Today, it is hard to turn on the television or open a newspaper without hearing or reading a news story about the “credit crunch” or “subprime crisis.” The start of 2008 was characterized by massive losses, write-downs, and new CEO’s, unveiling companies’ credit risk exposure. The credit crunch has led to a slowed economy, high costs of borrowing, and dismal stock markets. Banks, lenders, and other financial institutions are largely to blame for today’s credit crunch. However, government’s contribution to the debt crisis is easily overlooked. United States government policy is just as much to blame for the credit crisis as the financial services industry. Understanding the history of the credit crunch, the current status of the U.S. economy, and the financial industry’s role in the subprime crisis will illuminate the need for significant policy change. The U.S. government exhibits its role in the credit crisis through the repeal of the Glass Steagall Act in 1999, the Community Reinvestment Act, and the monetary policy of the Federal Reserve Board. But first, one must understand how the credit crunch developed.
What is the Credit Crisis?
Low interest rates and a rising housing market characterized the early part of the millennium. Low rates increased the demand for homes and mortgages. Lenders attempted to meet the housing demand by issuing subprime loans—high-risk loans characterized by higher rates, fees, and penalties to borrowers with poor credit histories (“Rising Damp,” “CSI: Credit Crunch”). Loans to subprime borrowers were typically Adjustable Rate Mortgages (ARMs) that offered initial low interest rates, and then they would adjust to higher rates in the future (“CSI: Credit Crunch”). The lending industry rationalized this precarious lending practice because rising housing prices were the market trend. Therefore, borrowers’ homes would appreciate, and they would be able to refinance their homes under a fixed rate before the ARM’s initial low rate expired. Conversely, the housing market declined, and home prices fell; interest rates increased, and subprime borrowers were unable to refinance or pay their increased mortgage payments. This sent mortgage defaults and home foreclosures out of control even to the present day.
Subsequently, why were banks and lenders willing to take on this extra risk of default from subprime borrowers? The answer is securitization. Banks and lenders would underwrite many of these risky loans (among others), package them into a Mortgage Backed Security (MBS) or a Collateral Debt Obligation (CDO) and sell them as securities with AAA credit ratings to investment banks or other financial institutions. By securing mortgages, banks and lenders got the risky debt off their books, and they were used as collateral by buyers when raising loans (“CSI: Credit Crunch”). Also, lenders did not scrutinize their borrowers as strictly because they knew they could just package up the risk and sell it off to another institution, thereby separating the lender from the risk. The MBS’s and CDOs were so highly structured and sold multiple times in the market that no institution in the global financial system could be sure who was responsible for what risk (“CSI: Credit Crunch”).
Presently, people are being forced out of their homes, and many consumers cannot obtain home financing. Dramatic drops in home prices are creating negative equity situations for homeowners. Banks and institutions are going out of business or are taking massive write-downs because the once profitable, securitized assets are now worthless. The economy is slowing because companies are finding it harder to grow their businesses and hire more people, due to the higher cost of capital. Consumption has slowed because people are saving money in case the threat of inflation and recession turns into reality. Investors are wary of investing because debt is more expensive and the stock market is dismal due to the economic stress. The Fed, to stimulate the domestic economy, has made one of the largest interest rate cuts in U.S. history, which only further weakens the dollar, increases inflationary threats, and takes investment outside of the U.S.. The credit crisis is obviously a vast problem. According to popular media, the financial services industry is to blame.
The Popular Counterargument
Glass Steagall Act of 1933
This repeal was arguably one of the largest deregulation bills of the financial services industry in U.S. history. Essentially, it reversed Glass Steagall and allowed members of the financial services industry to enter each others’ businesses. Large banking, brokerage, insurance, and securities companies have consolidated into some of the largest banking giants of our day since deregulation. Examples include Citigroup and Bank of America Corporation. With the growth of these superbanks, also came the growth of their balance sheets, liquidity, and ability to take on risk. Thus, banks could now take on riskier loans, package them together, and sell off the high risk as a high quality debt security. This process is lucrative because superbanks can collect fees throughout the entire process. Also, risk ownership on loans or structured products dramatically decreases because every financial institution is commingled in all businesses. Therefore, there is confusion about the portions of debt that are actually faulty. These lines were more concrete under Glass Steagall, which forced institutions to be conservative with their loan services. Allowing financial service businesses to consolidate and engage in high-risk-return structured products, Government’s repeal of the Glass Steagall Act enabled the credit crisis to occur. Likewise, some U.S. laws even encourage risky underwriting.
Community Reinvestment Act 1977
Additionally, many risky loans were issued based on “stated incomes,” which did not require verification of income statements or tax returns (Isidore). These loans were given the nickname, “liar loans” because borrowers could essentially lie about their income circumstances on loan documents. In effect, the CRA is a government push for banks to engage in subprime and other risky lending. The excess of subprime and “liar” loans makes banks and lending institutions vulnerable to any downturn in the economy, which decreases the probability of collecting from poorer borrowers. The motives for the CRA have backfired. A law that used to aid poorer borrowers in buying homes has now displaced them out of homes. Entire U.S. communities that were targeted for subprime loans, like Cleveland, a working-class city, have been abandoned since one in every ten homes have been repossessed by lenders (“The US Subprime”). The current economic downturn displays how vulnerable and exposed financial institutions as well as borrowers are when they originate too many “soft loans.” The Community Reinvestment Act plays an active role in contributing to America’s debt crisis. Similarly, the government encourages institutional recklessness by becoming a trusted safeguard, instead of the lender of last resort.
The Government Bails out Speculators
Another way the Fed bails out speculators is by cutting interest rates to inject more money into supply, which allows speculators to continue speculating. Speculators were permitted to create the current credit bubble because the Fed cut interest rates after the dotcom stock bubble burst in 2000. The cuts gave speculative investors cheap money to fuel yet another bubble—credit. For example, hedge funds purchased subprime bonds on credit, which amplified demand for CDOs. As they leveraged these purchases, they were able to purchase a lot more CDOs and bonds than if they used regular capital (Petroff). In turn, this increased demand for CDOs and created the overwhelming demand for subprime loans. After another period of irresponsible credit practices, the credit bubble burst last year. The U.S. is seeing the Fed’s credit rescue mission by its combined 125 basis point rate cut in January 2008. Although the rate cuts somewhat benefit the average consumer or company, they also send a signal to the strong speculative forces in the market. That is whatever risky stunts they pull-off, and whatever bubbles they create, “big brother” will be there to help in the aftermath. There is a reason the U.S. has jumped from the dotcom bubble, to the real estate bubble, and now to the credit bubble—because the government allows this sort of speculation. A moral hazard is created because speculators and high-risk investors feel safe underneath the Fed’s wing. This is because they are less inclined to scrutinize their risky actions unless they truly had to bear the consequences of perilous decisions. This same moral hazard was also a major problem in the Savings and Loans Crisis of the 1980s. These government-guaranteed institutions engaged in risky practices because they did not bear the full consequences of their bad choices. Unfortunately, the public is left with the burden of mishandled credit that hurts the real economy, even when they were not mainly responsible for it. The Fed’s involvement in cleaning up the speculative mess led to the current credit crisis, and it only perpetuates future asset bubbles.
About the Student Writer: From Las Vegas, Nevada, Adree (Adrianna) Smith is majoring in Business Administration with an emphasis in Financial Analysis and Valuation. She is a member of the Trojan Investing Society and after graduating in December 2008, she plans to enter the Banking or Advising Services industry thereafter. Her other interests include martial arts, which she has been “actively studying” for 9 years.
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