers—to major losses stemming from high default rates, as evidence from similar FHA programs shows. The Congressional Budget Office estimates that the new program would cost the government $618 million from 2006 through 2009. [5]

These furthered the initiatives of allowing low income families and individuals the opportunity to gain access to loans that they could obviously not pay back. In summary, the CRA and FSMA were tools and venues brought about by poor decision making by Congressional Republicans and Democrats and the Clinton White House. The biggest mistake was putting together free market capitalism with a liberal entitlement program. Both fed off of each other and allowed Wall Street to exploit the weakness. President Bush went further along with this "new" philosophy of pairing somewhat far right and left thinking with his contributions; the American Dream Downpayment Act and Zero Downpayment Act, accelerating the bubble into a bust. Due to the length of this post I will cover ACORN, Freddie Mac and Fannie Mae in a separate one.

-CT

"Hunting Happily!"

[1] Subprime Mortgage Problems: A Quick Tour Through the Rubble
[2] Community Reinvestment Act
[3] Gramm-Leach-Bliley Act: A Good Start in Need of Fine-Tuning
[4] American Dream Downpayment Act: Fiscally Irresponsible and Redundant to Existing
Homeownership Programs
[5] Congress's Risky Zero Down Payment Plan Will Undermine FHA's Soundness and Discourage
Self-Reliance

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One More Time, Stupid!

CT

Well let's go over it one more time. The American economy is entirely to sophisticated and intricate to be brought to this point by one person or group, especially over such a short amount of time. So what does that leave us? Maybe this has been an ongoing series of bad desicions and situations that were intertwined which caused this crisis. Just because it is election year does not give anyone the right to reprimand another group or person, it was all of us. From Wall Street to the Fed (Democrats and Republicans) to the everday American who had their hand out. Take responsibility for your actions and quite crying and blaming, no amount of spin is going to solve this mess. For those of you who missed it the first time here it is again.

As published on September 16th, 2008

Tuesday, September 16, 2008

An Obama Fact Check, Sub Prime Finger Pointing

CT

This post has developed very interestingly, while researching the sub prime mortgage crisis some months back I came upon some dates that tied the Housing Bubble to legislation as far back as 1994. Now, with Obama, blaming a Republican Congress and George Bush, those dates started popping back in my head. So, I started looking and found some interesting information. Well, the news is not all great for me though, it is making me rethink the conclusion I drew on my post Market Correcting Itself.

Now there is no denying the Republican Congress and George Bush are complicit in the Sub Prime Crisis, through the American Dream Downpayment Act and the Zero Down Payment Act. But the waters here run much deeper than that; enter Phil Gramm, Bill Clinton, Jimmy Carter and the 1977 Community Reinvestment Act, and Glass-Steagall Act of 1933.

If you notice, sub prime mortgages running flat until 1997. Then from 1997-98 there was a very noticeable spike that continued until 2000. Then it runs flat from 2001-02, possibly because of the economic implications of 9-11. After 2004, with the passing of the above mentioned Acts, there is a huge increase in the number of sub prime mortgages being acquired.

Let's backtrack to the Community Reinvestment Act and its amendment n 1995, under then President, Bill Clinton. As passed by the Carter administration, the CRA was supposed to provide credit, including home ownership opportunities to undeserved populations and commercial loans to small businesses. Under Bubba, there was an increase in the number and aggregate amount of loans to small businesses and to low- and moderate-income borrowers for home loans. CRA Moving forward a bit to 1996-97, with Glass-Steagall, a law which prohibited a bank from offering investment, commercial banking, and insurance services. Glass-Steagall was passed by the FDR administration, after a Congressional study revealed that the banking collapse of 1933 was directly attributed to the mixing of commercial and investment banking as well as the stock market crash of 1929. Glass-Steagall Act

In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent). This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively renders Glass-Steagall obsolete. [1]

If you noticed on the graph above there was a spike in sub prime mortgage loans from 1997-99. This is rather fascinating to me, because this truly highlights the very beginning of the Sub Prime Bubble.

