Friday, September 26, 2008

How We Got to the Bailout

Here’s my slightly-less-brief-than-my-comments-at-The Weblog synopsis about what happened in this crisis.

In the mid-1990s sub-prime mortgages begin their steady climb in market share.

Around the same time payday and title loan lending begin to take over America’s corners not already claimed by Walgreens, CVS, and Starbucks, especially in poor neighborhoods where there were no Starbuckses.

In 1998, there are a number of us (me as just a beginner in the movement) that are very loudly (or as loudly as we can) warning that this is problematic and needs to be re-evaluated. At this time, the real problem is that loans are being made with terms that are impossible or nearly impossible to repay. The borrowers are folks that should be able to get better terms. About 90% of the people affected negatively are not white so the problem is ignored.

In the early 2000s, a number of states pass anti-predatory lending laws or regulations. Around the same time, banks that are regulated by CRA are beginning to get in to the game more often. Chase and Citi and WaMu among others buy dedicated sub-prime lenders and designate them “another channel for mortgages” — the wholesale channel (because brokers, not loan officers, are the point of contact for the borrowers). That channel is the channel where people of color get worse terms than they could have gotten through the banks regular retail lending. In Georgia, possibly the state with the best protections passed, the banking industry (with the help of Wall Street and Fannie and Freddie) get the law repealed. Ohio passes a law that essentially is pro-predatory lending in classic Republican-controlled ironic-naming-of-bills fashion. The problem is still largely ignored and still predominantly harms poor people, seniors, and people of color (and most often people who fit all three categories).

Wall Street begins its fury to buy these loans because they offer a higher return than traditional mortgages. Sub-prime loans often have egregious fees, penalties, interest rates, and adjustments that make them look on paper like a better ROI. Even with state regulations, some of which are challenged by federal regulators, there's still room to soak "unsophisticated" borrowers.

(I should add here that some banks and brokers are doing their level best to stay out of this mess. But, it is becoming increasingly difficult to only lend based on sound practices and still get any significant market share.)

In the mid 2000s, competition takes hold in a top-down manner rather than a bottom up manner. This is where things really fall apart. Previously, the problem is more contained with a few banks and investment companies. Now, everyone wants some of that high return. To increase market share, the different investors start offering money with fewer strings attached (see This American Life’s “The Giant Pool of Money” for more detail). Now ridiculously poor judgments are being made and really poor loans are being made and sold into the secondary market.

Fannie and Freddie have lost much of their market share, dramatically, and feel the need to keep up with Wall Street. They have to compete in order to remain relevant and stable. This leads to the eventual conservatorship.

At a point near the beginning of 2006, the investors start to realize their mistakes. So, they accelerate and sophisticate the ways they hide their mistakes through multiple slicing and dicing of good and bad loans in their portfolios. The Urban Institute has a good description of just how incredible this all gets.

The hope is that the increase in home values will continue without pause and save everyone from their poor mistakes simply through inflation. It does not change lending behavior. The brokers have nothing to lose since they’re in and out of the process in a matter of days. Banks think they have nothing to lose because they sell their loans to Fannie, Freddie, and Wall Street. Apparently, Wall Street feels invincible. It just continues to buy these bad loans despite the fact that anyone paying attention, with an iota of financial knowledge, can see this is about to crash hard.

Around the same time, the problem is beginning to get attention because middle class white folks are now beginning to feel the effects as they begin to fail to pay their adjustable rate mortgages.

House prices fail to increase at high rates, then begin to decline or stabilize. Fannie and Freddie can’t capitalize enough. The feds take them over. The reality is now unavoidable.

The secondary market collapses/implodes, especially Wall Street (Fannie and Freddie are essentially still in business). The banks can't sell their bad loans and haven't held on to enough good loans in their own portfolios because those were needed to hide the risks when selling to the secondary market.

We’re $700b short, or maybe its less than that. No one knows for sure because of the shell game upon shell game upon shell game that kept this all going for far too long.

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