WHY WERE THERE SO MANY BAD LOANS?
As we have seen, the crisis was set off by an increase in the foreclosure rate. What caused this? One of the reasons was the speculation in real estate and creative financing promoted by lending institutions. It used to be that you only got loans with 20% down and a good credit score, except for VA and FHA and some other minor government programs which required little down payment. However, in order to increase business, lenders, supported by builders and r.e. brokers, began offering exotic instruments , such as 10% down, then 5% down, then no down loans until I actually heard loans advertised for more than the value of the house. This was mixed with short term ARM's (adjustable rate mortgages), option ARM's (you chose how much to pay each month) and negative payments wherein you paid less than the interest and principle and the principle increased. Also, lenders began doing "stated income" loans. This meant you told the loan originator how much your income was and you didn't have to document it. Also, lenders began to loosen their credit requirements so that those with marginal credit were given loans. And finally, a lot of ARM's had low "teaser" rates. Again, I saw some as low as 1 or 2% to start. This meant that someone who might not qualify for the rate on a 30 year fixed loan would qualify under the "teaser" rate which could last anywhere from about 3 to 24 months or longer. Some builders would buy down loans so that teaser rates woud be lower and last longer so that more buyers could then qualify for the builder's new homes. It's not hard to predict that this could lead to trouble, especially for those who qualified only under the teaser rate. Reset means when the teaser rate expired and the loan adjusted to a new (usually higher) rate that was based on the prime rate or other standard rate, such as T-bills or LIBOR. Then the question is why would lenders make what should have been seen as very risky loans? The answer is because of derivatives and greater profit. The real risky loans are what are called subprime loans. Because there is greater risk associated with the loans, they carried higher interest rates and larger fees (called points). Because of derivatives, the lenders did not have to worry about the risk because the loans would be sold to an investor, some in foreign countries. The mortgage brokers and banks made their money off the fees, they didn't keep the loan and often didn't even service the loan. Thus, they actually had an incentive to make subprime loans because they made more in fees and did not have any of the risk. Why would someone take out such a loan? The assumption that both lenders and borrowers made was that real estate prices would continue to climb so that if the borrower was having trouble making payments, then he/she would just sell it for more than it cost originally (flipping). For the first couple of years of the boom there was no problem. However, there becomes a point at which the market becomes saturated--after most people have bought a new house they aren't going to run out and buy another one right away. Then inventory builds up and there are more sellers than buyers, prices start to fall and then people find that they owe more than the house is worth. And, as foreclosures increase they drag the market down even further.
WHY DID THE CRISIS SPREAD BEYOND HOUSING?
We have already seen how, because of derivatives and credit default swaps, the problem extended beyond the lenders. There is another important element in the problem. In 1999 Congress passed the Gramm-Leach-Bliley Act which rescinded the Galss Steagall Act that was enacted during the depression. This new bill allowed one entity to be involved in investments, commercial banking, and insurance. This is why the big Wall Street investment companies got entangled in derivatives and credit default swaps. They saw this as another profit center. Among the people who pushed for this, by the way, was the head of Goldman, Sachs, a man named Henry Paulsen, Bush's last Secretary of the Treasure. About a year ago the collapsing real estate market claimed its first victim on Wall Street: Bear Stearns, which started to have cash flow problems and auditors discovered that it was becoming a shell company. This led to a massive sell-off of its stock so that it went from $69/share to $2/share when it was bought by, I believe, J.P. Morgan/Chase. Then, six months later Lehman Brothers was in real hot water. Paulsen decided to let Lehman Bros. fail, as this is what conservative orthodoxy says you must do, let bad companies fail. This happened September 15, 2008 and this is what led to the serious problem becoming a major crisis as banks, having seen Lehman Bros. fail, decided it was too risky to loan money to anyone. And, of course, because a lot of these firms have interest in each other, when one and then another fails, it weakens other institutions and the whole economic system. This whole sequence of events was clearly presented on a Frontline program on PBS on Feb. 18, 2009. According to noted economist Jeffrey Sachs, he estimates that in bad loans, unemployment, and the drop in the stock market, the U.S. economy has lost approximately $13 trillion as of Feb. 20, 2009 (MSNBC show 1600 Pennsylvania Avenue, 2/20/09). To paraphrase and update the late Senator Everett Dirksen (R-Ill.), a trillion here, a trillion there and soon you're talking real money.
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