Abstract

This paper will examine the historical factors that have led to the current financial
meltdown, led in large part because of the subprime mortgage market. Although blame
has been aimed at excessive regulation and de-regulation alike, a major factor has been
in the micro mechanisms that exist in the mortgage market itself. These mechanisms are
closely linked to macro level factors in the full chain of securitization that has taken
place with the increase in new and innovative financial instruments. This paper
concludes with analyzing the ineffective and misguided policy responses aimed at larger
institutional actors, and ways in which responses can be undertaken at the community
level.

This system was designed for plain vanilla loans, and we were trying to push chocolate
sundaes through the gears.

MARC GOTT, former director in Fannie

Mae's loan-servicing department, explaining
the company's collapse

The collapse of four major financial entities in the United States, and a
government backed rescue package of $700 Billion dollars (roughly the government
calculated cost of the Iraq War so far) has helped nerve up expectations of the economic
storm of the century. The causes of the crisis have been tossed around verbatim, with
excess deregulation and regulation spawned as culprits. A historic election year has not
made matters any less contentious; waking up a blissful world economy from its
splendour. Frugality is the term being used over excess. In these times Capitalism is
losing its candour, as the American electorate has become infuriated over the use of tax
dollars to bail-out the financial sector. It has become known as the socializing of risk –
and the death of the free market. Embedded within this sudden restructuring and shifting
of the global credit markets is the fundamental assumption it was built on for the last
thirty years: deregulation and the free functioning of the market. The old mantras
utterances do not seem to sound the same chime. The emerging market (BRIC’s) and the
least developing countries have taken the tone of chastising the United States for not
being able to keep its own cards in check, while lecturing others. The chief International
Financial Institutions (IFI’s), the World Bank and the International Monetary Fund (IMF)
are also quickly working to recast the way in which market fundamentals need to be
examined; a sudden change in decades old policy. Although the crisis has been a result
of interactions taking place in the real estate and housing market in the United States, the
effects have gone global. It is here where the roots of the problem need to be examined,
and if the responses can adequately help negate the unprecedented decline being felt in
the global economy.

Black cat, white cat as long as it catches mice.

– Deng Xiopeng

It is often quoted that history repeats itself; the current financial situation does not
show itself to be an exception to that rule. To understand the current crisis, going back to
a similar time, namely the 1930’s is important. After all, it is after the great depression
that the values and institutional mechanisms leading to the current crisis were created.
The great depression revealed just how much chaos could be created by mere
psychological panic. Like we see today, the failure of many large institutions (mainly
banks) created widespread fear. It was because of this, President Roosevelt instituted
specific institutional reforms such as the Federal Deposit Insurance Corporation (FDIC)
to guarantee bank savings to a sufficient level. More important was Roosevelt’s creation
of Fannie Mae, properly known as the Federal National Mortgage Association (FNMA)
in 1938 (Congleton, 2008). This fundamentally altered a basic value system in America:
namely the ideal for home ownership. Before this point, mortgages were held and dealt
with by banks, thus all the risk fell on them. After the creation of Fannie Mae, mortgages
were spread out more within the financial system. Fannie Mae’s mandate was to create
credit so banks could make more mortgage loans, and thus have more people move
toward home ownership – and be a part of the ownership society (Congleton, 2008). The
inclusion of other exogenous factors helped create what is known as the post World War
II boom. Much of this has to do with individual psychology then sound public policy.
Peacetime brought forth a new invigoration of freedom and the building up of familial
relationships, causing an increase in housing and Sub-urbanism. By the 1960’s,
homeownership had reached over 60%, although at such a high rate, an additional
housing institution was created in 1968. Freddie Mac, or properly know as the Federal
Home Loan Mortgage Corporation (FHLMC) was created to further increase the liquidity
and ultimate demand for mortgages (Congleton, 2008, 3). These two events are crucial
when examining the current crisis, which will be explored later in this paper. The U.S
government worked diligently to increase home ownership, with Fannie Mae becoming a
private company with quasi government regulation. This meant that indirectly its loans
would be backed by the government, which was not the case, but later provided the
underlying impetus for increased buying of its securities.

