« 6 How the Tax Code Subsidizes Businesses that Move Jobs Elsewhere | Main | 8 Understanding Health Insurance »

September 30, 2008

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

rm3friskerFTN

An Idiot's Guide to the Subprime Mess came to light via Harvard Economist Greg Mankiw's Blog, someone using 'stick-figures' illustrates how we got into this mess. Rough manly man 'Wall Street Language" is used. Some danger of food or fluid coming through nostrils cause it is wicked funny.

Link URL = http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1

Lous Fernandez

Credit default swaps plus mandated bad loans to unqualified recipients. Both had to happen, plus Barney Frank blocking reforms of Fannie and Freddie. You only touched on one part of the problem.

Government is insane. How can we trust government to oversee Wall Street, which is also capable of exuberant behavior?

Quilly Mammoth

Prof Seto, you are making an error when you disassociate "teaser" loans from the sub-prime fiasco. Almost all consumer loans are rated, in part, by debt to income ratio; which has really become payment to income ratio. If the payment was too high for the applicant to qualify then simply switch your customer to an ARM and Bob's you uncle!

I think we'll find that not a lot of people actually lied about their income. But the lack of paper work...the supporting documentation...required by Fannie, Freddie, the FHA and a host of non-governmental lenders from the late 90's on makes it difficult indeed for securities buyers to truly understand what the paper was really like.

A lot of people should have known better. Jaime Gorelick stood in front of the MBA in May of 2001 and _told_ people they were going to put a lot of sub-prime loans in securities. Yet it's hard to resist the yield of the "AAA" rated sub-primes when it is perceived that the whole process has Uncle Sam standing behind it.

And those promises of great yields spurred others to follow that same garden path.

T. Shaw

Here's my overlong, nonacademic list of causes.

The mortgage crisis, which was caused by way too much liquidity, caused this credit crunch which caused way too little liquidity. Too many $$$$ were chasing real estate (God isn’t making any more!) and that created the housing bubble.

Banks’ overuse (aided and abetted by FNM/FRE) of securitizations/money multipliers;

Banks’over-lending to individuals and/or over-lending by mortgage bankers, i.e., borrowing/lending more (monthly payments unsupported by income) than a borrower can reasonably repay - traditional standards for monthly income to mortgage payment ratios ranged from 28% for conventional loans to 43% for GI insured loans; PRICES ARE WAY ABOVE AFFRODABLE LEVELS FOR MOST AMERICANS.

Universal superstition - real estate values always soar, never drop;

Long Term Credit Management debacle – Fed lessened losses and added to moral hazard. LTCM was into thinly traded, hard-to-value paper.

Clinton signed repeal Glass-Steagall 1999

Clinton Admin. excluded financial contracts from commodities regulations.

Billions $$$ of foreign money;

Billions $$$ more chasing assets when SEC (2004) waived investment banks’ leverage (debt to equity) rule to go from 12:1 to 40:1 – only five largest received waiver: Bear Stearns (defunct - $30B cost taxpayers); Goldman (now a BHC); Lehman Bros. (bankrupt); Merrill Lynch (sold at huge loss to shareholders); Morgan Stanley (now a BHC).
Speculators’ flipping houses and then over-building/oversupply of housing stock;

Push for low-and-moderate income loans from ACORN/CRA/HMDA and community activists;
FNM/FRE 50% must be low-to-moderate income borrowers – added trillions $$$. Bush admin. half-hearted attempts to mitigate go nowhere

Greed, hubris, and stupidity;

A 1% fed funds rate;

Need to replace lost mortgage refinancing fee revenues;

People more embarrassed by living in as modest home than by being foreclosed from a McMansion;

Liberal appraisals – did not stabilize comparable sales for over-heated/unsustainable market conditions;

Regulators failed to enforce underwriting standards – again, ACORN/CRA/HMDA; CRA protests on every merger application application – extortion.

Banks and Wall Street believed they could sell and forget.

Andrew_M_Garland

So, teaser rate loans were originated that had large interest rate risks. I assume the risk was made greater by small or no down payments, eliminating the cushion for declining house values.

Ignoring these risks seems strange for sophisticated institutions, especially when there was common talk about the "housing bubble" and the eventual correction to follow.

(1) Who was buying those loans, providing liquidity to originate more and more of them? (was it Fannie?)

(2) Did all participants ignore the special risk of these "sub-prime" and "Alt-A" loans?

(3) Why didn't investors hedge the interest rate risk, resulting in an immediate, lower value assigned to these loans.?

