How Sound are the Fannie Mae and Freddie Mac Recoveries?

Fannie Mae and Freddie Mac (Fannie and Freddie) are the government-sponsored enterprises that back the majority of U.S. residential mortgage loans. In the last financial crisis, Fannie and Freddie played a large role by their purchase of inadequately qualified loans, subsequent bankruptcy, and bailout by the U.S. government. As a result, much has been written about the importance of monitoring the quality of mortgage loans purchased by Fannie and Freddie.

Recently, Fannie and Freddie have made new headlines due to its turnaround under government control. With the latest dividend payment, Fannie and Freddie have paid a total of $266 billion to the U.S. Treasury, making the bailout a tremendous success. In this article, the authors report our findings on the changes in Fannie and Freddie’s mortgage loan quality by analyzing over 15 million loans originated by Fannie and Freddie during the period of 2001-2015. Our results indicate an increase in the quality of post-crisis loans compared to pre-crisis loans, especially in debt-to-income ratio (DTI) and credit score (FICO) requirements. However, we also find that since 2008, their loan-to-value (LTV) requirements have been loosened, which has resulted in a steady increase of first-timer home-buyer loans.

The average characteristics of first-time home buyers are: higher LTV, lower FICO scores, and more likely to carry private mortgage insurance (PMI). As such, in the event of another downturn in the housing market, these loans are more susceptible to default. Accordingly, despite Fannie and Freddie’s recent positive performances, this article highlights the importance of monitoring the percentage of first-time homebuyer loans as well as LTV ratios within Fannie and Freddie’s mortgage portfolios.

Credit Supply of the Housing Market

The authors examined the credit supply of the housing market, which as of 2017 appears to have recovered from the 2008 financial crisis (see Case-Shiller Home Price Index in Figure 1). However, our question was whether the recovery was as complete as the Case-Shiller Home Price Index would appear to indicate, or whether there were still areas of vulnerability that would leave room for history to repeat itself.

Figure 1:

Case-Shiller 20-City Composite Home Price Index

Source: S&P Dow Jones Indices LLC

The majority of U.S. residential loans are sold in the secondary market where they are securitized, i.e., packaged into mortgage-backed securities and sold to investors. The two biggest securitizers are the government-sponsored enterprises Fannie Mae and Freddie Mac. As of 2010, 67 percent of residential mortgages were securitized, and 54 percent were securitized by Fannie and Freddie.[1] Fannie and Freddie were partially blamed for the 2008 crisis because, in alignment with the U.S. government’s first-time home ownership initiatives, Fannie and Freddie lent to less qualified borrowers. Hendershott, Hendershott and Shilling have provided a detailed summary of Fannie and Freddie’s role and influence in the housing market credit bubble.[2]

As the housing market has recovered, there have been stories about Fannie and Freddie’s tightening of their lending criteria.[3] But we wanted to know: how specifically have they changed their lending criteria after the financial crisis? Have loan qualifications indeed been made more stringent, and if so, in what ways?

The authors investigated these purportedly higher qualifications by looking at three major lending criteria: loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, and credit score (FICO). These criteria are used to measure what have been considered the two driving factors behind a borrower’s choice to default, which are ability to pay and willingness to pay.

  • DTI and FICO score relate to the borrower’s ability to pay the payment on time. A considerable amount of research finds that a high DTI and a lower FICO score result in a higher probability of default (for example see references[4], [5]).
  • LTV measures the borrower’s willingness to pay. Where the house value falls below the loan balance, borrowers are likely to strategically default on mortgage payments, even if they are able to Even where house prices increase and the current LTV does not exactly reflect the initial LTV at the time of origination, empirical research shows that the initial LTV nonetheless has predictive power in default determination.[6]

The authors also examined how loan qualities were different for first-time home buyers (FTHB) compared to non-FTHBs. Historically, more than a quarter of all borrowers have been first-time home buyers. Research is inconclusive as to whether these FTHBs tend to default more.[7] However, statistically, FTHBs are likely to be younger households with less established financial resources. As a result, it may be argued that they have a higher risk of default (although this risk might be partially mitigated by the fact that they may also have greater ability for quicker re-employment).

Data & Analysis

Quality of Fannie Mae and Freddie Mac Loans

Fannie and Freddie have released loan-level origination and performance data from 2000 (Freddie Mac data is available from 1999; Fannie Mae data is available from 2000). Our study covered a total of 15 million loans, all of which are 30-year fixed rate purchase loans for primary residences. Figure 2 displays the total number of loan originations (left axis). The blue bars represent the number of FTHB loans, and the red bars are non-FTHB loans. The gray line on the right axis represents the FTHB ratio amongst the total number of loans. Figure 2 displays, as commonly known, the sharp decrease of loan originations following the financial crisis of 2008 until 2012. It also displays that as of 2015, loan origination activities have recovered to pre-crisis levels.

Notably, since 2006, more FTHBs have entered the housing market. The historical average of FTHBs is about 25 percent of total home buyers; in 2015, FTHBs were about 45 percent of the total number, which is a significant increase. Considering this noticeable change in the FTHB ratio, we investigated FTHBs separately in the subsequent loan quality analyses.

Figure 2:

Loan Originations

As a first step in our investigation, we examined the two ability to pay measures. Figure 3 shows the historical average DTI. The gray, blue and red lines indicate all FTHB and non-FTHB loans, respectively. From 2003, Fannie and Freddie allowed higher debt payment relative to income, which increased the risk level of a loan. By 2008, the year of the crisis, the average DTI was 39 percent. Following the market crash, Fannie and Freddie tightened the DTI to approximately 35 percent. However, more recent figures show that DTI is on the rise. Additionally, FTHBs appear to have lower DTI than non-FTHBs by approximately 2 percent. This gap is offset by the fact that FTHBs usually take out loans higher than 80 percent LTV, which then require private mortgage insurance (PMI), leading to additional monthly payments. For example, in 2015, more than 62 percent of FTHBs obtained loans with PMI. Annual PMI premiums range from 0.3 percent to 1.5 percent of the original loan amount.[8] Applying even a conservative premium of only 0.41 percent of annual PMI fee to the FTHB average loan size of $226,000, the resulting PMI premium would be $927 per year. Consequently, an average FTHB with an annual income of $41,000, would need to pay more than 2.3 percent of their income for the PMI; this would in turn offset the reported 2 percent lower DTI level. Thus, there would be almost no difference in DTI between FTHBs and non-FTHBs.

Figure 3:

Debt to Income (DTI)

Fannie and Freddie also significantly raised FICO standards. Before the financial crisis, the average FICO score of loan applicants was around 730. Currently, it hovers around 760. However, as Figure 4 shows, this standard appears to be dipping. Furthermore, FICO scores for FTHBs are more than 10 points lower than non-FTHBs.

Figure 4:

Credit Score (FICO)

Next, the authors looked at the willingness to pay measure, and Figure 5 shows the average LTV level. The LTV limit was at relatively low levels until 2011. Current LTV levels, however, are even higher than at the pre-crisis level. In 2015, the LTV level of FTHBs was 86 percent, which was 6 percent higher than non-FTHBs at 81 percent. This higher initial LTV level exposes FTHBs to the default incentives when house prices drop.

