Sunday, 16 October 2011

The Credit Crisis - Bankers are Not the main ones to blame

In light of the Occupy Wall Street "movement" I feel the need to explain some important facts about the credit crisis and its causes. It is sad and shocking how many people (even educated people) have the view that the credit crisis was caused by bankers. I guess it is not surprising that people have this view given that the politicians (in order to deflect responsibility and find a scapegoat) blamed the banks, and the mainstream press (driven by envy) swallowed it without question.

The creating of the housing bubble and its bust is quite complicated. Not easy to explain in two sentences. Not easy to point the finger at one group.

Public discourse doesn't handle complex problems like this well. The media and public need one simple answer. "It's the fault of the Jews !!!" --they said during the economic crises in Europe. And now the mob says: "it's the fault of the bankers!!!"

So I have tried to explain whose fault it is as briefly as I can

Here are the steps and components in the process which created the housing bubble (just one part of the overall credit bubble), which when it burst caused the credit crisis.

1. Very low interest rates - set by the federal reserve bank (Greenspan)

2. Very lax bank lending laws which allowed for 100 pct financing of home purchases with zero down payment (allowed by the federal reserve bank, federal laws, and state laws). France and Canada on the other hand, which did not experience a housing bubble had federally set limits on mortgage lending capped at 70 pct of the purchase price. Given that the housing bubble created a lot of jobs (in construction for example) and allowed many more people to buy homes than would normally be feasible, it was political suicide to object to these policies - given the short term orientation of US democracy

3. Subprime Loans increased from Government proddings: Rep. Scott Garrett (R-N.J.) said, "The recklessness of government is the primary culprit here", on the House floor on January 18, 2007, "For years, Congress has been pushing banks to make risky subprime loans. You heard me right. It wasn't the lenders on their own. Congress passed laws that said we're going to fine you and we're going to file lawsuits against you lenders if you don't make risky loans. And using the authority of the Community Reinvestment Act, the big push for subprime mortgages began in earnest during the Clinton administration."

4. Mortgage origination companies falsifying financial details of applicants for mortgages because they get paid on volume, take no risk on lending and package the mortgages to send off to banks and other lenders.

5. Individuals lying on their mortgage applications. People who had no jobs and no income.

6. Credit rating agencies rated bonds backed by pools of these mortgages as AAA.

7. Because interest rates were low (set by the Federal Reserve Bank), cost of the mortgages to borrowers was low, incentivizing people to buy homes.

8. Because interest rates were low, investors were eager to lend and buy products which had a higher yield, like mortgage-backed bonds.

9. Certain tranches of mortgage-backed bonds were kept by the banks because they didn't yield enough for investors to want to buy them,. They were rated AAA by the credit-rating agencies so the banks didn't think they had much risk.

10. Eventually the worst borrowers (sub-prime) started to default on the mortgages, the market started to find out about the problem of sub-prime, lending stopped to them.

11. Lending to the housing market slowed, therefore buying of houses slowed. This caused house prices to go down because there had been overbuilding and excess inventory. This caused losses on mortgage backed bonds. The credit crisis then occurred.

12. Another very important source of excessive lending which fostered the housing bubble was the GSE's (Government Sponsered Enterprises). Their explicit function is to LEND and provide easy credit into the housing market. Politicians want happy voters, and voters are happy when they can borrow easily and buy new houses, and this creates lots of jobs of house builders, appliance manufacturers, furniture manufacturers, etc. No one cares that this might be excessive leverage and creating a bubble. Fannie Mae and Freddie Mac are the two largest GSE's, but there are dozens of other entities which pumped tremendous amounts of money into boosting the housing market and creating the housing bubble. Congressman Scott Garrett (R-NJ) has written that the GSE's played a central role in the housing bubble collapse and have cost tax payers hundreds of billions of dollars. And nothing has been done to reform these entities, in the Dodd-Frank bill for example. See this article, "Fannie & Freddie Reform Excluded from Finance Bill". He writes, "The government needs to look no further than itself to find the root cause of the financial crisis."

So, bankers are to blame?

There are many actors in this complex system who can be blamed for not doing their job well or for abusing the system (as well as the system itself). Furthermore, it is the responsibility of the regulators (the Federal Reserve Bank and Greenspan) to monitor and oversee the system as well as politicians.

The people who really stand out for me are:

--people who lied on their mortgage applications
--the mortgage origination companies who falsified info
--the credit rating agencies for not doing better stress tests to see what affect a drop in housing prices would have
--Politicians / Policy Makers, Greenspan and the Federal Reserve Bank for not putting a stop to the bubble

Ironically, bankers are the least to blame, but they can still be criticized because they should have been more cautious about the risks they were taking by holding large positions in mortgages. Goldman Sachs is not included in that group because they managed their risks prudently.

Links to Articles on this Topic:
Cato Policy Report:  A Perfect Storm of Ignorance by Jeffrey Friedman
Bloomberg to OWS: Congress caused the mortgage crisis, not the banks
WSJ: How Government Created the Financial Crisis by John B. Taylor

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