The Global Credit Freeze – Why It Happened and What is Next

There is great anger and confusion about the global financial meltdown and the resulting effect on the global economy. Why did it happen, who are the culprits, and what affect will it have on the global economy? Real estate cycles are a regular occurrence, and real estate developers go belly-up all the time. Why did this cycle lead to a global credit freeze and probably the greatest financial disaster since 1929?

The Culprits

The leading culprits include:

I. The Feds Who Created the Secondary Market for Mortgages

In 1934, Federal bank regulators were looking for ways to reduce bank risks so there would not be another collapse. They forced banks to divest their investment banking activities because they were “too risky”. The regulators were also concerned that banks would get the interest spread wrong and lose money (the interest spread being the difference between the bank loan rate and what banks pay for money: when this is positive, the banks make money; when it is negative, they lose money). As a result, they created a secondary market where banks could sell off their mortgages.

By using this market, banks would make money on a commission rather than on the spread. However, this decision had two important unintended consequences:

* Until this secondary market was created, banks and other lenders kept in touch with their borrowers because they knew they would not profit unless borrowers continued to pay on schedule. Creating the secondary market eliminated the reason for this supervision: once Banks profited from a commission on the sale of mortgages rather than from their spread, banks no longer cared about the borrowers ability to make payments on their mortgages. But this went way beyond mortgages: it effects all loans and through that, the global economy. The importance of this point cannot be overstated. My father was the president of a bank; my cousin was an insurance company executive. The bank wrote mortgages and made loans; the insurance company made loans. I estimate that one third of my father’s and cousin’s time was working with the borrowers to insure they would be able to pay off the loans. The secondary markets eliminate the need for this stewardship: who cares if the borrowers cannot afford the loan? As soon as we sell it into the secondary market for a sales commission profit, it is off our books!

* The secondary market also provided a new opportunity for the development of various leveraged derivative instruments, some of which have been at the center of the recent mortgage collapse.

II. People Who Took Out Mortgages They Could Not Afford

To qualify for a loan, most people use Fannie Mae Form 1003, now called the “Uniform Residential Loan Application Form”. This form is quite restrictive on who qualifies for a mortgage: you have to show adequate net income or assets to be approved. Very few persons qualifying for mortgages using this form will end up underperforming. Given the widespread use of this mortgage application form, how could 10% of all mortgages be in trouble? There are only two answers: either the numbers filled in on a large number of 1003 forms were inaccurate or there are ways to get mortgages without completing this form.

There are three distinct groups of people who take out mortgages they cannot afford:

* People who do not understand what their mortgage payment responsibilities will be. There are some in this category, but not many. Anyone who has taken out a mortgage knows there is a Federal mandate for full disclosure. Under this mandate, the borrower must either sign or initial at least 20 pages of explanatory material.

* People who bought houses believing they would make money by quickly selling them. As long as prices continued up, some people took out mortgages they could not afford in the expectation of selling in six months for a capital gain.

* People who regularly take on more debt than they can afford – and get away with it, be it credit cards, mortgages, or other loans. Americans have $10 trillion of mortgage debt and $2.5 trillion consumer loans. Of that amount, approximately $800 billion is credit card debt with an average interest rate of 13%.

III. The Mortgage Writers

Fraud on a grand scale? Quite possibly. Remember what the creation of secondary markets did. It eliminated any concern the lender might have about the creditworthiness of the borrower. Why? Because the mortgage writer could immediately sell the mortgages into the secondary market for a commission. Also, with secondary markets, one can write mortgages without having the funds to finance them. Mortgage companies do this and sell them into the secondary market.

In most cases, it is more complex than this. For example, suppose a mortgage company with no money of its own writes up $1 billion in 10-year mortgages at a net 6.5% rate, or $65 million annually. Suppose it needs the money for these mortgages in 30 days and raises it by floating $1 billion in bonds backed by the mortgages paying 5.5%, or $55 million annually. That leaves an annual remaining mortgage income stream of $10 million that can be sold off close to its present value of approximately $70 million (or slightly less if it gets an insurance company to guarantee the income stream. Not a bad business if you start with no money! But note, once the mortgage company has sold off the mortgages, it is indifferent to how the mortgages perform.

When mortgages can be sold for a commission as soon as they are written with little regard for their creditworthiness, imperfections are likely to develop.

* banks can take a commission on writing a mortgage and selling it off into the secondary markets;

* mortgage companies with no money of their own take a commission on writing up mortgages and selling them off into the secondary markets.

Neither group has to care about whether the mortgages will “perform” down the road: just write them and take a commission by selling them off.

IV. The Mortgage Buyers/Packagers

The major buyers are government – the Government Sponsored Enterprise (GSE) agencies that include Ginnie Mae, Fannie Mae, Freddie Mac, and the Farmers Home Administration and the private sector.

During the Clinton era, political pressure led Freddie Mac and Fannie Mae to provide assistance to low-income families to buy homes: standards were relaxed somewhat – down payment minimums and acceptable credit scores to qualify for mortgages the Feds would guarantee or buy were lowered. Click here for more Financial Advice. The result is that today, the Feds own approximately $5 trillion or half of all US mortgages.