Another important piece of policy to examine is the Community Reinvestment Act

(CRA) of 1977. When looking at the current crisis there is blame being pointed at both
the supply and demand side of the mortgage market. Although many are pointing to the
predatory supply side lending of loans, many are also firing back at those who took at
loans they could not afford. Yet convenience glosses over the fact that the repayment
rate with the CRA was much higher than seen currently with the sub-prime mortgage
market. Unlike predatory lending, which created distorted incentives for brokers to make
a profit from increasing loans to customers, the CRA was focused on providing credit to
low-income individuals who had the means and desire to own a home. New York is a
good case city that reveals the outcomes of CRA programming in helping residents buy
their own homes. Local Initiatives Support Corporation, a key partner organization with
the City of New York helped over 17,000 low income families receive loans. Company
president Michael Rubinger states, “Guess how many of those 17,000 loans have ended
in foreclosure...that’s right five.” (U.S Newswire, 2008, 3). Luci Ellis in her paper, The
Housing Meltdown reveals how banks covered by the CRA made less sub-prime loans
then the independent banks in crisis now. Rubinger believes it is the easy scapegoat to
blame government programs, and not the lax management guidelines in place by
financial institutions to look at profit over following sound business protocols.
Government policy will require some blame, yet going back to 1977 to the Community
Reinvestment Act has not provided the evidence for such charges. The push for
Affordable mortgages came later in 1992 by Freddie and Fannie (with government
encouragement) and will be examined later in this paper.
The “crack cocaine” of our generation appears to be debt. We just can’t seem to get
enough of it. And, every time it looks like the U.S consumer may be approaching [their]
maximum tolerance level, somebody figures out how to lever even more debt using some
new and more complex financing...

Jeff Saut, Chief Investment Strategist,

Raymond James & Associates,
September 2007

The last and most important area to examine in the lead up to the crisis is the
private supply-side, i.e. the role of predatory lending. As shown in the preceding
paragraph the Community Reinvestment Act helped those who would otherwise not be
eligible for mortgage loans. Yet the approach was much different than that taken by
parallel institutions, which saw these loans as a way to make easy profit. In his book Bad
Money, Kevin Phillips documents the evolution of derivatives and financial instruments
starting from the early 1970’s. It is no coincidence that a proliferation of such
securitization instruments increased in the mid- eighties at a time where the economy was
in a down turn and interest rates were high. Investors were looking for options to help
hedge uncertainties in the market. Although this phenomenon is not particularly relevant
for that time, it gives a starting point for how such investment instruments eventually
brought about the current financial crisis. The derivatives market acted as the pull for
lenders and brokers in the housing market. The shear monetary value of the derivatives
market is telling: some estimates have the leverage of mortgage backed securities at over
50 trillion dollars, which is more than the Gross Domestic Product of all the world’s
countries. In addition, looking at the growth of the financial sector reveals just how
much money was flowing in the system; money from the housing market. In 1990, total
financial assets (bonds, stocks etc) averaged 700% of the GDP of the United States; by
2007 it was at over 1000% (Henwood, 2008). Furthermore, Kevin Phillips in his
research shows the share of financial sector growth in the United States doubling in the
past thirty years, going from generating 20% of the United States GDP to over forty.
Often unknown to the average layperson is the basic fundamental mechanism which
allows the economy to function: the notion that money is debt, and debt is money. In the
case of households, debt rose from about 50% of GDP in 1980 to a peak of 100% in
2006. In other words, households now owe as much as the entire U.S economy can
produce in a year (Ferguson, 2008, 3). It is from this we can correlate where household
spending was going and where excess money was being recycled.