Joe Y

Good explanation on the credit crisis, and good corrections on the FMs' contribution. The (mistaken) belief that these were guaranteed by the US government (and I checked my old Series 6 & 7 study books the other day, and they say precisely that--not de jure, but absolutely de facto) meant that these mortgages, regardless of their terms, structure, etc., were the equivalent of a "free play" in football: Whatever the loan, the worst you can do is break even; anything else is a big gain.
It's crucial to add that the banks had to make these loans--though not on those terms--to stay out of trouble with the regulators. Worst of all Fannie and Freddie had to, by order of congress, i.e. Frank & Dodd, go out and buy a certain % of the subprime loans and were desperate to do so. I know this from deep personal experience working with them.

vincent

How does a teaser rate take a payment from $1000 to $4000?

That's the equivalent of raising the rate from 3% to 20%

Perhaps a tad hyperbolic?

Rebecca

I wondered about CRA, Fannie and Freddie also. Although I don't know much, I think they have ties to the problem.

I'm not as sophisticated as the posters here, but the add ons of special benefits to select groups strikes me that this isn't as serious as we were told, not saying it isn't, just didn't see them all on the steps of the Capital holding hands singing God Bless America.

Rebecca

I wondered about CRA, Fannie and Freddie also. Although I don't know much, I think they have ties to the problem.

I'm not as sophisticated as the posters here, but the add ons of special benefits to select groups strikes me that this isn't as serious as we were told, not saying it isn't, just didn't see them all on the steps of the Capital holding hands singing God Bless America.

Mark_0454

How did the two CSE's become involved, specifically with CRA loans and then with loans that may not have been to low-income, but at the teaser rate? or did Fannie and Freddie have any connection to loans at teaser rates?

George

How can you write an entire post on this subject without mentioning the giants of the mortgage industry, Fannie Mae and Freddie Mac?

Me thinks you're trying to hide something.

The only reason why the banks started expanding the sub-prime business was because Fannie Mae and Freddie Mac stood on the ready to buy them up. No financial institution would take such high risks without having some kind of guarantee to rely on.

Their guarantee was Fannie Mae and Freddie Mac's Clinton-powered lower standards. Since you don't mention these GSEs at all, you're obviously trying to hide the Democrats' role in all this.

Such a shame, because otherwise it was quite an informative post.

Fannie and Fred

Hi-- it's your friends Fannie and Freddie. We're disappointed that you seemed to have forgotten us. But we're very pleased that a) you think this was Bush's fault, b) you think McCain has shown poor judgment re: Cox, and c) you think the federal government ("the beast") has been starved.

We argee! We agree!

Please advocate the purity of the Democrats and ask those same members who we greased for these many years to raise taxes to satiate the beast. Maybe the beast might leave some scraps for us.

Those hicks in the sticks--the ones with the pitchforks-- are too dumb to realize that they really need us. After all, we're part of both the D.C. Beltway elites AND the NYC Masters of the Universe.

Hugs, F&F

David

"Remember what businesses use short-term money for – to meet payroll and put inventory on their shelves."

I keep hearing this. How long are these loans for? I don't know of any company that borrows to meet payroll. And inventory would only be initial inventory at startup, not for replentishment inventory. What size are these businesses? Local hardware store size or WalMart? Thanks.

dpt

"A teaser-rate mortgage allows a borrower to make relatively small payments for several years. At some point, the rate jumps dramatically..."

Was it the prospect of a rate jump that made the whole securitization an attractive--at the time--investment for the likes of Lehmans, etc.?

Why were these Wall Street types blind to the fact that defaults would shoot up as folks went to paying $4K per month instead of $1000 per month? It seems like commonsense as the whole business looks to be a pyramid scheme.

thanks for the post.

ian

A few thoughts:

I have had several ARM loans in my life. It always struck me that the problem with them is not the teaser rate per se, but rather, qualifying people for the loan based on the teaser rate. All of the ARMs that I have had have had a maximum lifetime cap on the rate (regardless of how high the underlying index went) - it would make more sense to qualify people on the basis of, say, 80% of that cap.

On the subject of debt chains: did all of the participants in the chain keep a stake in the loans? Weren't they usually sold outright?

Finally, what troubles me most about the 'rescue' package is that I don't hear anything about what changes we adopt (moving forward) if and when we get out of the current crisis. Do we allow Fannie and Freddy to continue in their current form? Do we change accounting rules? I see nothing to prevent this from happening again some day.

David Walser

"'Remember what businesses use short-term money for – to meet payroll and put inventory on their shelves.'