Figure 5:

Loan to Value (LTV)

If LTV is greater than 80 percent, lenders typically require PMI. This insurance premium as an additional expense reduces the borrower’s ability to pay. As FTHBs have higher LTV rates, more FTHBs have PMI payments. Figure 6 shows the ratio of loans that also had PMI. In 2015, almost 62 percent of FTHBs were paying for PMI, whereas only 45 percent of non-FTHBs had PMI. Thus, even if FTHBs had lower DTIs, this PMI added an extra payment obligation.

Figure 6:

Loans with Private Mortgage Insurance (PMI)

First Time Home Buyers (FTHB)

In this next section, the authors further investigated characteristics of FTHBs. Figure 7 shows borrowers’ average incomes, based on DTIs, loan sizes, interest rates and loan terms. FTHBs have lower average income than non-FTHBs: in 2015, these figures were $41,000 versus $44,000, respectively.

Figure 7:

Income

The relatively lower income of FTHBs indicated by the blue line in Figure 7 corresponds to the fact that FTHBs purchased lower-priced houses. Figure 8 displays the prices of these houses. As expected, because FTHBs were likely to be younger with less accumulated wealth and income, their purchase price level was lower than that of non-FTHBs. And, in 2015, the average house price of FTHBs was $260,000 while for non-FTHBs it was $310,000.

Figure 8:

House Price

House prices develop in different patterns depending on price tiers. See, for example, the Los Angeles Case-Shiller indexes for low-, middle- and high-tier price indexes in Figure 9. Low-tier prices are more volatile than the middle or high tier prices. Since FTHBs tend to buy lower price houses, FTHBs are more likely to go through unstable price changes in the future.

Figure 9:

Case-Shiller Index by Price Tier: Los Angeles

Source: S&P Dow Jones Indices LLC

Findings thus far suggest FTHBs represent a higher risk (higher LTV, lower FICO, and lower-tier housing market). This riskiness should be priced into their interest rates. Figure 10 displays the average interest rates of FTHBs and non-FTHBs. FTHBs were charged 0.05 percent higher interest rate on average, which merits further research as to whether this spread is sufficient to incorporate all risks associated with FTHBs.

Figure 10:

Interest Rate

 

Conclusion

Our investigations into Fanny and Freddie’s loans from 2001 to 2015 show that they did tighten standards for loan qualification after the financial crisis, as measured by higher average DTI and FICO scores. However, we also found that they did not tighten LTV requirements; in fact, LTV ratios have been rising since 2008. Furthermore, in the last few years, Fannie and Freddie have once again lowered their lending standards, likely due to criticisms that they have been too tight.[9] Thus, there is a growing risk attendant to the lowering of LTV standards, as it leaves Fannie and Freddie vulnerable for another housing market downturn.

The authors also found an increased percentage of first time home buyers (FTHBs). The characteristics of FTHBs are, generally, that they tend to borrow to their maximum capacity with a higher LTV, which requires extra PMI payments. Also, FTHBs tend to have lower FICO scores than non-FTHBs. Lastly, FTHBs tend to be in the low-tier housing market, which is more volatile than the middle or high-tier markets. Though on average FTHB loans have slightly higher interest rate (0.05 percent) than the non-FTHB loans, it is questionable whether this rate difference is sufficient to compensate for the higher risk associated with these borrowers.

Overall, despite recent positive performances by Fannie and Freddie, our study also revealed the growing need for increased monitoring of their deteriorating LTV standards and historically high number of FTHB loans. We also highlighted the need for further research as to whether the interest rate differential of 0.05 percent for FTHBs compared to non-FTHBs were sufficient to incorporate all risks associated with FTHBs.

 

[1] The Financial Crisis Inquiry Commission. (2011). “The Financial Crisis Inquiry Report”. January: p.69.

[2] Hendershott, P., Hendershott, R., & Shilling, J. (2010). The Mortgage Finance Bubble: Causes and Corrections. Journal of Housing Research 19: 1-16.

[3] MarketWatch. (2017). “Mortgage lending is so tight, more people aren’t even bothering to apply.” February. Accessed at http://www.marketwatch.com/story/mortgage-lending-is-so-tight-more-people-arent-even-bothering-to-apply-2017-02-14

[4] Holden, S., Kelly, A., McManus, D., Scharlemann, T., Singer, R., & Worth, J. D. (2012). The HAMP NPV Model: Development and Early Performance. Real Estate Economics, 40, S32-S64.

[5] Rose, M. J. (2012). Origination Channel, Prepayment Penalties and Default. Real Estate Economics, 40, 663-708.

[6] Deng, Y., Quigley, J. M., & Van Order, R. (2000). Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options. Econometrica, 68, 275–307.

[7] Ambrose, B. W., & Capone, C. A. (1998). Modeling the Conditional Probability of Foreclosure in the Context of Single-Family Mortgage Default Resolutions. Real Estate Economics, 26, 391-429.

[8] Lewis, H. (n.d.). “Private mortgage insurance, or PMI: Just the basics.” Accessed at http://www.bankrate.com/finance/mortgages/the-basics-of-private-mortgage-insurance-pmi.aspx

[9] MarketWatch, 2017.

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“Shaky Ground: The Strange Saga of the U.S. Mortgage Giants” by Bethany McLean

Shaky Ground sm

 

“Shaky round: The Strange Saga of the U.S. Mortgage Giants”

by Bethany McLean

Columbia Global Reports, New York (2015)

159 pages

 

 

In Shaky Ground Bethany McLean explores what she believes to be one of the biggest unresolved issues remaining from the 2008 financial crisis, namely what to do about the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). While large banks have generally repaid the U.S. government for funds received during the financial crisis and companies such as Chrysler and General Motors have exited bankruptcy, Fannie Mae and Freddie Mac still remain in conservatorship.

Although Mclean’s focus centers on what to do now about the fate of Fannie Mae and Freddie Mac, she also provides interesting insights into events relating to the U.S. Treasury Department’s $187.4 billion bailout of these institutions. For example, she reports how approximately $45 billion of this amount related to dividend payments back to the Treasury Department and she examines details of how the Fannie and Freddie 2007 through 2011 recorded provisions for losses ended up far exceeding the adverse cash impacts actually incurred.

McLean highlights the threefold tension making resolution of Fannie’s and Freddie’s ultimate fate so challenging, namely interest in ensuring viable U.S. mortgage and home ownership markets, concern about impacts to foreign investors holding Fannie and Freddie issued securities, and interest in keeping Fannie and Freddie liabilities off of the federal government’s balance sheet.

Of particular interest is McLean’s analysis of the three alternatives outlined in a 2011 study relating to Dodd-Frank related legislation: first, replace Fannie and Freddie with a private system and have the government provide only narrowly targeted mortgage guarantees for low income individuals; second, establish a flexible mortgage guarantee program that would expand and contract depending on the strength of the economy; or third, turn to private capital to assume the “first loss” position on mortgages, whereby any government exposure would not arise until after private investors had absorbed initial losses.

