Thinking About This Mess

So another day on Wall Street, another 300 plus point drop. This keeps up much longer and I'm going to start thinking that is the norm.

However, a little more seriously, I'm looking at what the Bush Administration intends to do. Essentially, it wants to pump a lot of, what will ultimately be, taxpayer money into saving people who are getting hit by the market downturn. Specifically, they (meaning the Administration and the Democrat-controlled Congress) want to spend about $700 billion (more on the credit card I suppose, since as I recall, Bush and the Congress have collaborated to create a huge budget deficit already) in order to buy up bad mortgages from failing institutions.

My question is why?

Yes, I understand that if they go under, it will be economically bad. But the plan that seems to be floating out there is going to do very little to either A) undo the mess, B) prevent it from happening again or C) punish those who got us into this mess in the first place.

Now, the financial situation, from my lay point of view, was sort of inevitable. There is always going to be a downturn, especially when it comes to housing. It just is un-realistic to think that prices would never fall, that defaults would never happen, or that the value would continue to go upwards. The sub-prime loans were a bad idea, that too many people bought into, and that too many presidential administrations did nothing to ensure that they would remain monitored.

Consider this, subprime lending only became available when the laws in this country were relaxed in regards to usury. What is usury you may be wondering? In TV shows, its what a loanshark deals in regular basis. Originally, usury meant the charging of interest on loans. For centuries, the practice was banned in the Catholic Church (and as an interesting histotical side note, one of the reasons why the great banking houses were Jewish originally, i.e. the Rothschild family). However, in the U.S., the concept of usury evolved into situation where the interest on the loan exceeded the permissible rate. In California, its anything over 10%.

In 1980, at the tail end of the Carter Administration, Congress passed a law called the Depository Institutions Deregulatory and Monetary Control Act in 1980. One of the things which this law did was it eliminated interest rate caps for a number of types of credit loans, including mortgages. In the 1990s, Wall Street started to securitize (or making them tradeable on the market) mortgages. Since they could use them as securities, it was a way to make more money. The more mortgages, the more securities available to sell or trade. So the mortgage companies started to look for more people to loan money.

However, they ran into a problem. With interest rates as they were in the 1990s, there was already stiff competition for people with good credit. However, despite the 1980 Act, there was still a relatively large and untapped pool of people to market subprime mortgages.

Now, it should be noted, that subprime mortgages were meant to be used by people who could not get a traditional mortgage. These are people who have bad credit histories, credit scores of below 620, and people with bad debt ratios (i.e. more than 45% of their income goes to servicing debt).

The Department of Housing and Urban Development estimated that in 1994, there were approximately 70 lenders who did subprime mortgages. By 1997, that number had more than tripled to 270. In 1993, subprime mortgages represented approximately $20 billion dollars in loans made. By 2000, the number had reached $140 billion and was continuing to rise.

With the increase in subprime lenders, there was also an increase in subprime mortgages being written. And the more that these companies got into the business, it seems, the more addictive it became for them. While this was happening, two administrations (Bush and Clinton) failed to recognize the potential problems that this could cause.

In addition to an overall expansion of subprime lending, there began to be a shift in how subprime loans were made. According to one report, the shift became most noticeable in 2006. Prior to that, subprime lenders were competing by making rates more attractive (i.e. not requiring such high interest rates to people who had blemished credit histories). However, begining with the mortgages in 2006, it appears that there was shift in the guidelines and a lowering of standards even further to allow more people to qualify for the loans.

Why did they do this? The answer is simple: profits. Prior to 2006, and specifically in 2004, interest rates on mortgages hit their lowest levels in decades. For people with good credit, that was a great. They could get mortgages at very low rates of interest. For people with bad credit, it was even better. They could get mortgages that were not usurious (or at least not as bad had been previously). The people who is was bad for was the corporations making the loans. For every dollar they loaned, they were making less than on previous years. Therefore, they needed to do somethign which would increase their profit margins. Their solution: raise the interest rates on their loans, but decrease or make exceptions to the requirements for people taking out the loans.

