Well, here we are. We’ve been talking about it for months on blogs all around the Internet. All of us that are managing our money in a responsible way have been wondering how much of an impact the irresponsible could have on our financial well being. It seems to be slowly coming clear now and it doesn’t look good.
Who am I talking about? Well, I’d lump people in to a couple of categories when it comes to being fiscally responsible or not. There are those of us that spend less than we earn and save for the future and for emergencies. On the other end of the spectrum there are those people that are spending far more than they earn with no plan to recover. Certainly there are people along the spectrum between these two extremes and each of them are either contributing to the problem or are doing the things they should to remain financially secure.
First, lets look at the responsible people out there. Month in and month out, you spend less money than you bring in. You have secured a mortgage that is affordable and you live in a home that is within your means. You don’t worry about whether you’ll get some overtime to help cover the basic necessities and you always know where your next meal is coming from. You drive cars you can afford to put gas in and can repair them when they break. You don’t owe more money on those cars than they are worth. In general, you have a plan and you stick to it. You don’t normally worry about money because you, long ago, learned that it’s better to own money than to have money own you.
Then there are the other people out there. They bought houses that were unaffordable through creative mortgage loans with terms like "interest only" and adjustable rate subprime loans that allowed for small payments in the early years of the loan only to have the payment balloon up a couple years later. Take a drive through your neighborhood. I don’t care where you live, I think you’ll be hard pressed not to find a few houses that seem to be vacant, for sale, and most likely owned by a bank or financial institution. The people that lost these houses are the same people that owe thousands and thousands of dollars on their credit cards and drive cars that cost more than their annual income with little ability to cover the payments. Sure there are exceptions to this. Sometimes people lose their homes due to situations completely outside their control such as medical bankruptcies or job losses that crush a person’s financial situation. I’m not talking about those people. I’m talking about the people that wear the latest designer clothes that they won’t own for years. These people are oblivious to basic financial management and have definitely been a major part of the macro level problems we are facing today.
So, it is the second set of people that have helped drive this latest crisis. I don’t put all the blame on this set of consumers though. Another part of the blame goes to the institutions that were lending money to all of these people. Through creative financial packaging of loans and the resale of those loans to greedy, hungry Wall Street firms, pretty much anybody could get a loan for a home, or anything else, with little ability to afford the payments. Need a great example of this? Read about the Spanish speaking farm workers that were able to qualify for a $720,000 house with a payment of $5375 per month. Needless to say, it didn’t take long for them to get in to trouble.
Now, after the party has come crashing to an end, we are left to pick up the pieces. We, as citizens of this country, are facing trillions of dollars of debt to save many of these institutions. That is not capitalism. Capitalism would call for the failure of these firms and others would rush in to pick up the left over bits. Consumers that didn’t play by the rules would face the consequences of their actions without bailouts. The whole idea of capitalism is that some people win and some people lose. If people believe they’ll be saved when they "lose", they will learn to take bigger and bigger risks. This just doesn’t make sense. I understand what our government is trying to do by bailing all of these companies out. They believe that by doing this it might prevent a massive failure in our society that would make the depression look like a Sweet 16 party. If this did happen, the impact to responsible citizens like you and me would be much different. In a sense we get two choices here. We either face the impact of massive debt to try to stabilize an incredibly crappy financial market, or we let capitalism play out and we all end up sitting on our porches with guns protecting what little we have left. Either way, we all end up getting screwed by the irresponsible people in both our local communities and in our financial communities.
We have to move forward and get out of this mess. It’s time to stop crying it’s done.
The financial picture is interesting. As you know the roots of this problem are in the housing market.
For decades when someone wanted a home mortgage they went to the bank. The bank was very careful because, if the agreed to lend the money, they would then carry that loan on their books until it was paid off. It often got sold to a second or third bank, but even then care was needed, because if a bank brought in too many loans that later went bad, if they later sold those loans their ability to sell future loans was at risk, and if they maintained those bad loans, then their balance sheet was hurt.
Then came the innovation of packaging these loans and selling them on the secondary market. And while the initial packaging was labor intensive and took a great deal of time, with innovation comes improved technology and faster responses. I suspect that at the height of these loan generations and packaging and selling things really moved very fast and the loan was prepared for packaging and resealing on Wall Street practically before the ink was dry.
So with this packaging the piece that was now missing was the retention of risk. When I loan you money and hold that note, I retain the risk that you may be unable to repay. But when I immediately sell your loan, which is then put together with multitudes of other loans, and is resold again, I have no risk. So my goal now becomes to generate as many loans as possible for resale, and when I am quickly paid for those loans, I improve my and streamline my processes more and more and the volume continues to increase.
And that retention of risk is a key part, in my mind, to success in a market based economy.
So that is where we are today. These huge financial institutions bought these packages of loans based on their yields without proper due diligence. And as more and more loans went bad, the institutional buyers were stuck with worthless paper on their books. And there leverage with the amount of bad loans compared to assets on hand continued to get way out of wack, and they eventually could not meet their bills. Then their stock price fell like a rock as investors bailed, and now they either sell themselves at a fraction of their value just a few shorts months ago, or go belly up, or now the third option is perhaps the government, and us as tax payers, will step in and rescue them.