By 1997, good loans were bundled with poor ones and sold as prime packages to institutions here and abroad. That shifted risk from the loan originators, freeing banks to begin pyramiding and make more of these profitable subprime products. [2]

This next little piece taken from a 1997 Wachovia press release provides some very interesting hindsight also, notice some of the names of these institutions involved.

The affordable mortgages were originated or acquired by First Union Corporation and subsidiaries. Customers will experience no impact - they will continue to make payments to and be serviced by First Union Mortgage Corp. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods under the Community Reinvestment Act of 1977."The securitization of these affordable mortgages allows us to redeploy capital back into our communities and to expand our ability to provide credit to low and moderate income individuals," said Jane Henderson, managing director of First Union's Community Reinvestment and Fair Lending Programs. "First Union is committed to promoting home ownership in traditionally underserved markets through a comprehensive line of competitive and flexible affordable mortgage products. This transaction enables us to continue to aggressively serve those markets."The $384.6 million in senior certificates are guaranteed by Freddie Mac and have an implied "AAA" rating. First Union Capital Markets Corp. is the investment banking subsidiary of First Union Corporation. [3]

Now, jump to Oct-Nov. 1999, Senator Phil Gramm (R-TX) successfully passes legislation that eliminates Glass-Steagall through passing of the Financial Services Modernization Act. Thus giving simple lending banks the ability to underwrite huge securities, as noted above (This is exactly what Bank of America has done with Merill-Lynch, hence my apprehension). This gave way to the evolution of Citicorp and Travelers merging into the mega-colossus, Citigroup. Unfortunately the elimination of Glass-Steagall did not come with out a price, enter Bill Clinton, once again, and the Community Reinvestment Act.

At first Gramm could not get the legislation to eliminate Glass-Steagull pushed through. He had to make a compromise with the Democrats concerning the Community Reinvestment Act.

Crucial to the passing of this Act was an amendment made to the GLBA, stating that no merger may go ahead if any of the financial holding institutions, or affiliates there of, received a "less than satisfactory [sic] rating at its most recent CRA exam", essentially meaning that any merger may only go ahead with the strict approval of the regulatory bodies responsible for the CRA. [4]

There were a few other equally important provisions added, one of note was Gramm's insistence on transparency concerning coercion of banks by community groups such as ACORN. But this, although, related is an entirely different article.

Gramm had maintained that he did not want anything in the bill that would expand the application of the Community Reinvestment Act because it was, he said, unnecessarily burdensome to banks.He had sought a provision that would exempt thousands of smaller banks from the law. He also wanted a provision that would expose what he has described as the "extortion" committed by community groups against banks by requiring the groups to disclose any special financial deals the groups extract from the banks. [5]

Summarizing this information, Clinton seeks to strengthen opportunity for home ownership in the States and amends the CRA, a few years later Phil Gramm seeks to overturn a Depression era piece of legislation, he cannot because of the Clinton administration concerns about lending practices concerning poorer people in the community. Gramm makes the compromise to get the Financial Services Modernization Act passed. You have coupled the farthest reaching free market thinking with a massive liberal community giveaway program. The regulations forced on these institutions, along with their greed, gave rise to the Sub Prime Bubble. Then a few years later, you have a Republican Congress and President who forgot they were Conservatives, passing liberalized legislation under the guise of free market thinking and I give you the Sub Prime Mortgage Crisis. Obambi might want to go back and check his facts, because it looks like most of the players in this were wrong, not just the Republicans. The last thought I have is what a wonderful idea it is to regulate an attempt at deregulation.