Although the exogenous factors have shown to be in place to have allowed for such
a large-scale financial disruption to take place (the large volume of money in the financial
system), what incentive did lenders have to loan to those with low-creditworthiness? It
seems that it was just plain foolish for lenders and financial intermediaries to have made
such high-risk loans. Only by digging deeper into the world of the “predatory lender”
does one find how such a system was able to exist, and be so profitable. The story of
‘Mrs. H’ has become all too common in the narrative that underscores this current
financial crisis. Mrs. H, like many other seniors was charmed into agreeing to a loan she
did not necessarily need nor understand, with clauses and ridiculous legalities that many
individuals would never have agreed to (Renuart, 2004, 468). Unfortunately the situation
Mrs. H found herself in is a complicated and evolving network that many have a hard
time understanding. Mrs. H was approached by a broker, individuals who traditionally
acted as intermediaries in facilitating loans. But now these brokers work for lenders, or
even more bizarrely work as both lenders and brokers (Renuart, 2004). Due to the
perverse incentives that existed, many brokers changed roles and did whatever they could
to increase loans, as they would be rewarded with bonuses based on this criterion. This
helped pave the wave to create what has become known as a push market, as people did
not take out loans they wanted or needed, but rather what was pushed on to them
lucratively (Renuart, 2004, 476). Although these loans were structured at significantly
higher interest rates, the loan terms were still agreed upon, as promises of increased
equity and falsified terms did not allow for consumers to seek out better terms. The
demographic of those who were targeted for such loans also serves to reinforce the level
of asymmetric information in this market, as a significantly higher amount of individuals
did not seek to find better deals, or stated to researchers that they believed they were
already getting a good deal (Renuart, 2004). This was due to the fact, that many of these
individuals were low-income blacks and Hispanics who had a less than satisfactory
understanding of basic finance. In a comprehensive study into sub-prime lending, which
compared the perceptions and actions taken by those in the prime and sub-prime
mortgage market, the findings were very revealing. Many sub-prime borrowers did not
seek out assistance from family or others who were familiar with loans, as compared to
those in the prime market. In addition, many sub-prime borrowers stated they felt
confident with their credit ratings and personal finances, when this was in direct
contradiction to their actual financial situation (Lax, H., Manti, M., Raca, P., & Zorn.,P,
2004). Thus a fundamental gap existed between what borrowers thought they knew and
were getting. Many of the brokers actually worked in clauses which put penalties for
repaying a loan too quickly, and extra processing and home inspection fees which were
not necessary (Renuart, 2004). Yet the extra spread on interest rates between prime and
subprime borrowers is understandable along with other miscellaneous “fees” when
looked in the broad context of securitization in the previous paragraph (Renuart, 2004).
The extra fees and increased interest rates were what would be paid out to investors who
bought these mortgages on the secondary market, thus there was a push from mortgage
lenders to brokers to get such extra spreads. In the end one can see the impact of
perverse incentives to sound business practice as shown by the figure to the right. The
evidence can be seen by this one statistic alone: the value of mortgage-backed securities
issued by the subprime market grew from $11 billion in 1994 to $133 billion in 2002, a
period of less than ten years (Renuart, 2004, 472).

Although the crisis was spurred by the mechanics of what was taking place in domestic
housing markets all over the United States, the micro-level phenomenon was being fed by
macro level factors (namely the need for greater investor returns).

This extended internationally to investors looking for sufficient returns, and the United
States who could only finance its need for more consumption through its debt. A well
known fact for some time now has been that low-income countries have been financing
increased consumption growth in the United States and other countries. This has been
done mainly through their purchasing of low-interest bearing treasury notes and bonds, as
pointed out by Stiglitz and others. Yet the Bond Market Association reports that the
secondary mortgage and mortgage derivative market has been larger than the US
Treasury note and bond market since 2000 (Congleton, 2008, 6). This again shows the
large amount of leverage these types of debt instruments held even internationally.
The low-income countries were financing the growth of the OECD (Organization for
Economic Cooperation and Development) through their high savings rates, interestingly
the two countries with the highest increased rate of savings were China and East Asia
(see figure). Yet ironically the U.S strategy was not to save, but try to make up its short-
fall by the returns on its exported investment instruments. As pointed out by Carman
Reinhart and Kenneth Rogoff, instead of the U.S recycling surplus dollars as in the early
70’s it borrowed them, and lent them out to a ‘developing market” within its own
borders. Over a trillion dollars was put into the subprime market with the same end result
of default, only this time it was not countries, but individuals spanning various spatial
locations all over the United States (Reinhart, Rogoff 2008).

Nobody foresaw the Great Depression of the 1930’s, or the crises which affected Japan
and Southeast Asia in the early and late 1990’s. In fact, each downturn was preceded by
a period of non-inflationary growth exuberant enough to lead many commentators to
suggest that a “new era” had arrived.