I keep hearing this. How long are these loans for? I don't know of any company that borrows to meet payroll. And inventory would only be initial inventory at startup, not for replentishment inventory. What size are these businesses? Local hardware store size or WalMart? Thanks."

They are all sizes and shapes of businesses. Most businesses have cycles. A farmer might receive close to 100% of his revenue in the fall when his crops are sold. A CPA might generate most of her revenue in the winter and early spring. A large retailer might generate most of its sales in the holiday buying season.

Because cash receipts do not (and usually cannot) match up well with cash expenses, most businesses find it useful (frequently necessary) to borrow for short periods. The farmer might borrow to plant with the expectation of paying off the debt at harvest. The retailer will fill its stores with goods using credit. A construction company may not be paid until completion of a project and need to borrow to cover payroll and other expenses while completing the project (which might take weeks or months). Car dealers typically borrow to place cars on their lot (it's called flooring). They pay off the debt as the cars are sold.

I work in a professional firm where we charge by the hour. There's usually a 45 - 60 day lag between when we work on a project and when we are paid. In the mean time we have to pay our people who are doing the work. Since we distribute our profits as quickly as possible (maintaining prudent reserves), we sometimes have to borrow to meet payroll.

None of this borrowing is, per se, and indication of bad management. Businesses have been borrowing for short term needs for decades, if not centuries. The practice is taught in business schools across the country. Too much short term debt may be an indication of poor management (or some other problem). So, too, can too little debt.

Tom Perkins

"More fundamentally, there is no evidence the present crisis started in 1977. Teaser-rate mortgages first became widespread after Mr. Bush took office in 2001.)"

Do mention, if you'll name him, that he (A) did nothing which incentivized teaser loans and (B) proposed reforms in 2003 and McCain did in 2005 that the Democrats shot down as unnecessary.

Helian

Great article? I think not. In fact, it’s naïve. It’s not naïve because the author is naïve, but because, like the authors of all of the other articles I’ve read on this subject on both the right and the left, he’s made a conscious choice to tell only one side of the story. He doesn’t leave us in the dark about which side he’s sitting on. Comments such as “Teaser-rate mortgages first became widespread after Mr. Bush took office in 2001,” make that perfectly clear. Of course, “Taxprof” will bitterly deny the political implications of this zinger, but, after reading it, all but the politically brain dead will realize that they’re only going to see one side of the story.

The author immediately confirms that realization when he deigns to educate us about the “real reason” for the crisis: “The media talks about “sub prime mortgages” – by which it means mortgage loans to borrowers with less than stellar credit. The real problem, however, was the advent and widespread use of teaser-rate mortgages in both the prime and sub prime markets.”

In the first place, of course, the “media,” if, by that rather vague term, our disingenuous author means CNN, MSNBC, NPR, et.al., are not talking about “sub prime mortgages,” or, if they are, they are doing so in such a subdued manner that I have never heard them refer to the subject. The alternative media on the right, including blogs, talk radio, Foxnews, etc., are, indeed, commenting on the subject, and that rather loudly. The put on naiveté in this comment about the “real problem,” is stunning. The fact that our obviously erudite author must surely know it is naïve is more worrisome than the naiveté itself. Are “sub prime mortgages” and “teaser rate mortgages” really mutually exclusive? Were no “teaser rate mortgages” ever made to “sub prime borrowers?” If so, what percentage of the “teaser rate mortgages” now in default were made to borrowers with “sub prime” credit?

I could go on and on. The upshot is that “Taxprof” has written another of the myriad of articles on this subject whose purpose is not to inform, but to bamboozle. I read him for the first time, but can still say with assurance that the chances that you will find anything in any of his work intended for consumption by the general public that can be directly or indirectly interpreted as a serious criticism of Obama or those close to him are virtually nil. The conclusion? You’d better read lots of articles on both the right and the left if you want to have even a faint chance of really understanding this issue.

Mark Shelley

Excellent explanation on such short notice. The longer solution has to address the subsidies that the federal gov't gives the real estate industry. From the deduction for mortgage interest on down, there has been a steady supply of gasoline thrown into the real estate valuation pool. Well-intended, no doubt to make home ownership more affordable, this policy has had (in my opinion) the unintended consequence of making the cost of home ownership even more costly. We really do need a free market correction and the bailout will impede this cleansing process.