CT

[1] The Long Demise of Glass-Steagall
[2] Age And Experience: Carter's Catastrophes
[3] Wachovia Press Release
[4] Gramm-Leach-Bliley Act
[5] Agreement Reached on Overhaul of U.S. Financial System

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In the News: October 2nd-3rd, 2008

CT

Today's headlines are brought to you by Drudge Report , The News Media Journal, & The Politico. These are some of the headlines from October 2nd, enjoy. More coming up once we time travel to the 3rd.
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Wachovia faced a ‘silent' bank run

Rick Rothacker and Kerry Hall, Charlotte Observer-On Friday, with its stock plunging 27 percent, Wachovia experienced a “silent run” on deposits, but the bigger worry for regulators was that other banks wouldn't provide the Charlotte bank with necessary short-term funding when it opened for business Monday, sources familiar with the situation told the Observer.

With Wachovia already looking for a merger partner, the Federal Deposit Insurance Corp., in consultation with other regulators, required the bank to reach a sale to Citigroup on Monday morning. Read more...

This is why I am for private interests buying out the weaker of the herd. Understandably, there has to be a certain degree of government intervention, but not to the socialistic degree that the Congress and President have pushed. Although many have claimed this is the end of capitalism, I am not going to join the ranks of knee jerk reactionaries. It is way to early in the game to be crying that this is the death of free market capitalism, but it is definitely on life support.
_____________________________________________________________________________________

Aides Promise an Aggressive Palin in Debate

Juliet Eilperin, The Washington Post-< GOP vice presidential nominee Sarah Palin plans to launch aggressive attacks against her Democratic opponent Joe Biden tonight, her campaign aides said, in order to remind voters of why she became popular in her home state of Alaska. "Governor Palin is eager for the opportunity to contrast her record of reform to the hollow rhetoric of a politician who has spent the bulk of his adult life inside the confines of Washington, DC," said Palin spokeswoman Tracey Schmitt. "Tonight will address a critical question; which is more relevant to the office of the vice-presidency -- real-life results or Washington double-speak?" Read more...

Well only a few hours away, I am saying no more on the topic other than it should be very interesting either way. This will either sink the McCain campaign or give them more than a fighting chance for the White House. I would not want to be Sarah Palin right now.

_____________________________________________________________________________________

Palin’s new plan: Go after Biden

Mike Allen, The Politico-ST. LOUIS — Sarah Palin plans to go on the attack in tonight’s debate, hitting Joe Biden for what she will call his foreign policy blunders and penchant for adopting liberal positions on taxes and other issues, according to campaign officials involved in prepping her for tonight’s showdown.

The Palin camp is projecting surprising self-confidence in the pre-debate hours, despite the vice presidential nominee’s uneven — and, at some points, peculiar — performances in recent television interviews, the officials say. Top advisers to John McCain privately say Palin’s recent CBS interview was a borderline disaster, especially since it played out in several segments over several days. Tonight will be different, they say. Read more...

If she is going to win keeping Joe Biden on the defense is the best tactic. It would fluster him and make him prone to his most notable feature, gaffing. But,I don't expect a blow out either way.

____________________________________________________________________________________

Check back for updated information on the debate. Good luck to Sarah Palin and Joe Biden both. Give us a good one!

-CT

"Happy Hunting!"

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Sub Prime Sludge and Solutions

C.T.

Sub Prime what? A year ago I think this would have been the response most Americans would have given you if you brought up the potential problem. Nowadays everyone is an amateur economist with all the investigation and research going on by the average American.

Before looking at the solutions for the Sub Prime bust, you have to understand what has happened and why. From about 1995-2005 interest rates fell, creating more capital which found it's way into the housing industry. People figured out with the lower rates they could buy a house, maybe even more than one. As prices for real estate began to rise so did the equity and so did the collateral for creating more debt. Thus creating a "bubble."

Enter, "Financial Engineering." Banks, hedge funds, and insurance companies thought they could make a quick buck off this insanity and everyone would be happy. They figured they could transform these rather risky low quality loans in top of the line AAA securities. Now, some of these types of loans did not even require a small down payment. Nothing, zero, nada.

