How Did We Get Into This Financial
Mess?
by Jason Leavitt
LeavittBrothers.com
The financial ?crisis? that exists in the US and world is
one that hasn?t been experienced
since the 1929 stock market crash and subsequent Great
Depression. Pointing fingers
after the fact is somewhat cowardly, but unless we know
why and how we got into this
situation, how can we expect to get out of it and avoid
another one in the future? Here?s
my take on who played a role in the financial situation
we?re in and who deserves most
of the blame
Federal Government.
Banks
lend money to home buyers. If the banks planned on
keeping those mortgages, they?d be very careful who to
lend to and how much to lend.
They?d really do their due diligence to make sure there
were very high odds the
borrower would pay the loan back. But if the bank wasn?t
planning on keeping the loan,
no doubt their standards would drop.
Enter the Federal Government sponsored/supported Fannie
Mae and Freddie Mac
(both created by the government) which buy mortgages from
banks, so the banks can
turn around and make more loans. This implied safety net
created by the government
with these two GSE?s (government sponsored enterprise) has
had a very negative ripple
effect. Namely, banks are motivated to take more risks and
have significantly lowered
their standards knowing they could always dump the
loans.
The government also encouraged policies that exacerbated
the situation. In short, their
extreme desire to increase home ownership ? especially to
lower income folks who
couldn?t afford a home ? completely backfired. But are you
surprised? Does any
government program work? There are 300-400 government
programs designed to
make housing more affordable. If a couple can?t afford to
buy a house, why help them
buy a house?
And I could go on and on about how the government has
branded home ownership as
the American Dream, but nothing could be further from the
truth. Owning a home is not
an investment, it?s a cost, and that cost is high. If you
rented for 30 years and put the
money you saved (lower monthly payments, no property taxes
etc) into the stock
market, you?d make a heck of a lot more money than if you
put your savings into a
house and held if for 30 years. But for years, people have
been brainwashed into
thinking they must own a home because renting is classless
? or something new college
grads do.
President Bush and HUD Secretary Alphonso Jackson
First a quick comment --- in
the government and military there is a chain of command.
You do what you?re told by
those you report to. If George Bush says: ?I want 5
million new homeowners,? Jackson
either works towards the goal or he resigns his position.
There is no middle ground. So
while I could leave the former HUD secretary out of this
because ultimately Bush should
take the blame, Jackson did have the choice to say: ?No
way, that?s not possible without
creating a mess. I?m outta here.?
Bush was way too eager. He was so excited for everyone to
live the American Dream of
owning a home. It was Jackson?s job to work towards this
goal, and Jackson was one of
the people who encouraged little- or no-money down loans
and interest-only loans. The
ripple effect this had is unknown, but when the Secretary
of Housing and Urban
Development encourages totally irresponsible financial
agreements, someone needs to
at least step up and say: ?that was a
mistake.?
Stupid, Gullible Americans.
Regardless of what happens in Washington, Americans
still have the choice to buy or not buy, so ultimately I
could blame them. They are, after
all, making the final decision, and they could have easily
walked away from the table.
But they didn?t. They bought houses they couldn?t afford
with money they didn?t have by
not putting money down, using interest only loans, and/or
using variable rate loans they
knew would reset higher than they could afford. If you
wanna throw a couple grand into
a stock because you think it?s going to move up, fine; the
damage will be minimal if
you?re wrong. But why in the world would you potentially
cripple the rest of your financial
life by buying a house you had no business
buying?
Banks.
The ultimate blame
could also be place here too. They are, after all, the ones
lending the money. They do have the ability to say: ?No,
you can?t afford that house. We
are not lending you the money.?
Call them greedy. They only make money when they make
loans and since money was
artificially made cheap, they couldn?t control themselves.
They drastically lowered their
standards and loaned money to parties they should have
know could not pay the loan
back. Shame on them.
Standard & Poor?s and Moody?s etc.
So banks loan money and take those
mortgages/loan docs etc. and package them together to be
sold as CDO?s
(collateralized debt obligations). Fannie Mae, Freddie
Mac, Bear Sterns, foreign banks
etc. buy CDO?s without scrutinizing the individual
contents because they trust the likes
of Standard & Poor?s to do their due diligence to
accurately rate the credit worthiness of
the package.
If Bear Sterns buys billions of dollars of subprime
mortgages from a bank, then only
they should be blamed for buying the junk ? the buck stops
at their desk. But if this is
the case, why does the entire planet pay such close
attention to the ratings?
