The Overlooked Culprit in the Credit Crisis
By Andrianna Smith

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?
The credit crunch is exactly what it sounds like—a crunch on credit.  The term refers to the difficulty for consumers to obtain credit, refinance, or take out an equity line of credit on a house.  It also refers to companies’ increased difficulty to obtain financing for value-adding projects that fund business growth (Coombes).  There are two main fronts where the credit crisis originated: the housing market and the securities market.  The burst of the dotcom bubble in early 2000 and the 9/11 terrorist attacks in 2001 prompted the Federal Reserve (the Fed)—head of the U.S. central banking system and monetary policy—to cut interest rates, stimulating consumption and investment. 

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
The media identifies lenders, homebuyers, investment banks, rating agencies, and hedge funds as the credit crunch’s main offenders.  Charted Financial Analyst, Eric Petroff describes how each of the parties mentioned above added to the credit mess. Lenders were largely at fault because they actually originated these high-risk loans to low-credit borrowers.  Homebuyers recklessly purchased homes with almost all debt and fickle income situations.  Not to mention, the equity that was built in their homes was used as a checking account, withdrawn as needed. Investment banks increased the use of the secondary market to purchase the securitized CDO’s and MBS’s, freeing up more money to lend to subprime borrowers.  Debt rating agencies inaccurately gave high-risk structured products AAA ratings.  Hedge funds’ “credit arbitrage” strategies increased demand for CDOs, and drove subprime rates lower, enhancing the problem (Petroff).  It was as if the entire financial community colluded together and manifested a subprime frenzy.  These financial institutions obviously could have averted subprime lending and securitization to ward off long-term risk.  However, the press fails to report on how U.S. government law and policy are also responsible for the recent credit crisis and asset bubbles that have characterized the U.S. economy since the 1990s.

Glass Steagall Act of 1933
The repeal of the Glass Steagall Act of 1933 set the stage for the credit crisis of today.  The Glass Steagall Act was the legendary banking legislation that separated commercial banks from investment banks and disallowed banks, brokerages, and insurance companies to enter each others’ businesses (“Chronology,” Kuttner).  The law clearly defined whether banks were a part of the Federal Monetary System, or if they were investment banks, not government guaranteed (Kuttner).  It prevented the formation of superbanks, speculative lending, and securitization that was consistent with the risky financial practices before the 1929 crash (“Chronology,” Kuttner).  This law was successful in preventing another catastrophic market crash.  However, the Clinton Administration repealed the Act by signing the Financial Services Modernization Act into law in 1999 (Haubrich, Thompson). 

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
The Community Reinvestment Act of 1977 (CRA) is another example of how government and its legislation have contributed to the subprime mess.  The Community Reinvestment Act of 1977 “encourages depository institutions to help meet the credit needs” of their communities, “including low- and moderate-income neighborhoods” (United States).  Although the CRA is the government’s attempt to curb the banking industry’s predisposition to chase wealthy clients, the law also puts pressure on banks and other depository intuitions to make riskier credit decisions.  Basically, the law entails “affirmative banking action,” which encourages banks to take a higher credit risk and loan to borrowers with poor credit histories and volatile income situations.  It specifies that banks are assessed to what extent they adequately serve poorer neighborhoods.  The extent of this service is measured by banks’ engagement in “soft loans for cheap housing” (“Finance and Economics”).  “Soft loans” is another term used instead of subprime lending. 