Individual mortgages, thousands of them, were wrapped up into groups called residential mortgage-backed security , or RMBS's. Large Wall Street banks such as, Bear Stearns, would buy the low quality loans from a mortgage broker. Concept was that unlike a regular bond, which was paid by a single corporation, RMBS securities were organized by risk called "tranches." Thousands of homeowners were paying the interest and the principal on these tranches. Most believed this bundle approach was less risky to own because the risk was spread around to so many people at different risk categories rather than just one entity. Well, everything was just fine until the summer of 2006. People for some reason started defaulting on these loans at a greater rate than expected. The big jump in subprime defaults led to the first hedge-fund blowups.

Now, the "liquidation" problem. As the market started collapsing the huge securities ratings were starting to be lowered. This in turn caused hedge fund liquidation. The amount of buyers for the mortgage backed securities dried up quicker than Joan Rivers. With no one their to buy sub prime mortgage brokers were left holding the bag and quickly started dropping like flies. This problem has catapulted all the way to the top, like Bear Stearns.

The solution? On March 13th the President's Working Group on Financial Markets offered some corrective actions. [1]

Improved Credit Ratings

The report calls for credit rating agencies to improve the way in which
they "grade" securities. Currently, both traditional securities and structured credit products are graded the same way. Structured credit products are
sophisticated and often highly complex packages that include such ingredients as tranches (pieces) of mortgages representing a specific level of repayment risk. They are designed to meet specific investor needs. [1]

This is simple plain common sense. This will attempt to make credit rating agencies much more vitreous. Since most of the risk assessment of the mortgage packages was faulty, the actual risk was underestimated, and the models used to rate them were not disclosed, investors were not able to appraise them properly. These recommendations seek to correct this flaw by disclosing the methodology and assumptions about the credit rating process and encourages reviews of these assumptions. Investors would be kept in the loop about how far these agencies looked into these new credit products and how they attained their ratings.

Improving Mortgage Origination

One factor in the current upheaval is that mortgages were made to homebuyers who normally would not qualify for them and were presented as being of much higher quality than they actually were. While much attention has focused on underwriting problems in the subprime market, the fact is that credit standards were relaxed for most classes of loans with the result that home purchasers found themselves in mortgages that were inappropriate for their financial circumstances, and underwriters of mortgage-backed securities purchased mortgages that were far riskier than they seemed. [1]

To avoid this in the future better standards for underwriting these loans should be implemented. Unfortunately, they also recommend better state and federal regulation of underwriters. This is an unfortunate situation, but had these mortgage companies not acted so irresponsibly, there would be no need for government regulation. According to the Heritage Institute, enforcing licensing requirements on unsupervised mortgage brokers would greatly improve the quality of the mortgages that they create.

Improved Risk Management and Regulation

The report also addresses poor risk management practices within
financial institutions that both purchased and originated sophisticated
mortgage-related investments. One of the more disturbing revelations of the subprime crisis is that major financial institutions are unable to estimate their actual exposure to losses resulting from these types of securities accurately. The causes of this range from improper understanding of the actual risk associated with individual investments to the inability to aggregate the holdings of various investments properly across all of a firm's business lines. As a result, financial institutions have found themselves far more exposed to risk and potential liquidity problems than expected, especially as credit conditions have deteriorated. [1]

One of the major problems with this whole scenario was the in-ability of these banks hedge funds, etc. to be able to know exactly how much risk they were going to be exposing themselves to. There was little to no understanding of how this undertaking might end up. The supposed protection of wrapping up so many individuals into one package, the RMBS, has been their undoing. So, to compensate this stupidity the government will require firms to have better management information systems so this information will be readily available. Also, they recommend firms meet liquidity and capital standards so that they can even weather the worst of times.

Final thought, from Bear Stearns, all the way down to the individual home buyer, everyone acted irresponsibly, hindsight is always 20/20. The banks thought they were smarter than the system and home owners were offered something they could not turn down, but couldn't afford. Problem is a loan is loan and someone will always expect you to pay it back, whether you can afford to or not.

C.T.

[1] Preventing the Next Subprime Crisis

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