Bank for International Settlements, June 2007

September 15, 2008, Black Monday as it has come to be called signalled the
beginning of the end for the recent financial crisis. It was here that everyone learned the
two biggest entities backing the market for mortgages (Fannie and Freddie Mae) needed
to go under government conservatorship. Furthermore, the Fed had to step in and provide
AIG with an $85 billion dollar bailout, its first of many, and saw five of the nation’s
financial institutions ceasing to no longer exist in less than a few weeks. Along with the
fall of banks and the mergers of others, came the domino effect in the stock markets.
Two trillion dollars in retirement savings wiped out in mere weeks, as Washington Post
staff writer Bridget Schulte asked pointedly in her column, is it good-bye to the golden
years? The domino effect of seeing such major institutional players fall at once, created a
psychological panic not seen in at least over half a century. The fact that this all
happened in the middle of a all-important election, and right after a time when Americans
were still furious about high oil prices (due to high speculation in commodities) could not
make matters any worse. To exhaust through the timeline of events would be tedious,
but what is important to point out is the all encompassing measure of the contentious
$700 billion dollar bailout. As soon as it became evident the monstrous beast that stood
before the world financial system, Treasury Secretary Henry Paulson moved quickly for
congress to approve his bailout plan. Criticism abounded as the initial plan, a mere two
and a half pages asked for sweeping authorities. Section 8 was a case in point, which
stated decisions by the Secretary would be non reviewable by any court of law or
administrative agency, even more pointed, no mention of how taxpayer money would be
repaid ( Emergency Economic Stabilization Act 2008). The proposal was criticized by
both the right and the left, by economists to laypersons, as the bill proposed no specific
mechanism to address the impending crisis. As Jim Jubak, stated in his MSN money
column, the gift of taxpayer dollars would only give further incentive to Wall Street to
continue its entrenched ways, and provide an incentive under Paulson’s plan to overvalue
asset prices (Jubak, 2008). An election year did not make things easier, as it was
politically convenient to call out the bailout of Wall Street firms, over those hurting on
Main Street (Obama Press speech, Oct 2008).

The inability of Paulson to stick to a concrete plan, helped to weaken confidence on Wall
Street. As the bailout was being voted on a second time, and even with its passage, the
mood on Wall Street remained. The Week of October 6-10, showed the largest drop in
the DJIA (Dow Jones Industrial Average) since 1933, a decline of over 18 percent.
Although the crisis was due to defaults by individual borrowers across the country it was
financial institutions that have been received federal assistance. The figure to the right
shows the large amount of non bank losses in this crisis. But the fed under the auspices of
the Treasury still pursued its strategy to inject capital into banks. By the end of October,
the Fed was forcing the nine largest banks to accept credit, even at their refusal.
Pearlstein criticizes this dyslexia of the Treasury as the reason the crisis was not being
dealt with appropriately. Only after two months into the meltdown, did the fed offer an
additional $800 billion targeted toward consumer spending. Working backwards toward
the causes of the financial crisis, the focus on banks and macro level institutions has
revealed the height of moral hazard, as those who created the crises are the ones being
offered the “first ride” out. No sufficient reform has taken place against the institutions
which helped perpetrate this crisis, only the lack of transparency abounds. As can be
seen with the reluctance of the Treasury to detail how two trillion in TARP (Troubled
Asset Relief Program) money was dealt out.

New reports have now surfaced that many lenders using the cover of the FHA (Federal
Housing Administration) have come back as new companies; cashing in on the insurance
backing of the FHA, to again make profit from predatory lending (Terhune & Berner,
2008). A spokesperson of the FHA, even admitted, “[the FHA] is not ready to deal with
the onslaught of new lenders who are trying to cash in.” (Terhune & Berner 2008, 38).
Although cries of socialism abound, it is really the long-standing corporate nanny state
that is being shown for what it has truly been. The lack of regulation, and the way in
which the current bailout is being handled is only helping financial institutions who were
“to big to fail” merge and become too big to fail. In recounting a childhood question
Ralph Nader asked his father, he describes the situation perfectly. “Why will capitalism
always survive.”? Nader’s father replied, “Because Socialism will always be used to save
it.”

One of the biggest problems that have surfaced due to the current crisis has been the
reluctance for those operating within the financial system to acknowledge what has
happened. Just as William Paley rebuked Smith’s notion of the Invisible Hand with his
argument of the providence given by natural forces (Shermer, 2008). The same was
being done by a key player in the current financial crisis, Mr. Greenspan, as he remarked,
“who am I a mere moral to second guess the collective wisdom of markets” (Henwood,
2008).

It seems all people wanted was recognition by Wall Street and the major players who
were closely linked to this crisis to acknowledge they had not taken the proper
precautionary measures to avoid this inevitable crisis. In his October 10 column of the
Washington Post, Stephen Pearlstein chastised the Wall Street elite for not even speaking
a word to the public after the crisis. The only appearances they made were in private
vehicles to the awaiting closed door rooms to be briefed by Treasury Secretary Paulson,
and Fed Chairman Bernanke (Pearlstein, 2008). In contrast, their Japanese counterparts
during the Asian crisis of 1997 saw executives publically apologize for what had been an
outcome of their business operations (not to underestimate the obvious cultural
differences to expect such a response from the Wall Street community). This has become
a metaphor for the sense of entitlement many firms are expecting now in terms of federal
funds to take them through the crisis. The attitude has been to not blame those who were
in positions to be linked to what was happening, but to blame their crisis of faith in the
long held ideal of the unregulated market. In his October 24th testimony before congress,
former Fed Chairman Greenspan remarked how he was in a state of shock that what he
fundamentally believed his whole life (minimally regulated free markets) had unravelled
in a matter of weeks. Yet many warnings had been sent his way by advisors and Senators
alike, as seen with Senator Feinstein of California’s letter to Mr. Greenspan in 2003,
calling for more regulation in the Energy Derivatives market.

