I have been taking an economics class at the right time. One of my chief frustrations has been my ignorance of the financial world, how it works, and what it all means. With all the talk these days of bailouts, mortgage backed securities, and credit swaps I would have been completely and totally lost. So here is an assignment I had in trying to explain the bailout in simple terms to someone who would not know a thing about the financial world… which I assume would be most of us.
Headlines are calling it the greatest economic challenge faced since the Great Depression. The alarm over the failure of the nation’s largest, most respected financial giants has prompted drastic action from political and financial leaders. The result of their decisions is a $700 billion “bailout” or “rescue plan” aimed at restoring fiscal credibility to the lending market that is suffering from stingy credit policies. In this paper I will explain the events and policies that brought this unfortunate state of affairs about with the hope of making it clear to the average reader.
Much of the bailout talk is connected to the failing housing market. Beginning there is crucial in our understanding of the current crisis as it is the lead weight tied to the ankles of our fledging economy. Homeownership has always been a rite of passage in the American life. It is perhaps the most definitive mark of prosperity that makes the American Dream a reality. One transcends class barriers not just by sleeping under a roof, but by being able to park in one’s own garage every night. Of course, no one has the money on hand to buy a house. Saving up for one would take decades, and would be nearly impossible. So a loan is needed to initially pay for it, and the borrower is obligated to pay it back over a long period of time. However, the borrower has to prove he or she is worthy of the loan, which simply means they have the ability to pay it back.
This is where the problem begins. Not everyone has the means to pay back a loan for a house, and therefore do not qualify for one. They fall below the “red line” so to speak. Unfortunately, these people tend to be of lower classes (not surprisingly) and minorities. However, those that politically represent these people found an opportunity. They introduced legislation that promised “affordable housing” to low income and minority borrowers by threatening lenders with punitive actions if they did not lower the red line. The most famous example is the Community Reinvestment Act passed by Congress and signed into law by Jimmy Carter in 1977, which obligated lenders to “meet the credit needs” of “low-income, minority, and distressed neighborhoods.”
In 1999 The New York Times reported that the Fannie Mae Corporation, the nation’s largest underwriter of home mortgages, relaxed their credit standards to extend loans to minorities and low-income borrowers. The reporter noted that Fannie was taking on more risk which would not be a problem during a boom, but could be troublesome in a downturn. The report quotes Peter Wallison, a fellow at the American Enterprise Institute as saying, “If they fail, the government will have to step up and bail them out the way it stepped up the thrift industry [the savings and loans industry of the 1980’s].” The “affordable” loans being issued were termed “subprime” to distinguish them from conventional loans that low risk borrowers would normally get.
Wallison’s warning would prove to be prophetic. In a recent Wall Street Journal article he and Charles Calomiris detail the history of the government-sponsored mortgage giants Fannie Mae and Freddie Mac’s unrestricted buying of subprime loans that stimulated subprime lending market. The explanation for the collapse of the market is found in the simple proposition contained in the original problem: low-income borrowers did not have the ability to pay back lenders. The huge increase of subprime loans financed by Fannie and Freddie saw a huge increase of foreclosures and defaults that resulted in gigantic losses.
It is important to note that Fannie and Freddie did not directly loan to consumers. Rather they financed the lending of private lenders by buying their loans and reselling them to Wall Street investors. But their borrowing was not only unrestricted, it was encouraged to fulfill the purposes of subprime loans. The pressure they felt from politicians in the quest for “affordable housing” resulted in a fervor of lending that reached its height during the housing boom. Not only did Washington want cheap loans, so did Wall Street.
Wall Street’s role is more complex but driven by the simple desire for profit. The boom in housing created a demand for more loans, and in turn a demand for investment in “mortgage backed securities” and “credit default swaps” (CDS’s). Mortgage backed securities are investments made on capital in the housing market. CDS’s are financial units of insurance against losses on investments. They function like mortgage insurance that a lender stipulates to a borrower to take out that will protect against potential loss. Insurance against losses on investments was easy money in the boom times, and sold at exponential rates. But when widespread foreclosures took the bottom out of the housing market, Wall Street’s investments in mortgage backed securities plummeted. The CDS’s in place simply could not compensate for the sudden dramatic losses, and the financial giants fell like Goliath on the battlefield.
Goldman Sachs Lehman Brothers went bankrupt and the insurer AIG crumbled to pieces.
The financial crisis at heart is a credit crisis. With the heavy losses suffered by banks and other financial institutions like Fannie, Freddie, and AIG the availability of loans is made tight. Lenders are reluctant to loan out money to anyone, including other normally reliable financial institutions. Investors in industry have less access to money to finance their ventures, which in turn affects consumers, slows economic output and increases unemployment. The intent of the proposed bailout is to buy up and pay off the bad loans so that lenders will free up the credit market and get things moving again. However, the time lag caused by the slow approval of Congress and the inaccessibility of monies may have caused irreparable harm. Only time will tell.
On thing is for sure, however: the poor, who were intended to benefit from subrime lending, are those taking the biggest hit.