Unfortunately none of these three alternatives has been implemented and McLean points to the 2012 so-called “Third Amendment” (referring to the third time the government amended rules relating to the Fannie and Freddie bailouts) as a major stumbling block. Now instead of requiring Fannie and Freddie to pay the Treasury Department the originally required 10% dividend, the Third Amendment requires all Fannie and Freddie generated profits to be turned over to the government, helping to reduce the federal deficit but limiting reserves available for Fannie and Freddie to weather any future downturns.

McLean’s in-depth examination of tensions relating to this Third Amendment provides readers with her most interesting insights on how Fannie and Freddie still represent “… a huge, consequential, and fundamentally unstable part of the American economic system.” McLean outlines very clearly why the fate of Fannie and Freddie remains in limbo and why this is an ongoing, though perhaps currently less visible, challenge for the economy and a concern for the country overall.

 

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Who are Fannie Mae and Freddie Mac?

This article examines the factors that led to the creation of Fannie Mae and Freddie Mac. The authors trace their history, discuss their importance to the U.S. housing market, and consider the implications of their recent government takeover.








Image: Digital Film








The Early Years

The Federal National Mortgage Association, commonly known as Fannie Mae, was created at the request of President Franklin D. Roosevelt in 1938. At the time, the mortgage market was segmented and the availability of funds to borrowers was inconsistent. As a government agency, Fannie Mae was authorized to borrow funds to buy Federal Housing Administration (FHA) insured mortgages from the institution that originated them, thereby providing additional funds to the loan originators and creating a secondary market for mortgages. Fannie then held these mortgages in its portfolio, receiving income as borrowers repaid interest and principals. The agency’s authority was later extended to enable purchases of Veterans Administration (VA) guaranteed mortgages.

From 1938 to 1968, Fannie Mae held a monopoly on secondary mortgage market operations in the United States. In 1968, Fannie Mae was privatized (but still regulated), and some of its responsibilities were shifted to Ginnie Mae, the Government National Mortgage Association, which was created as part of an effort by the U.S. Department of Housing and Urban Development (HUD) to use the “full faith and credit of the U.S. government” to support the FHA and VA mortgage markets. Ginnie Mae operated differently from Fannie in that it did not hold mortgages purchased as part of its portfolio, but instead, pooled them and sold securities backed by this pool to investors.

In 1970, Fannie Mae’s authority was further extended to allow for the purchase of conventional mortgages (non-government-insured loans) for its portfolio. To increase liquidity and stability in the mortgage market, Congress chartered the Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 1970, and authorized it to purchase and pool conventional mortgages. Freddie modeled its programs after those of Ginnie Mae. Fannie continued to hold all of the mortgages it purchased until 1981, when it began to pool mortgages.

In 1992, the Office of Federal Housing Enterprise Oversight (OFHEO) within HUD was created to regulate Fannie and Freddie. Among its responsibilities, OFHEO was authorized to place Freddie or Fannie into government conservatorship if it decided either agency was critically undercapitalized.

Prior to the government takeover, Fannie Mae and Freddie Mac were funded with private capital and their debt securities were not guaranteed by the federal government. They were stockholder-owned corporations listed on the New York Stock Exchange (NYSE). However, they were also government-sponsored enterprises (GSEs) owned by their shareholders, but regulated by government agencies.

Primary Versus Secondary Markets

Mortgage markets are divided into primary and secondary markets. In primary markets, loans are originated by lending institutions often mortgage banks, savings and loan associations, commercial banks, or credit unions. These lending institutions typically obtain the funds they loan from individual, business, or government deposits or mortgages sales in the secondary markets.

Both Fannie Mae and Freddie Mac operate in the secondary mortgage markets. They provide liquidity to the market by borrowing money to purchase the loans originated by lending institutions. They then either hold the mortgages in their portfolio or pool the mortgages and sell securities backed by these pools referred to as mortgage-backed securities (MBS) by Fannie and participation certificates (PC) by Freddie to investors. The pooling process is known as “securitization.” As of 2008, these mortgage giants either own or guarantee $5.2 trillion or approximately half of the U.S.’s $12 trillion mortgage market.

An MBS or PC provides an investor with an attractive option for participating in mortgage markets. First, they are actively traded through a network of dealers. This provides investors with a mortgage alternative that is highly liquid. Second, Fannie Mae and Freddie Mac guarantee the timely payment of principal and interest on the mortgages they securitize. Investors pay a guarantee fee and eliminate credit risk. Thus, these two mortgage giants increase the amount of funds available in the mortgage market, and provide an attractive mortgage alternative for investors.

How Did it Go Wrong?

Fannie and Freddie’s GSE status benefitted them in several ways. First, they were able to borrow at low interest rates because of the implicit government guarantee and purchase higher-yielding mortgages. This positive spread typically provided a nice profit. Second, they were able to operate at much higher levels of debt than most “private” firms. By the end of 2007, their combined capital of $83.2 billion supported debt and mortgage guarantees of about $5.2 trillion.[1]

However, Fannie and Freddie faced certain risks, mainly interest rate, credit, and pre-payment risks. Interest rate risk is the risk that interest rates will rise, causing the value of a loan portfolio to fall. Credit risk is the risk that borrowers will default on their mortgages. Pre-payment risk is the risk that the borrower will pay off a mortgage earlier than anticipated. Interest rate risk was of particular concern to Fannie and Freddie, given their high debt-to-equity ratios; a small drop in the value of their assets could wipe out their equity, making them insolvent. However, by pooling mortgages and selling securities backed by these pools, they were able to minimize this risk. But even with pooling, credit risk remained as Freddie and Fannie guarantee the timely payment of interest and principals. This risk was minimized as their government mandate stated that they were only allowed to purchase mortgages from individuals offering down payments and possessing good credit ratings. Pre-payment risk exists for the buyer of an MBS, as its price is based on the anticipated life of the mortgages. If borrowers pay off their mortgages early, the return to the investor is negatively impacted since the amount of interest generated by the mortgage is decreased. Interest is paid on outstanding principals no principals, no interest.

During the late 1990s, Freddie and Fannie modified their operations by buying MBSs issued by others, including those containing sub-prime mortgages. Freddie’s investment grew from $25 billion in 1998 to $267 billion by the end of 2007. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion by the end of 2007.[2] These activities exposed them to interest rate, credit, and pre-payment risks.

To minimize credit risk, they purchased insurance; to minimize interest rate risk, they purchased derivative contracts. However, insurance firms are also suffering. Moody’s and Standard & Poor’s recently downgraded the ratings of many insurers based on faltering financial strength,[3] making the value of this insurance questionable. In addition, the value of their $2.3 trillion derivative contracts depends on the ability of their counterparties who are unnamed to pay up. Given that both Fannie and Freddie have reported a loss on hedging transactions, the value of this “insurance” is also unclear.

Too Big to Fail?