I do find it amusing with both McCain and Obama promising regulation and additional oversight if they are elected. In my opinion the free market has already solved the problem. There is no more secondary market for packaged loans, which means lenders must go back to their original business models and measure qualifications, determine a interest rate that reflects the risk they are taking and be prepared to hold those loans. In these times the words from Lou Reed of the Velvet Underground’s song Heroin come to mind; “And all of the politicians makin’ crazy sounds.â€
So the free markets have fixed the problem. However, with the government/tax payer stepping in my fear is that if it/we once again provide a backstop for the lenders, they stand the chance of again not retaining their portion of the risk. And what happens? More risky loans and the cost to resolve the problem grows exponentially. If you don’t believe that can happen research the savings and loans fiasco from a number of years back. That is precisely what happened in that the government decided it did not want a number of S&Ls to fail, which in turn, allowed them to stay in business when they were effectively bankrupt, and they took bigger and bigger chances with their investments, and it ended up costing us substantially more in the end.
The same issue of risk retention can be played out in hurricane and earthquake zones. If the home owner does not retain a substantial amount of the risk, they will continue to build and rebuild while us, as taxpayers will foot the bill.
I actually don’t think that people overextending themselves in debt is the core issue. The core issue is that the debt itself became a financial instrument that was traded for profit. First, came the concept of a Home Equity Loan, back in the early 80s – a way to ‘tap into’ the ‘equity’ (i.e. paper profit) in a home.
Then came the concept of a mortgage as a tradable debt instrument. Hey, we’ve got this debt here, paying steady returns, let’s treat that like a stock or a bond and trade it.
Wow. We can make money on this. Better yet, we can ‘bundle’ mortgages and trade them as a group.
We’re making more money! Let’s make more mortgages that we can trade. Uhhhh….well, we’ve got to loosen some standards here, but that’s OK because we’ll make more money selling the debt, so make that loan! We’re not going to get stuck with it, and really if only a few in the bundle go bad it won’t matter.
Wow! Housing prices have gone insane now that we’ve loosened our standards! That means more debt to sell! Hooray! More money! Let’s loosen our standards even more so we can make more debt to sell and get really rich! We’ll just mix up more of these ‘loose’ loans into the ‘good’ loans. It’ll be fine.
Uh oh. Housing market is beginning to stall. I think we’ve reached our limits. And, uh, some of those not-so-good loans are failing. Errr…That’s OK, housing will stabilize, and we’ll be fine.
Uh…more housing falling…people are starting to walk away from their houses….uh-oh. And, er, some have found out that those AAA mortgages aren’t all AAA. Oops.
Oh, man, housing is NOT coming back. Jobs are starting to disappear as the engine that was fueling them (housing) is shutting down.
Now we’ve got a crisis of confidence – if we lied about this debt, what about other debt we trade? How could auction rate securities fail?
Bear Stearns got saved! Maybe Paulson didn’t mean it when he said once in a lifetime though…that was nice of Bush to Save! His! Friends! so they can go back to their yachts in the Hamptons and stick it to the taxpayers while still looking good to the little guys we don’t care about.
Oh BOY – FNMA and FRMA are in trouble! Why? Got caught up in the loosey-goosey find some money game as well.
What? They’re not saving LEHMAN? Hmm…must have meant it! Or the guys at Lehman pissed off Bush at the Country Club. Oh, man, Merrill sold themselves. EEEEEE….
Oh, geez, now it’s hitting even non-investment banks. AIG is flailing because the insurance policies they sold (and made tons on) to guarantee those mortgage debt packages are now having to pay out because more packages failed than they thought.
Oh, well, let’s hit up our buddies in the Fed and Congress and let them fix it all by creating a new place for taxpayers to buy the bad debt we made fortune off of AND we get to keep the fortune. Yay! We love Republicans!
Don’t get me wrong here. I think if you overextend yourself to the point that you’re in bankruptcy and you lose your house, you should in fact lose your house and all your stuff and have to pay it back. Anyone dumb enough to take on that much debt should have to feel pain to learn that you don’t take on more debt than you can handle.
I think there was some misplaced trust – remember, it used to be that your bank (or anyone else who wasn’t the mob) wouldn’t lend you money unless they really thought you could pay it back. And that was true. Then banks and other lending entities decided that your ability wasn’t so important because they weren’t going to make money on the loan interest you’d pay them. No, they were going to make far more money selling your loan to someone else than they ever would holding your note and just receiving a po-dunkey 5% or 6% return. So they breached their fiduciary responsibility to their shareholders in making that loan, and that is far more serious to me than the actions of the person receiving the loan.
And that’s what we should really be pissed off at. Not the people getting the loans, whose credit is now ruined and are not becoming renters again. The people who breached their responsibility and made the loans they should not have. And those that let them.
Oh, and I think those CEOs of the companies getting help should have to give the Government (i.e. the taxpayers) ALL THEIR BONUSES and SALARIES beyond, say $500,000 – what a CEO SHOULD MAKE – to pay for the mess they led their company in to.
JM (very long winded) HO.
Regina
Great comments! Thanks for posting them. I have to agree with you! I should have done a better job pointing out the responsibility of the lenders! The way they sold those loans with little consideration of the actual consumer and their inability to pay was definitely a key part of the problem. Maybe they should pass a law that says the person that makes the loan should keep it and service it. That would sure tighten up credit!