Wednesday, October 1, 2008

A Clearly Written Account of the Financial Mess

With a hat tip to the Instapundit, I'd like to point out this very well-written analysis of what it was that made our country's financial system to go kablooie.

Now, the guy who wrote this is a professor of Tax Law and Policy at Loyola U, and he clearly knows a whole lot more than I do, but I do have a few little quibbles I'd like to mention. The Professor states:

The media talks about “sub prime mortgages” – by which it means mortgage loans to borrowers with less than stellar credit. The real problem, however, was the advent and widespread use of teaser-rate mortgages in both the prime and sub prime markets. A teaser-rate mortgage allows a borrower to make relatively small payments for several years. At some point, the rate jumps dramatically, and the borrower faces much higher monthly payment obligations....

(Some have tried to blame teaser-rates on the Community Reinvestment Act of 1977, which encouraged lending to minorities and lower income Americans. But that act only applied to commercial banks. A majority of this crisis’s teaser-rate loans were made by unregulated originators not subject to the act. More fundamentally, there is no evidence the present crisis started in 1977. Teaser-rate mortgages first became widespread after Mr. Bush took office in 2001.)

The main quibble has to do with the sentence about "Some" people blaming these teaser-rate mortgages on the CRA of 1977. Maybe, but that's not the version of the argument I've been hearing. In fact, this post is the first place I've heard Teaser Rates and the CRA mentioned in the same breath. The argument that "Some" people are making is that:
  1. The CRA gave power to federal regulators to punish lenders that were perceived as having racist lending practices. This power was used increasingly aggressively during the course of the 1990s. This was the "Stick" (as in "Carrot-and-Stick").
  2. But it wound up undermining the banks' lending standards. The trouble is, minorities tend to be less wealthy than whites; and on that basis alone a colorblind lending standard results in minorities tending to qualify for less credit, and getting more rejections.
  3. But simultaneously, Fannie Mae and Freddie Mac were there to "Fund the American Dream". And the way they did it, was to buy up all these shaky mortgages from the banks, repackage them as Mortgage-Backed Securities, and sell them to third party investors. This was the "Carrot".
  4. So the mortgage lenders--being pressured from the regulators on the one hand, and incentivized by Fannie and Freddie on the other--chucked their lending standards out the window and started making a whole lot of really shaky mortgages to borrowers that they wouldn't otherwise have touched. Of course, they sold these loans to Fannie and Freddie, thus unloading the risk.
  5. All this meant that the mortgage lenders could start making lots and lots of really lousy loans, secure in the knowledge that someone else would be on the hook if the loans defaulted.
That's the scenario that "Some" people have been making--at least, one small part of it. (I haven't even touched the part about how easy credit fueled a spike in demand for real estate, which touched off a price bubble, which made the houses look more valuable than they really were, which caused lenders to overestimate the value of the collateral, which caused them to issue more credit....)


In this context, the teaser-rate loans only became possible because the lenders were confident they'd be able to sell these loans to other parties. Had Fannie and Freddie--and the other purveyors of Mortgage-Backed Securites--been more discriminating in the debt they were buying up, or had the lenders been required to hold their loans until maturity, they may well never have issued the stuff.


Nevertheless, that's a minor quibble. The article is very good at explaining a very complicated situation in laymen's language.

In fact all of the articles I've read on the Understanding Tax blog are very interesting. Who'd'a thunk that a blog entitled "Understanding Tax" would have articles that wouldn't put everyone straight to sleep?

1 comment:

Crimson Wife said...

I know several highly educated, fairly affluent, Caucasians who are in financial trouble now because they used these kinds of gimmicky mortgages to either purchase houses they couldn't really afford or to refinance & cash out equity in order to spend it on luxuries. My godfather is a business school professor and is upside-down on a house that he bought more than 15 years ago (!) because he treated it like a piggybank during the boom.

I have sympathy for people who are losing their houses because of unforeseen circumstances like unemployment, serious illness/injury, divorce, etc. I do NOT feel any sympathy for all those who are in trouble because they were greedy and/or stupid.