Although again, this crisis was created and generated at the local level in the offices of
mortgages brokers and lenders across the country, the solutions have been implemented
and pushed toward macro level players such as the banks and financial institutions who
played a leading role in growing their risk to unjustifiable levels. It is therefore important
to look at solutions for homeowners, and structural changes to not allow for another
housing based bubble to occur, as has been the root cause for many other crisis as well
(Asian Crisis of 1997, etc).

Yale economist, Robert Shiller, details various key findings about the current crisis that
have not been well researched in the area of residential housing. Beyond his obvious
findings of the increase in homeownership rate beginning in 1997, and its positive
correlation with investment in housing as a share of GDP, his most interesting find is the
lack of historical data; no long-term data exists in any country regarding house prices
(Shiller 2008). Shiller’s research found the belief in increased home values was a mere
psychological phenomenon rather than economical. If Baumol’s law is correct; stating
those goods and services that are akin to technological processes decrease in value over
time, then it is easy to understand the fall in housing. This is applicable to housing, as
inputs (interior, finish) are always changing to fit stylistic and cost considerations.
(Shiller, 2008). Therefore housing prices can fall, as it has been shown in various places,
not just with the current U.S financial crisis. The problem has been the underlying belief
that fixed capital (land) and increase in population would inevitably create scarcity and
therefore higher prices (Shiller, 2008). Since the housing market has shown to be about
psychological speculation and mis-information, it is important to create mechanisms to
prevent such misalignment of information. Many have called for looking at housing like
insurance, a standard plan applies and opt-out is only considered if the individual choose
such a plan (Shiller, Barr, Mullainathan, and Shafir). Due to the fact mortgages and as
can be argued for health insurance, the problem of asymmetric information is large in
comparison to the benefit of full consumer autonomy. Many individuals do not
understand the underlying economic and legal issues that go into such processes. It is
therefore better in the long-run, and society in general (seeing the positive as avoidance
of large scale crisis) to provide standardized sets of mortgages, than allowing for supplier
(lenders) to create terms that are beneficial for their own purposes. It has been shown the
biggest aspect in helping to create the current crisis was the way in which lenders, and
consumer misinformation has helped spawn the financial meltdown. It is thus imperative
that these mechanisms be re-examined, and ensures false and misaligned reward
structures are not in place to help those who use predatory schemes to profit. Ironically,
this has not been the case, with the government still trying to pursue the ideal of every
American owning their own home. The fed has done what it can to prop up the housing
market, not trying to address the underlying issue that many of the individuals should not
have gotten loans in the first place. In addition, on Dec 3 the Treasury Department
announced its plan to intervene in the mortgage market directly, decreasing the
borrowing rate to 4.5% (Washington Post, Dec 3 2008). The problem this has caused is
individuals now waiting for better rates, and the government trying to create a false
mechanism to promote perusals for home loans, and more lenders to give them –
ironically the initial cause of the problem. As various individuals have pointed out,
institutional mechanism to stimulate a false mechanism to increase home loans is the
wrong response; rather the rethinking of mortgage lending itself is needed.

In late September I was surprised to see advertisement for a “Save the block party” over
the traditional use of the term. Instead of celebrating it has become a time of trying to
hold people together. The headlines have been numerous, presenting the enormous fall in
home values and foreclosures. Although the responses have been necessary, the question
has been around the appropriateness and targeting of the aid. It has been increasingly
understood the mechanisms which helped create the current crisis: misinformation
created at the community level in giving loans to unqualified and uninformed individuals.
Although the response has been at targeting major financial institutions, and trying to
keep home sales and home values high and sustained. Yet the irony is both measures, the
major institutions helped incentivise the practices which led up to the current mess, with
the current crisis a outcome of false expectations in an overinflated housing market. It is
thus important to realize that the lesson learned from this crisis is at the grassroots level.
Looking at the way business is conducted, and the role of those who conduct financial
transactions and their responsibility toward the public good must be closely evaluated
(Khurana, Nohria, 2008). The responses have been the major concerns in the aftermath
of the crisis, not the actions that have led up to the crisis which will help dictate future
solutions and preventative measures.
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