What caused the Financial Melt Down?
The first step to extricating ourselves from this financial mess is to understand what happened. I happened to have a front row seat to the collapse and I intend to share with you exactly what I believe caused this disaster. I am a licensed real estate agent and I also am an investor in real estate.
The first issue I am going to address is the accusations that this collapse was brought on by the banks loaning money to poor families that could not afford the loans. The reality and truth of the matter is most families that were given loans for a single family home have worked very hard to keep them. Most cases of defaults on single family homes come from Job loss, not irresponsibility on the part of the “poor” family. What really caused the problem is that in order to make homes available to as many people as possible the banks lowered their lending standards. This not only made it possible for low income families to buy homes, but it also made it possible for “Investors” to qualify for a lot more money than the banks were traditionally able to lend.
As an example, in the past as an investor if I purchased a home to rent out it was expected that I put 20% of my own cash down on the property, and then I had to demonstrate that I had enough cash reserves to cover all of my normal expenses for 6 months. This system insured the bank that even if you couldn’t get a renter the investor had enough money to float the loan until a renter could be found or the home could be sold.
Under the new rules I could get a no document loan or a no doc as they are commonly referred to. The bank could give me a loan without verifying any of my income if I had a decent credit score and a reasonable down payment. They moved the down payment down from 20% to 5% of the purchase price. And the best part was, after I purchased the home they would happily refinance me and get me some cash back that I could use as a down payment on my next investment. My credit score would be fine because all the payments were made on time and I showed a healthy real estate portfolio.
Where the wheels came off the national bus is when the banks began selling loans on the secondary market. (This is where they package $100,000,000 dollars worth of loans together and sell them to an investor.) And changing the rules for exactly what constituted a solid loan. In the past a bank would season a loan (meaning they would get payments on it for 6 months or so) and the loan would be on a house that was worth a minimum of 20% more than the loan was for because of the 20% down payment. Under this system the banks had a 100 year track record of rock solid real estate investments. It was under this assumption that investment banks like Lehman brothers borrowed money from the government at 2% interest and purchased these bundled mortgages paying 4%. The numbers are approximate but close enough. The government allowed Lehman brothers and others to borrow up to 40 times their assets. Let us pretend you have 1 dollar and want to play this game. If you are to buy a bundled mortgage package you would make 4 cents a year. But if you were to use government leverage and borrow 40 dollars on your 1 dollar of assets. You could then buy 40 bundled mortgages and make 160 cents a year and have to pay the Federal Reserve 80 cents a year. So you end up making 80 cents a year profit on 1 dollar invested in rock solid real estate. This is a phenomenal return far better than you can get on almost any investment you could make.
When the money began flowing so easily demand went up for the packaged loans. The only way to increase the amount of loans was to lower the standards. The real estate investors were more than happy to take out the loans because the easy money was driving the price of real estate through the roof. When you have ten investors that all have easy access to cash and only a few homes those home prices are going to go up. That is precisely what happened. Investors snatched up every available home in all the Hot Markets. Phoenix, Las Vegas, San Diego etc. The builders saw increased demand as well as their homes became targets of investors. New homes mean more taxes so cities started issuing massive building permits because of the home shortages. Stuck in all this commotion was the average family. If you had to buy a house you were competing with 10 investors but luckily for you the banks made it so you could get some really crazy financing that would make it so you could afford the house now and you could refinance in 2 years before the payment went up to what it was supposed to be in the first place.
The Banks, Freddie Mac, and Fannie Mae began to invent new categories of bundled mortgages. Instead of AAA and troubled. They made AA+ and several other minor adjustments diluting the quality of the bundles. Basically they sold investor no doc loans as if they were prime loans. Because they had a long track record of success no one questioned this practice. Congress passed a little noticed law a few years ago known as Mark to Market. This basically stated that a bank has to list its assets at current market value. At the time it was passed this seemed like a reasonable rule. Unfortunately for the banks this rule would have the unintended consequence of nearly destroying them.
