Next Gen Politics

(This article is meant to be part one of a two part series about the current financial crisis and the events that led to it. It took a lot of work and research, so I hope you like it. I thought the subject matter was pretty interesting, and certainly important.)

With the financial turmoil of the last few months, many may be wondering how something like this could have happened. It wasn’t one thing, or one person, but a series of events that led to where we are today. This problem wasn’t caused solely by the housing bubble, nor by the dot-com bubble, (though they had a part to play), but rather a series of deregulation measures that began to be implemented under President Richard Nixon. How could this problem have started that long ago and not have been stopped before we reached the most financially disastrous event since the great depression? Let’s take a look back and see for ourselves.

The first comprehensive proposal to “deregulate” a major industry in the United States, transportation, originated in the Richard Nixon Administration. The thought behind the deregulation push of this time originates in research at the University of Chicago by Ludwig von Mises, Friedrich von Hayek, Milton Friedman, and a few others. Two of the major “think tanks”, The Brookings Institution and the American Enterprise Institute, were also involved in these activities. Later, during the Carter administration, Alfred E. Kahn would play a role in both publishing and academic work on the deregulation of transportation.

President Jimmy Carter worked hard on transportation deregulation, and worked with Congressional and civil society leaders to pass the Airline Deregulation Act (October 24, 1978), Staggers Rail Act (signed October 14, 1980), and the Motor Carrier Act of 1980 (signed July 1, 1980).

Transportation deregulation was focused on rail and truck transportation, but not air carriage, and studies have shown that transportation deregulation has actually increased GDP by as much as 3% annually.

A series of enactments were needed substantially to work out the process of encouraging competition in transportation

Savings And Loan Scandal

Savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s, and originally served as community centered institutions that focused on savings and mortgages. In the United States, S&Ls were tightly regulated until the late 1970s. For example, there was a ceiling on the interest rates they could offer to depositors.

In the 1970s, many banks were experiencing significant erosion of assets due to a combination of the high inflation rate of the time, depositors moving their deposits into high interest money market funds, and a large percentage of money tied up in long term mortgage loans that were signed at fixed rates. If you have inflation moving prices upward, and a move to high interest money market accounts (away from low interest rate alternatives), then the amount you are paying in interest, and the amount you are getting from interest from mortgages don’t match and you have a recipe for failing banks.

Under financial institution regulation, which had its roots in the Depression era, federally chartered S&Ls were only allowed to make certain types of loans. Late in the administration of President Jimmy Carter, caps were lifted on rates and the amounts insured per account to $100,000. (FDIC) In addition to raising the amounts covered by insurance, the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing Federal Savings and Loan Insurance Corporation (FSLIC) coverage also permitted managers to take more risk to try to work their way out of insolvency so the government would not have to take over an institution.

Deregulation

Although the deregulation of S&Ls gave them many of the capabilities of banks, it did not bring them under the same regulations as banks, and the new legislation allowed them to enter new lending businesses with very little oversight. Thrifts could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, the state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states (notably, California and Texas) changed their regulations so they would be similar to the federal regulations. States changed their regulations because state regulators were paid by the thrifts they regulated, and they didn’t want to lose that money

Some of the factors of the S&L crisis included:

• Imprudent real estate lending
• Keeping insolvent S&Ls open
• Brokered deposits
• End of inflation

So up to this point we have the deregulation of transportation, which was good for the economy, and we have deregulation of the banking industry, that turned out to be disastrous. The deregulation was meant by the government as a way to allow banks to dig their way out of insolvency with out needing the government to bail them out. It had the opposite effect, and we the tax payers paid the bill.

Dot Com Bubble

The “dot-com bubble” (or sometimes the “I.T. bubble”) was a speculative bubble covering roughly 1995-2001, during this time stock markets in Western nations saw their value increase rapidly from growth in the new Internet sector and related fields. The period was full of “start up” internet-based companies, sometimes called dot-coms. A combination of rapidly increasing stock prices, individual speculation in stocks, and widely available venture capital created an environment in which companies were able to gain massive amounts of investments even when they had no business model and no clear direction.

To fight the increasing inflation caused by so much money being artificial created during this time. The Federal Reserve, between 1999-2000, increased interest rates 6 times. As a result of the dramatically increased interest rates, the economy began to slow and on March 10, 2000 the dot.com bubble burst. When the bubble burst, the U.S. was pulled in to a recession, and in an attempt to stem this recession the Federal Reserve began lowering interest rates.

Subprime Mortgage Crisis

As a way to explain the next section, let me start by explaining a very important group of individuals that had a very important part to play in this crisis.

There is a huge pool of money that represents all the money that the world is saving. The pool includes insurance companies saving for disasters, pension funds saving for retirements, etc. In 2000, this pool of money was approximately $36 Trillion. Within just 6 years, the giant pool of money doubled. This drastic increase in international wealth was brought on with increasing numbers of poor countries, (China, India, Abu Dhabi, Saudi Arabia, etc.), becoming wealthy through globalization and through resource exploitation. China alone has over $1 Trillion in its central bank.

In all, there is about $70 Trillion, (That’s $70,000,000,000,000), floating around in this pool of money. This American Life put this amount into perspective by telling it’s listeners to imagine:

“…all the money that people spend everywhere in the world. Everything you bought in the last year, all of it, then add everything that Bill Gates bought, and all the rice sold in China, and that fleet of planes that Boeing just sold to S. Korea, all the money spent in every country on earth in a year, that is less than $70 Trillion.”