Officially, the U.S. government did not guarantee Fannie Mae and Freddie Mac’s securities. Unofficially, it had long been assumed that due to the size of their holdings and their importance to the mortgage market, these GSEs were too big to fail. They enjoyed the widespread perception of being federally-backed financial agencies. Vernon L. Smith, the 2002 Nobel Laureate in economics, called these two agencies “implicitly taxpayer-backed agencies.”[4]








Photo: Henk L








Critics have long argued that Fannie and Freddie did not adequately offset their financial risk because they were seriously undercapitalized. As early as 2002, The Wall Street Journal expressed concern about the size of the outstanding debt of these two GSEs, as well as their increasing dependence on derivatives.[5] However, they were able to circumvent congressional efforts to increase oversight due to many believe their deep and vast political connections. Both Fannie and Freddie were particularly hard hit by the current subprime mortgage crisis. As home prices continued to fall and delinquencies increased, the impact on their balance sheets became obvious. In the nine months that ended on March 31, 2008, the combined losses of Fannie and Freddie soared to more than $11 billion.

The share prices of both mortgage giants were buffeted by speculation that either they would have to issue additional stock to offset losses, leading to greater dilution of current shares, or the government would have to bail them out, causing current shares to become worthless. To compound their problems, Lehman Brothers yes, the recently deceased Lehman Brothers announced on July 7, 2008 that a change in accounting rules would require them to raise billions of dollars in new capital.[6] By July 8, Fannie’s shares had lost 76 percent of their value and Freddie’s shares 80 percent.

The Bailout: Step 1

On July 13, 2008, Secretary of the Treasury Henry Paulson unveiled an emergency plan to support Fannie Mae and Freddie Mac. Secretary Paulson noted that without government intervention, the housing market could lose major players, the banking system could face new losses, and foreign investors could flee the country. Roughly $1.5 trillion of Fannie and Freddie’s AAA-rated debt, along with that of other U.S. “government-sponsored enterprises” is now in foreign hands.

The emergency plan was followed weeks later by action the American Housing Rescue and Foreclose Prevention Act passed by Congress and signed by President Bush. The act had three purposes: to prevent foreclosures, increase home purchases, and aid Fannie Mae and Freddie Mac. It included most of the provisions in the Treasury’s plan, albeit with some limitations. First, it set up a new regulator, the Federal Housing Finance Agency (FHFA), to oversee Freddie and Fannie. Second, it authorized the Treasury Department to increase its lending to Fannie and Freddie, and to purchase stock in the two corporations if necessary. However, the aid could not cause a breach in the federal debt ceiling, a constraint meant to limit taxpayer losses. Third, it authorized Treasury to restrict dividend payments to shareholders and approve the salaries of top executives. Last, the act permanently increased the cap on mortgages that Fannie and Freddie can purchase in high-cost markets to $625,500.

The lobbying efforts of these two quasi-government institutions appeared to have been successful. Not only did they benefit from the rescue package, but Congress did not impose any changes in their management, nor were there any penalties to be paid by shareholders. The lack of accountability for the executives of these two companies stands today. As Robert Reich, former Secretary of Labor under President Clinton, remarked, “We’ve created the worst of socialized capitalism private gains combined with public losses.”[7]

In the last election cycle, Freddie Mac’s political action committee (PAC) contributed $202,997 to federal candidates (evenly split between Democrats and Republicans) and Fannie Mae’s PAC contributed $617,900 (59 percent to Democratic candidates).[8] Opponents of the bailout sited the danger of the government and the financial markets becoming too cozy. Republican Senator Jim DeMint proposed an amendment to the housing bill that would have banned Fannie and Freddie from making political contributions if they received a bailout. However, the Democratic leadership refused to allow a vote on his proposal.

The Bailout: Step 2

The first market response to the housing act was positive. Fannie and Freddie saw the value of their shares increase and they were able to borrow at a reduced premium over Treasury securities. However, the positive outcome soon turned, and  on September 7, the government placed Fannie and Freddie in conservatorship in order to prevent a financial meltdown. This provided access to loans, secured by their assets, until the end of 2009. In addition, Treasury assumed the role of buyer of last resort for bonds packaged by Fannie and Freddie, in case there was a slack in demand.[9]

The immediate market reaction was positive. The Dow Jones Industrial Average gained over 300 points, the cost of Fannie and Freddie’s borrowing dropped 40 basis points, and the mortgage rate dropped 50 basis points. However, there were losers. The chief executives of both organizations were replaced, although controversy continues over the multimillion-dollar severance packages they are slated to receive and the U.S. Federal Bureau of Investigation announced it is investigating them for possible fraud. The share price of Fannie plunged to $0.73 and the share price of Freddie fell to $0.88, with the takeover expected to further diminish their value.[10] Shareholders suffered, but bondholders, including foreign central banks, were protected.

Conclusion

Given the current turmoil in U.S. capital markets and the faltering housing market, the U.S. government was left with little choice but to rescue Fannie Mae and Freddie Mac. Market observers suggested that the failure of either mortgage giant would substantially decrease the amount of available mortgage funds and increase the cost of funds to home buyers. In addition, the impact on the confidence of foreign investors in U.S. capital markets would be disastrous given the agencies’ implicit government support. However, this step was not enough to stabilize financial markets. The financial crisis soon spread from Wall Street to Main Street, leading to the passage of the $700 billion rescue package by Congress.

The question now is: what will Fannie and Freddie look like after the credit markets stabilize? Several ideas are being discussed both openly and behind closed doors. Some Democratic lawmakers, including Senator Christopher Dodd and Representative Barney Frank proposed that few structural changes be made. Although they have provided no specifics, Dodd and Frank suggest that Fannie and Freddie be nursed back to health and returned to their former structure with additional safeguards. Some have suggested that they shrink in size and become public utilities. In this scenario, their profits and activities would be tightly regulated and their investment portfolios reduced. Others have suggested that Fannie and Freddie should be nationalized, i.e., transformed into government agencies similar to Fannie’s original incarnation. They would then be managed by government-appointed officials, with their profits turned over to the Treasury. Finally, some suggest that after the crisis passes, Fannie and Freddie should be liquidated. Private sector institutions with no government support would then replace them in the marketplace.[11]

At this time, we return to the original question: Who or what are Fannie Mae and Freddie Mac? They have been important organizations within the housing market, but they are evolving. In the future, what you will see is not necessarily what you will get.


[1] Economist.com, End of Illusions, http://www.economist.com/finance/displaystory.cfm?story_id=11751139.

[2] Ibid.

[3] James Hagerty and Serena Ng, “Mortgage Giants Take Beating on Fears over Loan Defaults” The Wall Street Journal, July 8, 2008, at A1.

[4] Vernon Smith, “The Clinton Housing Bubble” The Wall Street Journal, July 22, 2008.

[5] “Fannie Mae Enron” The Wall Street Journal, February 20, 2002, at A22.

[6] The Economist, July 12, 2008, 12.

[7] Robert Reich, “A Modest Proposal for Ending Socialized Capitalism” Robert Reich’s Blog, http://robertreich.blogspot.com/2008/07/modest-proposal-for-ending-socialized.html. (no longer accessible).

[8] Richard Simon, “Congress Tosses a Life Preserver to the Housing Market” The Los Angeles Times, July 27, 2008, at A1.

[9] Economist.com, Suffering a Seizure, http://www.economist.com/finance/displaystory.cfm?story_id=12078933.

[10] Walter Hamilton, “Wall Street Applauds Takeover” The Los Angeles Times, September 9, 2008, at C1.