Mark to Market accounting works fine under normal markets but if there are any setbacks this rule becomes a huge weight around the banks necks. What happened was inevitable for any bubble but it was made far worse by the Mark to Market rules. When the market became completely saturated by new and vacant homes the prices came back just a little. All the investors who were 100% financed ran into real trouble at this point. If they sold they would have to come up with cash out of pocket. As inevitably happens someone blinked. Cash investors were the first ones out the door. If they had 100,000s in cash to buy homes with they were smart enough to take their losses and get out. They put their properties up for sale took their losses and brought home whatever cash they could salvage. The investors with some money down also bailed realizing they did not want to come out of pocket if they could avoid it.
Prices dropped 20% virtually overnight. The 100% financed investors and some others thought hey this will get better it is just a minor hiccup in the market. It didn’t get better. When you are sitting on 10 homes that you owe $2,000,000 on and they are only worth $1,600,000 it gets tough to sleep at night. Soon these guys began to panic. Some walked away completely abandoning the homes to the banks, others negotiated short sales and still others worked out rental agreements grabbing any tenant they could find. Owning vacant homes gets very expensive very fast and even those with equity began to squirm. Imagine paying for yard service, pool service, minor maintenance, major maintenance all on homes that are in the end maybe going to breakeven, but will probably end up costing you a lot of money.
This is where Mark to Market came back into play and nearly killed our banking system. The Mark to Market rules required banks to report their assets at current market value regardless of if they were planning to sell or planning to hold a note until maturity. A bank can only loan money based on a ratio of its assets or cash on hand. So when a bank has to change an asset from being worth 100,000 to being worth 80,000 it actually costs them far more than $20,000 because they are allowed to loan out significantly more on assets than they actually have. This is a fairly complicated formula I have included a link for anyone seeking a better understanding.
But basically by reducing their assets by $20,000 they reduce the money they can lend out by more than $200,000 dollars. So even though they have yet to lose a dime in actual money they are forced to either stop lending or sell assets to raise cash and get their ratio’s back up again. A lot of banks chose to sell assets this further reduced the value of those assets and caused a death spiral for real estate. This contributed heavily to the collapse of many investment and regular banks. And this was the credit freeze we heard so much about. Banks refused to lend money to each other because no one knew who would be standing the next day.
Our treasury secretary Henry Paulson offered to save the banking system if Congress would only give him 700 billion dollars for him to purchase toxic assets, meaning bad home loans. He asked for the money with no strings attached and remarkably congress gave it to him in two 350 billion dollar increments. George Bush intended for Paulson to use 350 billion to shore up the system and then leave the other 350 billion for Barack Obama to deal with any issues in his presidency. Somehow Paulson convinced Barack and George to turn the money over to him early so he could have all 700 billion right away. When he took in the money rather than buying up assets he bought up a percentage of all the top banks in America and negotiated terms with them for heavy handed loans passed out by our government to the banks. He never bought a single asset other than the banks themselves. He used the money to fully fund these institutions which either were complicit in the deception or had no part in it and did not want to sell out to the government but were forced to. Either way this is where we sit today. Our banks are under the thumb of our government. The corporations have all been vilified all though most had nothing to do with this melt down and the entity most responsible for the chaos, the government is now taking ownership of the banks.
Why is the government the most responsible for this collapse? Primarily they are responsible, for their complete lack of oversight of the pseudo government entities Freddie Mac, and Fannie Mae. They refused to listen to regulators that demanded better oversight. These companies were allowed to make ridiculously irresponsible loans and sell the loans in unregulated bundles to countries and companies all over the world with the US government giving their unofficial but very real backing to the product. If the companies were private they would of simply collapsed under the weight of their own stupidity but because they were semi government entities they were given the backing of the American Tax Payer. The people, who are now calling for regulations of our banking system, are the same people who were in charge of regulating Freddie and Fannie. The reason AIG nearly died is because of Credit Default swaps or insurance policies they had written on companies that traded in these giant Mortgage bundles. AIG was made out to be the bad guy by the media but their only crime was insuring companies that had long track records of success. In hindsight it is easy to see they should not have sold those policies but can you really fault them for selling policies on companies that the government had loaned billions of dollars to and were invested in the safest investment known to exist at the time the Credit default swaps were written.