If Standard & Poor?s inaccurately rates the CDO?s, and
banks end up buying chickens
they thought were eagles, who is to blame? Nobody will
argue S&P had extremely high
ratings on loans that were total junk. Should S&P take
some of the blame? Have they
admitted their calculations where wrong? Moody?s recently
said a computer glitch may
have resulted in inaccurate ratings. Is this little
admission enough? Were these rating
agencies and the banks working together?
In my eyes, the rating agencies need to either admit they
screwed up, or forever, they
have zero credibility whatsoever.
Mortgage Lenders.
These
are the guys most home buyers work with. I know banks
ultimately lend the money, but most buyers don?t work
directly with a bank; they work
with a middleman which may be a big company like Lending
Tree or Quicken Loans
(you see their banner adds all over the internet) or a
small ma and pop type shop. There
are some very good lenders out there that won?t let buyers
get in over their heads (I?ve
bought two properties in the last two years, and each time
it was a simple 30-year fixed
with no bells and whistles or special conditions), but
there are many that will do anything
to get your business because they only get paid when they
hook up a buyer with a
bank. They?re the ones that told people they could afford
?that? house if they used an
interest only loan; they?re the ones that encouraged
buyers that putting no money down
wasn?t such a bad idea; they?re the ones that exposed
people to such mortgages as
Payment Option Adjustable Rate Mortgage which allows
borrowers to pay a small
portion of the interest due each month (but then the
remaining principle and interest
balance due is added to what they owe).
If these middlemen collectively were more upfront and
honest with buyers rather than
selling them up a river just to get their business, the
housing market may not have
gotten out of control.
Alan Greenspan
is the man
most would like to blame, and while I certainly agree he
played a role, it?s my belief he only added fuel to the
fire after the fire was already lit.
The economy?s expansion and contraction hinge most on one
thing, and that thing is
liquidity. The more money there is, the more growth that
happens. Unfortunately the
opposite is also true. Give me a city full of brilliant
entrepreneurs, and without money,
they won?t create much.
Greenspan artificially lowered overnight rates to
encourage banks to loan beyond their
reserve requirements. Essentially, he flooded the market
with money which you may
think is good, but at some point, if there is too much
money, that money is wasted or
used inappropriately.
It?s pretty simple. When money is tight, it?s naturally
funneled towards safe investments
just like tight money in your household results in
spending only on the bare necessities.
As more money becomes available, riskier bets can be made,
and when there?s ?too
much? money, bets that should never be made no matter what
the circumstances, are
places.
This is what Greenspan did. He made too much money
available, so businesses that
should not have gotten loans, got loans, and people who
had no business buying a
house, bought a house, and people who should have bought
$300K house bought
$400K houses.
Too much money results in totally irresponsible usage of
that money.
A tightening of rates ? or if he at least held them steady
? may have partially choked off
the aggressive lending.
But Greenspan is not #1 on my list because I do not
believe people have to sip from the
bunch bowl even though it?s full. Anyone who?s gotten into
financial trouble could have
chosen to walk away from the table. Several years ago my
girlfriend (now my wife) was
in the market to buy a condo. She was approved for much
more than she knew she
could afford. Did she buy up to the limit her lender
approved her for or did she buy what
she knew she could afford? You can guess the answer; she
wasn?t about to get herself
in trouble.
To say that Greenspan is most responsible for this mess is
to desire the Fed play a
greater role in tinkering with the money supply. This is a
discussion in and of itself and
not one I wish to go into here. There are some well-known
economists (John Maynard
Keynes comes to mind) who absolutely believe the
government should stimulate and
suppress the economy to dampen the economic fluctuations.
But let?s not get into a
political discussion.
There are many people involved in buying a house. A buyer
works with a mortgage
lender to secure a loan from a bank which then packages
that loan to sell to GSE?s such
as Freddie Mac or other banks such as Bear Sterns. The
system was greased with
artificially low rates, easy money, and extremely
irresponsible activity from the rating
agencies. If any of the parties involved would have put
their foot down, and said: ?No, I
cannot in good conscious do this,? I would not be writing
this report.
But the roots of the problem cannot be traced back to any
of these parties.
Bill Clinton.
All these
people and institutions played a role getting us to the current
housing situation, but ultimately, I blame Bill Clinton.
This probably comes as a shock to
most of you because his name is hardly ever mentioned, but
in my opinion, if you start
with today and work backwards, seeds of the housing mess
were started in 1999 when
Bill Clinton replaced a 66-year old law that restricted
the capabilities of financial
institutions with one that vertically aligned the industry
and set it on a path to
destruction. Let?s go back in time.