[11] Stephen Labaton and Edmund Andrews, “Reinventing Mortgage Giants: A Big Rebuild or a Teardown?” The New York Times, September 9, 2008, at A1.

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Editorial: Crisis in America: A Nation at Risk

“It was the best of times; it was the worst of times. It was the age of wisdom; it was the age of foolishness. It was the epoch of incredulity; it was the season of Light. It was the season of Darkness; it was the spring of hope. It was the winter of despair; we had everything before us; we had nothing behind us. We were all going directly to Heaven; we were all going the other way.”

Charles Dickens, A Tale of Two Cities






Photo: Lilli Jolgren Day






The U.S. economy is in a “once-in-a-century” crisis, according to former Federal Reserve Chairman Alan Greenspan, who appeared on the September 14 episode of ABC’s “This Week with George Stephanopoulos.”[1] Little did we know how insightful Greenspan’s comment would prove to be; in the following weeks, we witnessed the entire U.S. financial system bordering on total collapse. On September 28, as the bailout bill languished in Congress, Warren Buffett, “The Sage of Omaha” proclaimed that the government must agree to bail out the economy or face the “biggest financial meltdown in American history.”[2]

The bailout bill finally did pass on its second pork-barrel-enhanced try to become the law of the land. Most economists were in favor of some congressional action, but a substantial number of economists were against the bill that was finally approved. Needless to say, the question remains whether the funds will be sufficient in financial terms or viable enough to save the teetering American, and world, economy.

It is important to recall the words of Karl Marx: “History is economics in action.” Congress’ current actions appear to be in deep conflict with America’s historical economic conduct. The nation is more socialist than at any time in its history. The government not only owns Freddie Mac and Fannie Mae (an event that doubled the total debt of the U.S. government overnight if properly accounted for); it also owns American International Group (AIG), and will shortly own an unknown portion of the U.S. financial system. There is no way to even estimate the magnitude of the bailout. The bailout bill (which went though Washington morph-speak on the second try to become the “rescue bill”) stands at over $700 billion, and that does not include the amounts advanced by the Federal Reserve (FED). It is even more remarkable that the FED does not know whether certain derivative investments (this does not even include the $55 trillion for credit default swaps, many of which the U.S. government is now liable for through ownership of American International Group [AIG]) are assets or liabilities to the financial institutions.

It appears that more than just the American economy is bordering on breakdown. It is far more significant that America its culture and spirit is in total crisis and bordering on collapse.

First finance is industry next?

The economic collapse is beginning to take its toll on American industry. Quietly and without fanfare (but preceding the financial system bailout), President Bush approved a $25 billion bailout to the “Big Three” automakers, General Motors, Ford, and Chrysler, the last of which was recently taken over by a well-connected, Wall Streetleveraged hedge fund. Like Wall Street, the automakers eschew terms like “bailout.” The two presidential candidates even referred to it as part of the overall investment in green technology. As Jim Press of Chrysler told ABC News: “It is not a bailout. It is a good investment between industry and government.”

This crisis in the financial sector will, of course, bring additional negative impact to the industrial sector. The September 1 Barron’s cover story said it all “Look Out Below!”[3] when it noted that the increasingly slow economy and scarce credit spell more disasters at debt-laden companies.

Unfortunately, the list of possible industrial failures is far too long to outline here. However, it should be noted that the problem is so large even General Electric (the highest-credit-rated industrial company in America) announced it is having difficulty securing credit to cover the $15 billion it needs to continue operating in these final months of 2008. GE, like Goldman Sachs, turned to Warren Buffet who is investing $3 billion in the corporation.

In early October, Standard & Poor’s Ratings Services announced that General Motors only has enough money to operate through December and, currently, it cannot raise funds. Is the federal government going to bailout industry as well? The states of California and Massachusetts are currently unable to secure sufficient credit to pay all their bills; other states are having difficulty as well. Is the federal government going to bailout states, too?

One major concern centers on whether further erosion is preventable. Congress seems quite willing to shower the privileged elite of American finance and industry with financial bailouts or loans that others cannot secure. Who makes these choices and are they fair to middle-class Americans? The answer remains unclear.

Americans have been polled many times on the bailout bill. Their opinions have vacillated sharply, depending on where the bill was and where the stock-market indices were on any given day. Even after its passage, the bailout bill remains utterly unacceptable to the majority of Americans.

What accounts for this depth of hostility and anger?

This anger and hostility represents, in my opinion, a critical moment in American history, when those who follow the rules realized they had been completely undermined by an unscrupulous and incompetent government that enjoys an incestuous relationship with the corporate and financial elite of the country.

This belief can be seen in the October 21 CNN poll that found widespread dissatisfaction of Americans with over 75 percent saying things are going badly in the United States. Similar numbers say they are both angry and stressed out. Two-thirds of those questioned said they were scared about the way things are going.

“It’s scary how many Americans admit they are scared” said Keating Holland, CNN’s Polling Director.

The message of government is clear: To hell with the rest of you. The message is followed by the realization that the government appears determined to destroy the middle class, the last obstacle threatening a controlled society.

A review of the mortgage meltdown clearly shows this orientation. The real beginning of the financial meltdown came when the Clinton administration wanted Fannie Mae to ease credit scores to allow increased home ownership among minorities and low-income consumers. These credit scores continued to deteriorate during the Bush administration, and under Alan Greenspan, the FED made this orientation into a major problem in the ongoing low-interest environment. Wall Street jumped on the bandwagon reselling these toxic loans without full disclosure, and the key regulators, the FED and the Securities Exchange Commission (SEC), chose to do nothing to stop this insane party. The minor regulators were pressured by the FED, the SEC, the White House, and Congress to take no action. Congress received kickbacks (also known as “Campaign Contributions for Better Living”) to block the minor regulators from their fiduciary duty. The day of financial judgment would ultimately come.

Many consider the failure to support Lehman Brothers as the defining day and moment of judgment in this crisis. Lehman Brothers’ failure resulted in the subsequent “bankruptcy” of certain money market funds that held Lehman Brothers’ commercial paper. This resulted in the run on many money market funds that caused not only redemption problems, but also Treasury bill interest rates to fall to virtually zero. Was Secretary of the Treasury, Henry Paulson whose net worth (accumulated while Chairman of Goldman Sachs) is estimated at $700 million trying to send a message of drawing the line or was he effectively destroying one of Goldman Sachs’ primary institutional competitors?

Who is representing Main Street?

The middle class, also referred to as “Main Street” has very legitimate reasons to question all of this conduct. Who is representing them? Can they rely on a very tainted Secretary of the Treasury? Can they rely on Christopher Dodd, Chairman of the Senate Banking Committee, who has received campaign contributions directly from Henry Paulson, Goldman Sachs, Freddie Mac, and Fannie Mae? The latter two even contributed during Congress’ attempt to enforce more regulation that might have avoided their collapse. It would not, of course, come as a surprise that Senator Dodd voted against the increased regulation. In the interests of fairness and full disclosure, seven (three Democrats and four Republicans) of the banking committee’s 21 members received campaign funds from Henry Paulson. I suggest that the members are just a group of his “friends and family.”