Perhaps it was unwise for the GSE entities to be pushed so hard to support the housing market at a time when real estate prices were already rising. However, the Feds were not directly responsible for the sub-prime crisis: of the $5 trillion in mortgages held by the GSEs, only $114 billion, or a little more than 2%, are sub-prime. In short, the Feds bought or backed a very small portion of the sub-prime mortgages.

Almost 98% of the problem mortgages were purchased by the private sector. How could this have happened? Let us start with the fact that sub-prime mortgages, while performing, were paying a higher coupon than mortgages with higher ratings. Financial firms all talk about their risk assessment methods, but as long as they could package and sell sub-prime mortgages into the secondary market, they saw no risk. Here is how it might work. A big bank would task staff to buy high-risk mortgages already in the secondary market. The bank would then package them with other mortgages to reflect the coupon a buyer was looking for and sell the package for a commission. Apparently, nobody was discounting such packages for their inherent risk.

Banks would often “sweeten” such packages with their own guarantee. Their guarantees would allow them to sell packages for an even higher price. These guarantees constituted a significant portion of banking losses registered this year.

In short, financial institutions made no allowance for level of risk associated with sub-prime mortgages. They saw a higher coupon and bought them up. And when the sub-prime mortgages stopped performing as the real estate market started down, these institutions panicked and refused to buy or sell any mortgages, whatever their rating. And this in turn led to the freezing up of all credit globally.

V. Insurance Companies

If there were any group of financial institutions that should have been aware of the risk associated with sub-prime mortgages, it would be the insurers. After all, their primary business is to assess all types of risk and set fees accordingly. And yet, AIG has now borrowed $123 billion from the Federal Government in a desperate survival effort. What happened? According to the New York Times, most of the mortgage insurance was written by a semi-autonomous AIG unit based in London. In essence, this unit guaranteed mortgage packages written by other financial institutions.

VI. The Paulson Bailout Bill

$700 billion is a lot of money. And it apparently can be spent however Paulson chooses to use it. Some of it will be used to buy up mortgages. Think about it: figuring out how to value real estate mortgages. This is not an open invitation for graft and corruption on the highest scale.

The problem is how to unfreeze global credit. The Federal Reserve already has credit windows for the private sector. It has employees in place to make loans to the private sector. Freddy Mac and Fannie Mae hold approximately half of all US mortgages. They have the authority to do everything that was requested in the bailout bill, including buying up mortgages and guaranteeing them. Why do we need all this power centralized in a new Treasury Department bureaucracy?

The credit crisis could have been resolved via the authority already held in the Federal Reserve, The Treasury, and GSEs; a new Treasury bureaucracy was not needed.

The most cost effective way to end the credit freeze is to have the Federal Government guarantee the loans of the major financial institutions. This approach avoids all the problems of purchasing stocks, bad loans, and sub-prime mortgages. It has no budgetary impact except for the small portion of loans guaranteed that fail.

Looking Ahead

The housing collapse and the freezing of the credit markets have been bad enough. But things are going to get worse. There is going to be rising unemployment and lower income. And the problem will be more severe in the United States than in most other countries.

Here is why. Anyone who has had an introductory course in economics knows that consumption depends on income: higher income means higher consumption. Income is usually defined to include wages, interest and dividends net of taxes (disposable personal income). But the US is unlike most countries in that a significant source of personal income comes in the form of capital gains from the stock market and real estate.

Some economists argue that capital gains don’t influence people’s buying decisions: people know that today’s capital gains can be tomorrow’s capital losses. And partially as a consequence, capital gains are not included in disposable personal income. The only problem with this is that US consumers have just come through a series of years of steady capital gains on houses and stocks. People have come to expect capital gains as part of their income. In fact, in the 2003 through 2006 period, capital gains was just under 50% of disposable personal income.

Contribution of Capital Gains to US Personal Disposable Income

Sources: Bureau of Economic Analysis, Federal Housing Authority, and Federal Reserve Flow of Funds.

Since 2006, capital gains have nose dived. In 2007, capital gains from real estate turned negative and capital gains from equities fell from $2.6 trillion to a mere $526 billion. This year, the bottom has fallen out: equities are down $8 trillion, and the asset value of homes is off almost a trillion dollars. To see this in perspective, disposable personal income for the year to date is running at an annualized value of only $10.6 trillion.

If you sum disposable income and capital gains, this total has fallen from $15 trillion in 2003 to only $1.7 trillion annual rate for this year! This dramatic falloff will reduce US consumption significantly. And US consumption is important: it constitutes 75% of the US Gross Domestic Product and is larger than any other country’s GDP. This will undoubtedly have a global effect: foreign stock markets have fallen more than the US markets.

How much will US consumption expenditures fall and for how long? One can expect a significant drop in the purchase of so-called durable goods such as autos and appliances. And as long capital gains income from equities and real estate stay negative, US consumption will not recover. It will probably take the real estate market two or three years to run down its inventory, and the stock markets have not yet factored in the lower profits that will result from the falloff in consumption. It will be a tough couple of years.