Don Mynack

Echoing and expanding upon one of the commenters above pertaining to foreclosure:

Foreclosure law is different from state to state. Some states have ridiculously lax foreclosure laws that force lenders to allow people stay in their homes for as little as $50/month. Foreclosure basically works like this: Once you miss a payment, you have a certain amount of time to make up that payment. If you miss multiple payments, then you get a demand letter from the lender demanding all the payments due at that time, in one lump sum. If you can't make that, then you go into foreclosure, and a clock starts ticking until your scheduled hearing (in court) to seize possession of the house. Well, some states force the lender to reset that clock even if you make a token payment (as low as $50!). This can go on forever. It ruins the borrower's credit, but the lender can't seize the asset to recoup the investment. There is no incentive to work out terms with the lender because one can keep the house for a very long time just by making token payments. I am betting that if someone looked into states with massive amounts of homes in foreclosure, they would find that those states also have laws that are very advantageous to the homeowner, and also most of those loans would be CRA loans. I haven't seen one thing in this mess about reforming foreclosure laws in this manner, but it's a real problem and has been one for some time.

All that being said, the fundamental cause of this is a major decline in home values, and way too many people stupidly buying (and lending) on a bubble. Just convert all teasers and ARM's to 15 or 30 year fixed and let the people stay in the homes - it's better than trying to sell in this market.

Hume

Honest question: if the credit freeze is the result of banks' unwillingness to lend to each other, and this is problematic because small businesses will be unable able to obtain short-term loans, why must banks loan to other banks in order to reach small businesses? Why must banks loan to each other in the first place in order to provide additional loans to a third party? Why not loan directly to the businesses? I am not familiar with the process so this is an honest question (I realize it may sound naive and it may be elementary, but it is something I dont understand).

Hawk

As a retired derivatives trader, I'd like to make a brief point. When notional numbers are discussed such as $45 - 60 trillion, they seem rather scary, but are quite misleading. The risk of an initial swap is typically laid off in subsequent trades. This leads to multiple counting of the underlying risk. Debt can only default once, but may be counted in the notional value many times.

Sean

I dont know how you can separate the CRA from the craziness that ensued. Or how you can separate Fannie and Freddy, who were buying these "mortgage products" like crazy and spurning them on to crazier and crazier heights. At the same time ACORN was suing anybody who even thought about turning down a loan to somebody, teaser rates seem to me to be the market response to insane requirements. Are you just trying to be contrarian?

David Walser

"Honest question: if the credit freeze is the result of banks' unwillingness to lend to each other, and this is problematic because small businesses will be unable able to obtain short-term loans, why must banks loan to other banks in order to reach small businesses? Why must banks loan to each other in the first place in order to provide additional loans to a third party? Why not loan directly to the businesses?"

Not only an honest question, it's a good question, too. Here's an honest answer, which I hope will be a good answer:

The amount of cash in a particular bank fluctuates -- a lot -- from day to day. Just look at your own checking account. If it's like mine, is shows a few sizable deposits with lots of small and a few large withdrawals and your balance varies from one day to the next. Multiply that by thousands of customers -- businesses and families -- making deposits and withdrawals. Similar variability happens with loans. A business may pay a loan off earlier than expected (adding to a bank's cash balance) while another might draw down on its line of credit (reducing the bank's cash).

Given such fluxuations in the individual account balances, it should be apparent that estimating accurately how much cash a bank will need to meet the day's needs is very difficult. Invariably some banks will be a little short of cash (to cover net withdrawals or new loans) while other banks will have "excess cash" at the end of any given day. Rather than let the extra cash sit idle, the banks with excess cash will lend to those that are short. Typically these loans are just overnight. They are paid back the very next day.

Absent the ability to borrow on such a short term basis, banks would need to stock pile much more cash. This would be a bad thing since banks make money by lending it, not by hording it in their vaults. Forcing banks to hold more cash reserves is one of the ways the Fed uses to SLOW the economy. Forcing banks to do without short term borrowing would all but stop the economy.

Why don't banks refuse to lend to someone when they are out of money and allow another bank to do the lending? Sometimes they do. However, most business loans require banks to become intimately acquainted with a business' operations. A bank needs to understand the financial statements, the products and customers, plans, management, etc. of a business before the bank can properly assign risk to a particular loan. Making a business go through that process with several banks (just to find the one that has cash available that particular day) is inefficient. It would add significant costs to the borrowing process.

Hope this helps.

Joe

You wrote: "Why did banks stop loaning money to each other? When lenders lend, they generally look at borrowers’ financial sheets to determine how creditworthy they are before giving out money."

That's hilarious!

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been posted. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

Your Information

(Name and email address are required. Email address will not be displayed with the comment.)