Can we even trust the new directors of the bailout plan? They almost all are ex-Goldman Sachs executives. Many have raised questions over this potential conflict of interest. At a House Oversight Committee hearing on the fall of Lehman Brothers in early October, Congressman Henry Waxman, committee chairman, criticized Paulson’s position; A spokesperson for the Treasury stated, “Bringing additional expertise to bear at a time like this is clearly in the best interest of the U.S. financial system and the U.S. economy.” To paraphrase Charlie Wilson of GM’s famous misquote: What is good for Goldman Sachs is good for America.

Congressman Dennis Kucinich, who sits on the oversight committee, also voiced his apprehension that putting Paulson (and other Goldman executives) in charge puts him “in a direct position where he can benefit the people that he worked with while he was CEO of Goldman Sachs.” This only reinforces the concern over Paulson’s questionable behavior towards both American International and Lehman Brothers.

Can we even have confidence in Warren Buffett? He touted the bailout bill, which could make him millions if not billions in his yet-to-be-consummated investment in Goldman Sachs? Can we even take Alan Greenspan’s words seriously? He is the man who may have caused the Greenspan-Bush Depression, but he claims that the housing bubble is the fault of unscrupulous bankers repackaging loans as securities and selling them to investors. That is typical of the Washington mentality it is always the other guy’s fault.

After months of not addressing his responsibilities as FED chairman to monitor and, if necessary, modify such banking activities, Sir Alan finally conceded to errors in his regulatory policies in late October. Many, including this author, firmly believe that he absolutely helped inflate housing prices by keeping targeted short-term rates too low for too long, which, in turn encouraged reckless lending and borrowing. The credit derivatives allowed even more reckless behavior by allowing the ultimate justification: You are insured against loss.

The FED is the regulator of bank holding companies as well as the lender of last resort. The FED has deep institutional relationships with the primary dealers of government securities, including all the major securities firms like Goldman Sachs. The FED, even while choosing to continue low short-term rates, could have exercised discipline in the financial community. But the FED chose not to regulate the derivatives, which allowed credit swaps to swell to a degree that certainly contributed to reckless Wall Street behavior.

The FED and the SEC could have used multiple methods to convey their displeasure to banking and securities firms; however, the FED and the SEC chose to do nothing. The call for new regulation is nonsense; we have enough regulation on the books to accomplish any task.

What America needs is a value-centered government that enforces rules and does not become beholden to those they are charged with regulating and taxing. Such beholden relationships develop into incestuous relationships that foster corruption.

Main Street knows that they have been had, and they are furious at the tainted kickback system between congressional members and the privileged elite of finance and industry.

Just how stupid do they think the American middle class is?

It is increasingly obvious that the implosion of Wall Street has created a new populist movement. Hopefully, this will change the political landscape and reshape the country’s economic policies, especially tax and trade. John Sweeney, of the AFL-CIO, commented on this populist sentiment: “One thing is certain. No one no politician, no investment banker, no television commentator, no economist should be able to say again with a straight face that here in the United States we just let markets do whatever markets do and everything works out for the best.”[4]

It is equally obvious that, in the corrupt economic system that is the current America, the economic “trickle down theory” does not work. All the American middle class has received is a “trickle down” in their standard of living. To quote Ross Perot, “the giant sucking sound” one hears is the sound of jobs leaving America in the great sellout.[5] Fair trade only works when the other guy also allows fair trade.

Most Americans believe that something is fundamentally wrong and that we are moving in the wrong direction. Americans want change now more than ever. This is quite true regardless of which presidential candidate one supports or which candidate is elected.

It is increasingly obvious that Americans are becoming very fearful of the economic crisis and its negative implications. The current administration is trying to curb this fear, but they are the ones who created it. They sold the bailout bill through fear tactics and this fear factor, which cannot be easily abated, has the potential to create real havoc. It is, without a doubt, one of the greatest blunders of this incompetent administration.

The next president must instill in all Americans, but especially in middle-class Americans, a sense of psychological well-being and a belief in America’s capitalistic system and democratic government. There are no financial panaceas that the government can undertake that will be successful without this belief. Many believe that America came out of the Great Depression not because of the programs undertaken but because Americans believed in their government by 1936.

“The incoming president will be facing many bigger challenges than any president since Roosevelt” said John Kamensky, senior researcher at the IBM Center for The Business of Government, in a CNN.com article. In the same article, it stated that 71 percent of people surveyed in a recent USA/Gallup poll feel the next president “faces more serious or much more serious challenges than any new president in the past 50 years.” According to the poll, two-thirds of those surveyed want stabilizing the economy to be the next president’s top priority; only 12 percent said managing the wars overseas comes first.

This disillusion in both industry and government by Americans can be noted in the statement of Professor Roubini of the Stern School of NYU. He stated that “We have reached the scary point where the dysfunctional behavior of financial markets has destructive effects on the financial system and much worse on real economies.” He further noted “so it is time to think about more radical policy actions and government interventions.”

Thus, the to-be elected President simply must provide forceful and effective leadership to reverse this dysfunctional behavior ominously present in America today.

As Will and Ariel Durant argued, “When the group or a civilization declines, it is through no mystic limitation of a corporate life, but through the failure of its political or intellectual leaders to meet the challenges of change.”[6]

The endgame message is clear: You must take care of yourself.

In these difficult economic times, it is worth remembering Charles Darwin’s observation. The species that survive are not the strongest or the smartest ones, but the ones most responsive to change.[7]

Time is of the essence. Do not delay.

It is time to be politically aggressive. Middle-class Americans must act to save themselves. Middle-class Americans must push government to be responsible, so they can believe in their government. Hopefully, everyone will act in heretofore-unimaginable ways, within the bounds of the laws of the land, to avert what may become The Greatest Crisis of America.

Middle-class Americans must rescue America to save themselves.

Good luck and God bless.

Please refer to my two most recent articles in the Graziadio Business Report: The Top 10 U.S. Economic Items to Monitor and The Top 10 Embracements for Difficult Economic Times. It is my firm belief that they will help in this most difficult of economic times.


[1] ABC News Blogs, Greenspan to Stephanopoulos: This is ‘By Far’ the Worst Economic Crisis He’s Seen in His Career, http://blogs.abcnews.com/politicalradar/2008/09/greenspan-to-st.html.

[2] CNNPolitics.com, “Buffett to Congress: Bail out economy or face ‘meltdown,'” http://www.cnn.com/2008/POLITICS/09/28/bailout.deal/.

[3] Andrew Bary, “Look Out Below!” Barron’s, September 1, 2008.

[4] Nina Easton, “Main Street turns against Wall StreetFortune, September 28, 2008.

[5] Andrew Farrell, “‘Giant Sucking Sound,’ Part DeuxForbes, July 15, 2008.

[6] Will and Ariel Durant. The Lessons of History, (New York: Simon and Schuster, 1968).

[7] Charles Darwin, On the Origin of Species by Means of Natural Selection, or the Preservation of Favoured Races in the Struggle for Life, (first edition, 1859).

