The Eye of the Financial Storm

First and foremost, this is a problem that has been percolating for a few decades. I know it’s the fun and easy way out, but Bush isn’t completely the culprit. Sorry haters. We have to go back to Jimmy Carter’s wonderful presidency for one of the major roots of the problem. The Community Reinvestment Act (CRA), passed by Congress in 1977, required, among other things, banks and lending institutions to relax their standards for extending credit. Congress decided it was their duty to make sure everyone obtained home ownership and the only way to do that was to require banks to give everyone mortgages. So, in order to avoid being sued for discrimination, banks absolved their loan officers of using much, if any, discretion in approving mortgage applications.

Enter stage left: the sub-prime mortgage. Since banks couldn’t offer traditional financing to these risky creditors, they offered mortgages with much higher interest rates. On the surface it’d be easy to say banks were greedy and predatory, etc.; but because of the risk of loaning to unqualified people, the high interest covers the bank for the imminent default on the mortgage. Think of it this way: if a bank knows it’s not going to be paid back in the long run for the credit it’s extending, they need to get paid upfront to cover the certain loss, i.e., high interest rates.

The other major culprits are now household names, Fannie Mae (established under President Roosevelt in 1938) and Freddie Mac (Nixon, 1970). These two government chartered corporations operate in the secondary mortgage market. They buy mortgages from banks and in turn bundle them into securities for investors. The problem with Fannie and Freddie was their implicit guarantee from Congress. Essentially, they were assured they’d be reimbursed by the Federal Reserve for any losses. With such a safety net, they took incredibly reckless actions, bought far too many mortgages, and bloated to unprecedented levels. The inherent problem with even the existence of companies like Fannie Mae and Freddie Mac is a topic for another discussion but management of these companies can be blamed for overreaching and dangerously expanding. However without any explicit standards from the federal government, they had no reason to be cautious. It wasn’t their money to lose.

Within each one of these major foundations of the current crisis are several more nuanced issues, which I won’t discuss here. But one final major contributor to the state of finance nowadays was the attack on September 11, 2001. Following that terrible day, the Federal Reserve kept interest rates low to avoid a tightening of the money supply that crippled the economy in the lead up to the Great Depression. This enabled Americans to continue their lives as usual with easy credit and lots of lending. The American economy is very credit driven and with tightening of terms, consumption is harder. The problem though, is the false sense of prosperity we encountered. Interest rates were artificially low and in every reach of the economy, spending was rampant. People bought homes they couldn’t afford with an interest rate they shouldn’t have received. Not until the housing market began to correct itself by bringing values back to normal last year did people start to default. They owed more money on their home than it was worth. They couldn’t pay, banks had to take losses, and in turn mortgage securities lost enormous value. A little perspective: the number of delinquent mortgages across the country in 2008 is at 6.4%. Compare that to around 45% in 1933 during the height of the Great Depression.

I was very thrilled to see the House vote down the “Emergency Economic Stabilization Act of 2008” on Monday. This bill was an egregious violation of the Constitution and completely failed to address the deep-rooted problems I noted above. I find it incredibly ironic and sad, but also typical that those responsible for getting this nation into trouble are so quick to jump up and “fix” the problem. What we really need is the government to reign itself in and quit interfering with the market. We have the epitome of a “do-nothing” Congress and at the exact time we need them to stay out of the way, they rush to “save us.” The failure of this bill was a success for capitalism, but knowing this United States Congress and this President, we’re not out of the woods yet.

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