There are people who’s job it is to manage this money. Every dime. Not only do they want to protect this giant pool of money, they want to make it grow as much as possible. How do you make money grow? You have to find something to invest in. For most of modern history, these managers bought very safe and reliable investments like treasuries and municipal bonds, but with the doubling of the giant pool of money, and the same amount of “safe” investments, these managers needed to look somewhere else to put their money. Their first reaction would probably have been investing in U.S. Treasury bonds, however, about this same time, something happened that made the situation even worse.

At this same moment in history, when these managers are looking for something to invest their money in, Alan Greenspan declared that the U.S. would keep the Federal Funds Rate at the incredibly low rate of 1%. Greenspan, at this time, was fighting the recession caused by the dot-com bubble burst.

What this statement signaled to investors of the world was that the no one was going to make any money off of U.S. Treasury Bonds, for the foreseeable future, and it encouraged them to look someplace else. The “someplace else”, was the new safest investment they thought they could make; Residential mortgage trading. (i.e. The U.S. housing market) While U.S. Treasury Bonds were paying 1% returns, mortgages were paying 5% - 9%. So these financial managers went about looking for a way to get into residential mortgage trading.

Now a single mortgage wasn’t going to do the global pool of money any good, so as TAL stated:

“[Someone] gets a mortgage from a broker, the broker sells the mortgage to a small bank, the small bank sells the mortgage to [someone] at a big investment firm on Wall Street. Then [someone] takes a few thousand mortgages he’s bought this way, he puts them in one big pile, now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next 30 years (the life of a mortgage). He then sells shares of that monthly income to investors. Those shares are called Mortgage backed securities, and the $70 Trillion global pool of money loved them.”

Because these securities were so popular, investment firms had a hard time getting enough of them to satisfy the number of investors that wanted to invest in them. As any graduate of high school can tell you, when there is an increase in demand, there is usually an increase in supply. The problem was how to increase the number of mortgages. These investment firms didn’t need a few thousand mortgages; they needed a few hundred thousand mortgages to fill demand.

In the beginning of this drive for mortgage back securities, the brokers and banks would only buy standard mortgages; mortgages where the people had put up their 20% down payment, proven that they had a steady income, and had very good credit. These securities, however, were so popular that by 2003 the pool of safe mortgages had just about dried up. Almost everyone that had wanted a mortgage had already gotten one, but the investors were not close to being satisfied. They wanted more. In order to fill these requests Wall Street had to find more people to take out mortgages. This meant lowering the standards by which banks decided who qualified. Every month the standards got a little lower, eventually leading to what we now know as the “liar loan” (No Income No Assets-NINA Loans). As more loans are being approved, housing prices are skyrocketing, and the appetite for these securities is not letting up. This whole system, while completely insane, doesn’t hurt anyone yet. Banks don’t have to hold on to the mortgages; they sell them to the investment firms within a month, and the investment firms sell them to the global money managers. No is getting stuck with the shady loans. It’s a crazy game of musical chairs, but the music is still going and everyone is happy.

From 2000 - 2005 these securities were all the rage. The lax standards by which banks were approving home loans led many to invest in multiple houses based on the assumption that housing prices would only continue to rise and never fall. The problem was that as more people bought houses, the prices of housed skyrocketed, however, from 2000-2007 the median household income stayed flat.

Borrowers began taking out home equity lines of credit in the early to mid 2000’s, not only for improvements on their existing homes or to buy that speed boat, but many people took out these loans so that they could continue to make their mortgage payments. In order to pay off their debts, they took on more debt. Borrowing incentives, such as low initial interest rates, in addition to rapidly rising house prices encouraged borrowers to assume difficult mortgages on the belief they would be able to quickly refinance at more favorable terms, or easily sell their home if the loans become too difficult to pay. As housing prices leveled off, then began to decline in 2006-2007, refinancing became more difficult. Defaults and foreclosures increased significantly, as introductory “teaser” interest rates began to expire. Rates, in some cases, doubled or even tripled, home prices failed to go up as anticipated, and ARM interest rates reset higher. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.  Increases in foreclosures, in late 2006, triggered a global financial crisis when mortgage companies and small banks, that had previously leveraged their own net worth to take out huge loans to buy bundled mortgages, began finding it difficult to find buyers for the securities. With their company’s net worth leveraged to buy these mortgages, many of these companies were forced to default when they couldn’t unload the mortgages. This is the point at which the music began to stop and everyone began to scramble for the chairs.

Remember that these mortgage backed securities were considered almost as safe as treasury bonds. With the massive loss of money, people aren’t calling this the Subprime mortgage crisis anymore; now they are calling it the credit crisis. This “global pool of money”, that was only interested in making a profit on their investment, a higher interest rate return, but now the opposite is true. The “global pool of money” now wants zero risk. U.S. Treasury Bonds, still at historically low rates of 1%-2%, are looking very attractive. The “global pool of money”, is now avoiding any risk, which is making it harder to get credit, no matter who you are. If you are in the marker to buy a new house, a car, or even start a business or build a factory, you are going to feel the freeze up of credit.

Next time we will talk about how these events shaped the crisis we are facing now as well as a cast of characters that helped usher in the Mortgage crisis, as well as the later credit crisis through aggressive deregulation in the 1990’s.