Let's see. A desire for ever increasing profits. Mixed that with predatory lending practices targeting people who have demonstrated they can not be trusted with credit in the first place. Sounds like a great plan to me.

What did this lead to? Increase home values (because so many people had access to money they were able to bid up the prices of real estate), increased profits over the short-term (looked great on their balance sheets) and lots of people owning property that they did not really have the money to support.

So now the Bush Administration, as well as both major candidates, want to bail everyone out. About the best that can be said for Senators McCain and Obama is that they both agree that none of the bailout money should be used to pay for CEO/executive compensations for getting us all into this mess. The initial plan proposed by the Bush Administration was best summed up here.

Now, where will we get the money to do this bailout? Well, it will have to be borrowed, since the government does not have nearly three quarters of a trillion dollars lying around (which by the way means that every taxpayer is on the hook for approximately $2,300). What will it do? Well that is a good question

Part of the argument which is going on now in Congress is exactly what should happen with the bailout. (If only half as much thought had been put in the PATRIOT ACT... but I digress).

Reading some of the interviews that are going on, its interesting to get some of the mindset of the Bush Administration people who are doing the talking. For instance, when asked about limiting executive compensation, Secretary of the Treasury Hank Paulson declined to consider that as part of the package. As he stated, if such language were included in the bailout package, "institutions aren't going to participate ...this won't work the way we need it to work,...." apparently because it will be viewed as punitive. It almost seems to me as if he is saying that the drowning man won't accept a lifeline because it means he will have to let go of the thing that is dragging him down.

Besides, if the entity accepting help under the bailout needs help, isn't that an indicator that something is wrong in the first place? When did we start rewarding failure as if it were success? Apparently, the Bush Administration wants to pretend as if nothing the financial houses did was wrong, because to admit to that might leave the door open to.... a modernized, comprehensive regulatory system that makes sense! Horror! Regulations are bad... and must be abolished to allow market freedom which will benefit everyone in the end. ... Except of course when the Republicans want to tinker with the market to protect their friends.

Which takes me to my next point. The people who owe the money on the mortages. They are just as complicit in this financial mess as the executives on Wall Street. Not partly. Equally. They sat across a table from someone and had a chance to review the terms. As long as they were all included, and all the necessary discolsures were made, they had a choice. Subprimes were always a gamble. They had to hope that the value of their property would increase enough to help them refinance or that they would continue to be making enough money to meet their loan payments. Many people, including myself, looked at subprime mortgages when they had an opportunity to buy property. Many people, including myself, walked away from subprime mortgages because they were simply too economically risky.

Why then should we reward these people by keeping them housed? All it will do is continue to artificially inflate the value of real property. This in turn will make it harder for people to put together sufficient capital necessary to get a prime mortgage, at a good rate.

In fact, part of the proposal put together by Congressional democrats includes a provision which will allow bankruptcy courts to refashion mortgage terms in order to avoid foreclosure. Apparently, to the Democrats, contracts are really meaningless until an outsider has a chance to reform the terms which the parties previously agreed to in good faith? Apparently, according to the Democrats, we should reward people for not taking into account what the terms of the contract means before signing. We should encourage people to not consult an independent financial or legal advisor, and instead just tell them to go ahead, fail, the government will come and bail you out just like the Republicans do for the executives on Wall Street.

From my point of view, the mortgage industry enhanced this mess by not realizing that they were going to get the profits which they hoped for and instead sat down to reformulate the terms with the customers. Instead, they just kept letting properties go into foreclosure, leaving them with worthless mortgage securities to trade. At the same time, too many of the people who took out these mortgages did not pay attention to wath they were doing. They did not do what was necessary to keep up with the mortgage payments. They were not proactive enough to get things done.

The Chairman of the Federal Reserve says that there will be a recession if we do not bail out the mortgage industry. I am not in favor of a recession, but if all we are going to do is spend money to save the people who put us in this mess, without providing for real reform and real consequences to both Wall Street and the subprime defaulters, then it might not be a bad thing. Otherwise, we are just artificially inflating the markets... and inflation which will come back to hurt us even more later.