MYM Series: Wall Street Bailout Explanation 2 of 4
Understanding the Crisis: Timeline of Failure & Who’s at Fault?
How did we ever get to the point of needing $700 billion dollars from the Federal Government? Were the regulators asleep at the switch or were they simply out smarted by the markets? Did greed win over principles on Wall Street? These are great questions that will probably be the topics of countless books over the course of the next ten years. Of course, I don’t have the answers, but I do have an opinion, that you can take for whatever it’s worth. Here is my quick and dirty version of the root cause of our current financial crisis, described by the following primary actors:
The Federal Government’s Role- The Federal Government has advocated home ownership for some time now. The idea has essentially been the cornerstone of the American dream. The Government practically begs citizens to purchase a home by offering tax incentives, Government backed mortgages, and various other programs designed to aid in purchasing a home. The reality is that many people simply should not purchase a home, even if on paper it’s somewhat affordable. (If you have time, read this article where we weigh the pros and cons of Renting vs. Buying).
As a homeowner, I completely understand the desire to own a home, and I think everyone should purchase a home at some point in their life to avoid rent or mortgage payments during retirement, but our desire to own homes has helped banks create exotic mortgage products that put us in the situation we are in today.
Securitization- You have likely heard this term thrown around in the news the past couple of months. Securitization was a major reason we had a housing bubble and the major reason banks could offer so many nontraditional mortgage products. Think of securitization like a mutual fund, its the process that bundles multiple mortgages into one security, like a mutual fund that holds various stocks. As banks sold loans to homeowners, they would then bundle these loans or securitize them into securities that could be purchased by investors. Investors of all types (this is where investments banks really lost their wallet) would then purchase these securities full of mortgages from the banks. In turn, the banks would have capital from selling these loans, which allowed them to sell even more mortgages.
As the housing business began to boom and home values started going through the roof, everyone wanted in on the action. Thus, more consumers took out mortgages, more investors purchased these mortgages through securitization, and the banks were rewarded with even more capital, which allowed them the freedom to become creative (the creation of ARM loans). Investors were particularly drawn to these investments for a couple reasons. For one, mortgages were originally thought of as one of the safest investments you could make. Two, because a lot of these loans reset to higher interest rates, investors would only see their profits increase, which made these seem like no brainers. Lastly, these securities or bonds were rated by credit rating agencies AAA, the best rating a bond can get (we’ll get to this later). As you can see, securitization of mortgages was the fuel that fed our housing fire.
Credit Rating Agencies- As I just mentioned, credit rating agencies also played a role. The main job of credit rating agencies is to examine securities like bonds, and assign a rating to it—the higher the rating, the safer the investment. Investors took a lot of comfort in securities loaded with bad mortgages because of the high rating assigned to them, which only helped encourage the lending of these mortgages. Credit rating agencies have come under fire since our housing crisis has unfolded and deservedly so. They are now under the radar and regulators are paying closer attention to them.
One of the main problems I see in the system of credit rating agencies is the conflicts of interest that exist. Basically, the system works like this; financial institutions will go to a credit rating agency as a customer and pay the agency to rate their security. The credit rating agency then finds itself in a tight spot because they are in competition with other rating agencies to rate a particular financial institution’s securities favorably, or they might leave and get a rating they like better from a competing agency. As you can see, companies seeking ratings are shopping around for the best possible rating and agencies are trying to please the customer in order to get repeat business. This system is flawed and needs to be addressed.
Regulators- Lastly, I believe it’s worth looking at the role regulators played in the housing meltdown. Because there are various regulators that have jurisdiction over various issues, some products go unregulated or lightly regulated. For example, until the crisis, mortgage brokers did not have to register like broker dealers who sell securities. The value of registering mortgage brokers is great to consumers because bad actors are in a database, easily accessible to consumers shopping for mortgages, not to mention potential employers looking to hire mortgage brokers. I realize this is just a small piece of the pie, but this has been a positive that has come out of our mess. Another problem with regulation is the constant turf war that goes on.
Each regulator is out fending for themselves and always trying to justify their existence. Many times, this is a good thing because it forces regulators to take action. But in this case, because the jurisdiction among investment banks and other major players involved in selling mortgage products was unclear, no regulator really wanted to step in, rather some backed away. This is why you’ll hear me say regulators and regulation is needed, but they have to keep pace with the markets and at the same time cannot infringe on market innovation. This is no small task, but it seems a new administration and Congress is sure to tackle the issue of assessing our current financial services regulatory framework.
Its also worth looking at other timelines to try and piece together this whole mess, here is a doc that does a really good job of breaking it all down, albeit somewhat exhaustively.
Who’s to blame?
There has been a fair share of finger pointing going on since the foreclosures first sprouted. Regulators have been pointing their finger at other regulators. Industry leaders have been pointing their fingers at regulations, credit rating agencies, and even Congress. Congress has been pointing their fingers at virtually everyone but themselves. As much as everyone wants to blame one party for the crisis we find ourselves in today, the reality seems to be that everyone deserves a little bit of the blame, including the consumers.
All of the roles I talked about above, in my opinion, helped us get to the point we are currently at. There’s no one person or entity to blame, rather a system that was flawed and leaders including consumers that were greedy. It’s easy for us as consumers and investors to look the other way when things are going really good, like they were during the housing boom. It’s easy to not ask questions and jump on board like many homeowners, investors, and financial institutions did. It’s embarrassing that we didn’t see what was coming sooner, because in the end, it seems like common sense. Going forward, I hope we learn a lesson and get back to old school financials, where if it’s too good to be true than it is and if you can’t afford something, you can’t have it. $
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Who is to blame?
The ‘Stupid common man’!
Who is suffering?
The ‘Stupid common man’!
I fully endorse your point of view. The wisdom says,”Please lets go back to Basics”
We have to salvage and move on. It is easy to postmortem and have debates. What is important to promise ourselves not to repeat this calamity again.
It was the greed of the operators which baited the ‘Stupid common man’ into the trap.
They have gained out of this debacle and moved away!
This calamity will keep on repeating till the ‘Stupid common man’ does not grow as a responsible human being & a person - responsible to himself, to his family, to his community, to his country and now globally!
Desire gives rise to greed and eventually sufferings - this what happened presently.
Greed is important too because it helps in developing business/wealth/and competition but selfish greed is damaging!
This is my personal feelings and I am viewing it from a holistic point of view - which I feel is primary and important.
Vinay