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The End of the Beginning for the Global Credit Crisis

After years of easy credit, borrowers suddenly faced a new world. The first signs of change occurred in the mortgage market, where people hoping to buy or refinance homes found that credit standards had tightened, pushing them out of the market. The change soon spread to other financial markets, and borrowers looking for credit for anything from a car loan to a student loan found the doors closed.

What happened? This article examines events up to this point and where one goes from here.

The Subprime Mess

The September 11, 2001, terrorist attacks on the United States accelerated the economic slowdown that began in early 2001. Immediately, the U.S. central bank, the Federal Reserve (FED), stepped in and began lowering interest rates. Soon, interest rates were at 40-year lows and market participants reacted they borrowed.

The low interest rates allowed more Americans to qualify for mortgages, causing home prices to rise.[1] Rising prices encouraged speculators to jump in as “returns” on homes exceeded those on other investments and low interest rates increased the demand for second homes, fueling the upward pressure on prices.

As rising prices pushed borrowers out of the market, financial institutions reacted by offering a variety of mortgage instruments that eased standards for loan qualification. In addition, loan officers were often compensated based on the number and the size of the mortgages they wrote, not based on the likelihood that the borrowers could repay.

To satisfy the demand for loans, lenders sold the mortgages they originated to Wall Street banks and other investors, and lenders used those funds to finance additional mortgages. The purchasers of the mortgages pooled them and sold bonds backed by the pools to hedge funds, insurance companies, and other investors.

Credit Default Swaps

Institutions used credit default swaps (CDS) to insure against default of the mortgage-backed securities. A credit default swap is a contract in which the buyer makes a series of payments to the seller. In exchange, the buyer receives the right to a payoff if a credit instrument goes into default, or if some event such as bankruptcy or restructuring occurs. Originally a form of “insurance” against bad debt, CDS became an instrument for speculation after the Commodity Futures Modernization Act of 2000 when the market exploded, peaking at $62 trillion for this derivative. Warren Buffett called these instruments “financial weapons of mass destruction” in the 2002 Berkshire Hathaway Annual Report, and many of the problems during the past year can be traced back to CDS.

The Cracks Begin to Show

The FED began increasing short-term interest rates in June 2004. By mid-2005, mortgage defaults and delinquencies in the subprime category, while still low, began to grow. The housing market continued to flourish until early 2006, when cracks began to show. The upward march of housing prices slowed, and the inventory of unsold homes increased as buyers took to the sidelines anticipating price cuts. Slowing prices dampened speculation and higher interest rates reduced second-home purchases, decreasing the demand for homes.

To exacerbate the problem, adjustable-rate mortgages that closed two to three years earlier began to reset. In the past, many subprime borrowers continually refinanced their homes with loans featuring low teaser rates to postpone large jumps in payments. However, rising delinquencies caused lenders to tighten standards, limiting the ability of subprime borrowers to refinance. In addition, falling home prices and slowing demand limited their ability to sell their homes.

By January 2007, 14.3 percent of subprime loans were at least 60 days late, up from 8.4 percent in January 2006. For Alt-A loans, which fall between subprime and prime, the late payment rate rose to 2.6 percent, up from 1.3 percent in January 2006. Foreclosures continued to climb, and by March 31, 2008, 2 percent of single-family homes were in foreclosure and 6.4 percent of all mortgages were delinquent by 30 days or more. Fifty percent of the mortgages that went into foreclosure in the first quarter of 2008 were subprime, but a startling 42 percent were prime loans.[2]

U.S. Financial System Begins to Unravel

The first U.S. victim of the subprime debacle was the investment bank Bear Sterns. Its troubles began when two of its hedge funds failed in July 2007. As its losses from subprime bets mounted, Bear Sterns’ financial condition continued to deteriorate until a takeover bid by JPMorgan Chase in March 2008 was orchestrated with the FED’s assistance. The fire sale of the institution resulted in the demise of the 85-year-old firm and the loss of approximately 60 percent of Bear Sterns’ 14,000 jobs. The FED immediately extended the privilege of borrowing at the discount window to other Wall Street banks, providing needed liquidity and temporarily reducing the fear of more failures.

Lenders continued to tighten borrowing standards, but change did not occur fast enough for financial institutions not to feel the heat. Wells Fargo announced a drop of 11 percent in first quarter 2008 net income because of mortgage defaults. Countrywide Financial Corporation, once the largest mortgage lender in the United States, lost $2.5 billion over a nine-month period and agreed to be bought by Bank of America Corporation in January 2008.[3] Merrill Lynch acknowledged almost $25 billion worth of asset write-downs and charges, while Citigroup recognized over $22 billion.

Credit Crisis Turns Global

The pain was not limited to U.S. institutions. UBS, the Swiss banking giant, announced in May 2008 that it would issue $15 billion worth of common stock shares its second trip to the equity market in three months to restore capital depleted by mortgage losses. Additionally, UBS announced that it would lay off 5,500 employees, mainly in the United States and Britain. While UBS was the hardest hit, banks globally have written off more than $330 billion in losses since the summer of 2007.[4] Even the Bank of China acknowledged that it held $9.7 billion of securities backed by U.S. subprime mortgages.

The bad news continued with the downfall of IndyMac Bancorp, which acknowledged large losses in its subprime portfolio. Senator Charles Schumer expressed concern that the bank might fail; soon after there was a run on the bank, causing a shortage of cash and forcing the Federal Deposit Insurance Corporation to seize it. IndyMac has the dubious distinction of being the second largest federally insured institution to fail, but it was certainly not the last.

Failure of Freddie and Fannie

Banks and mortgage lenders were not the only institutions to be hurt by the subprime debacle and credit crunch. Two government-sponsored institutions, Freddie Mac and Fannie Mae,* saw their stock prices plummet as they recorded huge losses. In mid-July, the FED provided a short-term solution to liquidity worries by allowing the two institutions to borrow at the discount window. The Bush administration proposed and Congress approved a longer-term solution, which could inject up to $300 billion into the two institutions through investments and loans. However, even this did not restore public confidence in the two institutions, and the government placed them in conservatorship in early September.

(*Editor’s Note: Click here for the authors’ analysis of what went wrong with Freddie Mac and Fannie Mae)

The Crunch Continues

Mortgage debt is not the only worry for consumers and financial markets. U.S. credit card debt stands at $915 billion, a 435 percent increase since 2002 and approximately the same size as the subprime mortgage debt. Additionally, about 45 percent of credit card loans have been packaged in pools that have been sold to banks and other institutional investors. Delinquencies of over 90 days on credit card debt have increased by 50 percent, and credit card companies have written off approximately five percent of payments.[5] Is this the next ticking time bomb?

Troubles exist across the board. Distressed debt has affected industries beyond the typical sick sectors (airlines and automobile) or industries related to the real estate sector (home builders, mortgage lenders etc.). Banks are reluctant to lend money and investors have no appetite for risk. According to Standard & Poor’s, about two-thirds of non-financial firms carry a junk credit rating.[6]

The Bailout Bill

The FED reacted to the meltdown in the mortgage markets and the ensuing credit crunch by lowering interest rates. In September 2007, the discount rate and target for the FED fund rate stood at 5.25 percent and 5.0 percent, respectively. Decreases continued until the rates stood at 2.25 and 2.0 percent, respectively, in June 2008. The decline in interest rates helped lower the rates at which many adjustable rate mortgages reset, thus lowering potential payment increases for many borrowers. However, the lower rates also increased the risk of inflation; therefore, they had only modest impact on the rate of 15- and 30-year mortgages.