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
The government has contributed to the credit crisis by aiding speculators whenever their high-risk strategies have backfired.  For instance, economist Robert Kuttner concludes “today, whenever the speculative excesses lead to a crash, the Fed races to the rescue…it bails out the speculative system, so that the next round of excess can proceed.”  Basically, banks and market-moving investors, like hedge funds and private equity firms, make bad decisions in efforts to ride short-term bubbles, which inevitably burst.  Then, the financial services industry loses a lot of money, and the Fed is right there to help.  For example, in 1998 the Fed coordinated a bailout between big banks of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse put the capital markets at risk, (Kuttner).  Additionally, sometimes the U.S. government is secretive in its bailouts. For instance, when the president of the Central Bank in New York personally sought out a Saudi prince to inject billions of capital into Citibank as it was going under in 1990 (Kuttner).  The Fed’s behavior demonstrates the unwillingness of the government to let these institutions suffer the consequences of their actions.  The U.S. government condones this irresponsible financial behavior by continuing to bailout risk-taking institutions.   

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. 

Conclusion
Today’s credit crunch has far reaching effects on the U.S. economy, capital markets, consumers, as well as the global financial system.  Popularly, the debt crisis can be directly linked to the financial services industry.  Indirectly, the government is just as much to blame for the U.S.’s credit problems.  Its laws and policy set the stage for industry abuse.  Government policy such as the repeal of the Glass Steagall Act of 1933, the Community Reinvestment Act of 1977, and the Fed’s unconventional, rescue-oriented monetary policy have facilitated the financial services industry in chasing excessive returns, creating asset bubbles, and jeopardizing real, long-term economic stability.  The government should revise the Financial Services Modernization Act 1999 and reenact some of the safeguards of the original Glass Steagall Act that can help prevent future debt or asset crises.  Banking legislation since the New Deal era debatably needed a twentieth century update, but deregulation was taken too far in 1999.  The Federal Reserve needs to let the market face some of the consequences of its actions and learn from its mistakes.  The government and the Fed need to take a stronger stance to limit the real externalities created for citizens by high-risk, market gamblers.

 

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.

Works Cited

 “Chronology-U.S. Banking Regulation.” Reuters 22 Oct. 1999. Factivia. University of Southern California Library, Los Angeles, CA. 2 Mar. 2008 <http://global.factivia.com/aa/default.
aspx?pp=Print&hc=Publication>

Coombes, Andrea. “What the Credit Crunch May Mean for You” RealEstateJournal.com. 2 Mar. 2008 < http://www.realestatejournal.com/buysell/mortgages/20070814-coombes.html>
"CSI: Credit Crunch." The Economist 18 Oct. 2007. 1 Mar. 2008 <http://www.economist.com/specialreports>.

"Finance And Economics: Time for a rethink; America's Community Reinvestment Act. " The Economist  5 Mar. 2005: 84. ABI/INFORM Global. ProQuest.  University of Southern California Library, Los Angeles, CA.  3 Mar. 2008 <http://www.proquest.com/>

Haubrich, Joseph G., James B Thomson. "Umbrella Supervision. " Federal Reserve Bank of Cleveland. Economic Commentary  15 Sep. 2005: 1-4. ABI/INFORM Global. ProQuest. University of Southern California Library, Los Angeles, CA. 5 Mar. 2008
<http://www.proquest.com/>

Isidore, Chris.  “’Liar Loans”: Mortgage Woes Behind Subprime.”  CNNMoney.com 19 Mar. 2007. 9 Mar. 2008 <http://money.cnn.com/2007/03/19/news/economy/
next_subprime/index.htm>

Kuttner, Robert. "The Alarming Parallels Between 1929 and 2007." The American Prospect 2 Oct. 2007. 1 Mar. 2008 <http://www.prospect.org/cs/articles?article= the_alarming_parallels_between_1929_and_2007>.

Petroff, Eric. "Who is to Blame for the Subprime Crisis?" Investopedia. 1 Mar. 2008 <http://www.investopedia.com/articles/07/subprime-blame.asp>.
“The U.S. Subprime Crisis in Graphics.”  BBC News 21 Nov. 2007. 9 Mar. 2008
< http://news.bbc.co.uk/2/hi/business/7073131.stm>

United States. Federal Reserve Board. Community Reinvestment Act. 16 Feb. 2007. 1 Mar. 2008.