It was believed improper and super aggressive banking
activity played a big roll in the
1929 stock market crash and subsequent Great Depression.
At that time, commercial
banks took depositors? money and made risky investments in
the stock market. Call it
greed, but times were so great in the 1920?s, the desire
to be involved and the feeling
the good times would never end, caused many banks to
over-speculate with money that
wasn?t theirs. They were literally taking depositor?s
money and using it to finance risky
investments. Even worse, unsound loans were made to
companies in which the banks
invested in, and they encouraged their clients to also
invest. Can you say: Major conflict
of interest?
Remember back in 2002 when Citigroup came under fire for
their over involvement with
WorldCom. Citigroup was not only acting as an investment
bank which made money
when WorldCom ?made deals,? they were also upgrading the
stock, so those deals were
easier to execute. It was a Ponzi scheme that had no
system of checks & balances, and
it eventually imploded. This is exactly what was happening
in the 1920?s that partially
led to the collapse of the stock market and many years of
struggles. Along comes the
Glass-Steagall Act in 1933 which separated commercial
banking from investment
banking ? essentially a bank could not also be a brokerage
firm and vice versa.
Sectioning off the financial industry incidentally set up
a system of checks and balances
and eliminated many conflicts of interest. Also, banks
were insulated somewhat from
the stock market.
Since then, there have been periods where housing prices
appreciated faster than
historical norms or flattened out for a couple years, but
overall, it was smooth and
steady sailing with no major, national interruptions. And
although we?ve had several
recessions (recessions are no big deal; they surface every
handful or years and we
always emerge from them stronger than when we entered) we
didn?t have anything
even remotely close to the financial crisis that followed
the 1929 stock market crash.
Why? Because of the explicit system of checks &
balances that existed due to
companies not being permitted to have their hand in more
than one part of the process.
That?s what the Banking Act did. It said: ?You can?t be
everything in the process; you
can?t be vertical integrated.?
But this all changed on November 12, 1999. With the CEO of
Citigroup looking over his
shoulder, Bill Clinton signed into law the
Gramm-Leach-Bliley Act which repealed the
Glass-Steagall Act of 1933.
The Gramm-Leach-Bliley Act permitted commercial and
investment banks to
consolidate, and almost overnight behemoth financial
service companies that supplied
everything to everybody were born. Smith-Barney, Salomon
Brothers, PaineWebber
and many other well-known and respected investment banks
were gobbled up by
Citibank, JP Morgan etc, and while the lay public didn?t
have a clue what was going on,
conflict of interests were rampant. Suddenly the banking
arm of one of these financial
service companies was pressuring the investment arm to
raise its ratings on stocks to
help lubricate the deal-making process.
(As a quick side note, Citigroup played a major role
lobbying for an end to Glass-
Steagall. Starting in 1998, the finance, insurance and
real estate industries together
spent more than $200 million to get Glass-Steagall
repealed, and not so coincidentally,
only a couple days after Clinton signed Gramm-Leach-Bliley
into law, recently-departed
Treasury Secretary Robert Rubin was hired by Citigroup as
a member of its 3-person
office of the chairman.)
If you start with today and work backwards with intentions
of figuring out when ?all this
mess started,? you?ll find many parties that played a role
in adding fuel to a fire which
was spinning out of control, but your journey won?t end
until November 12, 1999 when
Bill Clinton tore down the walls within the financial
community.
I?m not going to go as far to say if Bill Clinton had not
repealed Glass-Steagall, we
wouldn?t be in the financial situation we?re in, but I can
certainly say it would have been
much more mild and probably isolated. When second and
third parties are involved in a
transaction, more due diligence is done, more scrutiny is
applied, and less risk is taken.
Bill Clinton started this financial
mess.
In Summary
Bill Clinton
laid the foundation. Alan Greenspan greased the wheels.
Then, extremely unscrupulous mortgage lenders and banks
took full advantage of
gullible, unsophisticated borrowers.
By replacing Glass-Steagall with Gramm-Leach-Bliley, banks
and investment brokers
were permitted to consolidate, and the natural system of
checks & balances was
destroyed. Not to mention the conflicts of interest that
were born. Yes, Greenspan aided
the situation by lowering rates and keeping them low, and
S&P encouraged risky loans
by giving them AAA ratings, and many idiot Americans who
thought prices would keep
appreciating need to check themselves into gamblers
anonymous, but if I had to go
back to the beginning, to where this mess started, it
would be with Bill Clinton?s
signature on November 12, 1999.
You opinion is welcome and
appreciated.