Financial markets stumbled along until late September 2008, when a fast and furious series of events occurred. In a five-day period, Lehman Brothers, the 158-year-old investment firm, declared bankruptcy; the insurance giant American International Group (AIG) required a FED bailout; Warren Buffett invested $5 billion in Goldman Sachs to keep it afloat; JPMorgan Chase purchased Washington Mutual; and Bank of America purchased Merrill Lynch.

In response, the Bush Administration sent U.S. Treasury Secretary Henry M. Paulson, Jr., to Congress with a three-page plan that granted the Treasury Department authority to spend up to $700 billion to purchase soured mortgage-backed securities from banks to relieve the pressure. After tense negotiations, the U.S. House of Representatives considered a bill that added oversight and accountability, restrictions on executive compensation, and mortgage workouts; however, the bill was rejected.

On September 29, 2008, the Dow Jones Industrial Average responded by falling 7 percent or 777.68 points in one day. The Standard & Poor’s 500 Index plunged 8.8 percent and the Nasdaq Composite Index plummeted 9.1 percent. A total of $1.3 trillion in wealth disappeared in less than 24 hours. Markets around the world followed the downward slide.

The U.S. Senate acted quickly to get the bill passed by adding “sweeteners” to entice reluctant legislators to approve it. These included raising the limit on federally insured bank deposits from $100,000 to $250,000, which had broad-based support. In addition, the new bill included tax breaks, tax benefits and tax credits for domestically produced films and TV shows, natural disaster victims, “clean” coal and renewable energy, and research and development costs. The bill also revised the Alternative Minimum Tax, which under the U.S. tax code disallows several deductions and exemptions allowable in computing tax liability. The revisions added more than $100 billion to the plan, and the three-page plan exploded to 451 pages. On October 3, the House passed the bill and President Bush immediately signed it.

No Relief

The passage of the bailout package did not stop the hemorrhaging in financial markets and the financial contagion spread worldwide. On October 6, the Dow Jones Industrial Average dropped below 10,000 points for the first time since 2004. In Europe, London’s FTSE 100 suffered its worst one-day drop in history, and stock markets in Germany, France, and Italy declined by between 4 and 5 percent. Russia halted trading on its stock market three times and ended with a 20 percent decline. In Latin America, stock markets slid as much as 17 percent. Even Japan’s Nikkei stock market index lost more than 3 percent.

Supporters warn that it will take time for the bailout to stabilize banks and loosen credit. Critics claim that the bailout is too little, too late. At best, it will serve as the first step in re-establishing trust in the global financial markets.

Erosion of Faith

Trust is the foundation on which the U.S. financial system rests U.S. financial institutions were considered to be highly regulated and, therefore, their products were assumed to be safe. Unfortunately, recent events have shaken faith and confidence as institutions worldwide have recognized losses from securities backed by pooled U.S. subprime mortgages. What seemed to be a containable problem in the subprime market is becoming a comprehensive financial crisis.[7]

An international backlash appears to be growing as the credit crunch continues to affect the global financial system. Trillions of dollars in paper wealth have evaporated in global stock markets. Central banks around the world have been injecting liquidity into the system to maintain some sense of stability, with limited success thus far. Hamid Varzi, in an article written for the International Herald Tribune,[8] summarized world opinion: “The U.S. economy, once the envy of the world, is now viewed across the globe with suspicion.”

International Backlash

As the crisis deepens, the criticism grows. Russian Prime Minister Vladimir Putin sharply criticized the United States for its economic failures, which have negatively impacted the Russian economy. Russian President Dmitry Medvedev noted that the financial crisis signaled the end of U.S. global economic dominance.[9] This sentiment was echoed by Peter Steinbruck, the German finance minister, who declared that the United States was “the source . . . and the focus of the crisis” and was no longer the world financial superpower.[10]

World confidence in the United States is important because we depend on the rest of the world to finance our debt. U.S. government debt is at a record $10 trillion. U.S. household debt hovers at $14.5 trillion, while U.S. savings rates remain at historic lows. Foreign investment has offset this imbalance, attracted by fairly competitive interest rates, financial security, and economic stability. More importantly, Asian economies, with their export-led growth models, purchased U.S. Treasury securities to keep their exchange rates stable by protecting their currency against the depreciating dollar.

With the events of the last year and the danger of a global recession, it is likely that the world will find a new world financial order; one the United States may no longer head. Dubai and Shanghai have been touting themselves as the next financial centers and market participants may start believing them if U.S. markets do not stabilize soon.

What’s Next?

In May 2008, the stock markets seemed to stabilize, the corporate credit spreads narrowed, and the price of gold dropped. Treasury Secretary Paulson announced that the worst was behind us. But recent events demonstrate there are still plenty of concerns.

Banks continue to tighten credit standards and report losses. Bailouts and mergers to prevent bankruptcy seem to be announced daily not only in the United States, but around the world. Credit card debt continues to be a concern. Home prices continue to decline, and defaults and foreclosures in the housing market are still on the rise. Small businesses are finding short-term loans, their lifelines, expensive or unavailable.

Following one of the biggest credit crises of all time, when will the worst be over for the financial sector, the stock market, the housing industry, and the global economy? Home prices need to stabilize and confidence must return before markets will rebound, but rebound they will. Markets are probably approaching the bottom, but growth will likely be sluggish for the remainder of 2008. In the words of Winston Churchill, “…this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”[11]


[1] For a complete discussion of the subprime meltdown, please see “Will the Sub-prime Meltdown Burst the Housing Bubble” by Peggy J. Crawford and Terry Young, Graziadio Business Report, 11, no. 3 (2007).

[2] Maura Reynolds, “Mortgage Troubles Hit Record Highs” The Los Angeles Times, June, 6, 2008, at C3.

[3] Bloomberg News, “Wells Fargo Home Loan Policies Get Tougher” The Los Angeles Times, May, 23, 2008, at C4.

[4] David Jolley, “After Losses UBS Seeks to Raise $15 Billion” The New York Times, May, 23, 2008, at C5.

[5] Danny Schechter, “House of Cards” LA CityBeat, June 25, 2008.

[6] Henry David and Matthew Goldstein, “The Fires May Not Be OutBusinessWeek, May 19, 2008.

[7] Jia Lynn Yang, “How Bad is the Mortgage Crisis Going to GoFortune, 157, no. 6, March 31, 2008.

[8] Hamid Varzi, “A Debt Culture Gone AwryInternational Herald Tribune, August 17, 2007.

[9] Andrew E. Kramer, “Russia Sees in Credit Crisis End of U.S. DominationInternational Herald Tribune, October 2, 2008.

[10] “World on the Edge” The Economist, October 2, 2008.

[11] Winston Churchill, “The End of the Beginning” Lord Mayor’s Luncheon, Mansion House, London, November 10, 1942.

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