Economics

The Roots of the Crisis

How did Wall Street get into this mess?

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The unexpected 228-205 defeat of the housing bailout in Congress Monday threw a curveball across Wall Street. It contributed to a large sell-off on Wall Street, where the bailout had already been "priced" into the market. The Dow shed just over 6 percent, the 18th largest drop in its history. But given the dire warnings about financial chaos that would result unless there were a bailout, this seems fairly modest.

Let's be clear: This is a Wall Street crisis, not a national economic crisis. The overall economy, while a bit weak, is still growing. Some politicians are comparing the current environment to the Great Depression. But in 1932, when the federal government last moved to bail out the banking sector, economic output had fallen 45 percent and unemployment was a staggering 24 percent. Today, economic output is actually up and unemployment is a historically modest 6.1 percent.

The overall economy doesn't even face a liquidity crisis in the current turmoil. Consumer, commercial/industrial, and real estate loans are all up over last year. Main Street is doing fine. The liquidity crisis is confined to Wall Street, between and among investment banks, insurance and securities firms, and hedge funds. There is the possibility that the contagion could spread, but in a global capital market, this is hardly certain.

It is the intersection of several underlying trends that have brought us to this point, not a breakdown in any specific part of the financial sector. The fundamental flaw with the bailout approach is that it ignores these trends and simply seeks to shore up the finances of certain Wall Street institutions.

Mortgage-backed securities (MBSes) are the principal source of pain in the current environment. Investment houses would bundle individual mortgages from several banks together into a bond-like product that would be sold to individual investors. Mortgages have historically been seen as among the safest investments. In an era of rising house values, "safe" became "guaranteed returns."

One of the major factors pushing investors into these securities was the Federal Reserve's weak money policy. Immediately after the terrorist attacks of 2001, the Fed began a sustained period of easing interest rates. Its efforts went so far that, at one point in 2003, we had effectively negative interest rates. Institutional investments needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on treasury notes.

In the early years of this century, mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. There was a lot more money available to underwrite mortgages. At the same time, investment houses were looking to replace the healthy fees earned during the dot com bubble. MBSes had fat margins, so everyone jumped into the game.

The additional capital to underwrite mortgages was a good thing…up to a point. Homeownership expanded throughout the decade. Over the last few decades, the American homeownership rate has been around 60 to 62 percent. At the height of the bubble, homeownership was around 70 percent. It is clear now that many people who got mortgages at the height of the bubble should not have. But Wall Street needed to feed the MBS stream.

At the same time, Fannie Mae and Freddie Mac were going through a crisis. In 2003 and 2004, an accounting scandal was revealed. The two public-private partnerships were cooking the books to show phantom profits. The Bush administration and its allies on the Hill pushed a strong bill to reform how these institutions operated. The measure came very close to passing, but Fannie and Freddie cut a deal. They would refocus on expanding mortgages for low-income borrowers if the feds kept out of their operations. The bargain worked. Virtually all the Democrats and a few Republicans backed the two companies and the reform effort failed.

Fannie and Freddie then went on a subprime bender. They made it clear that they wanted to buy all the subprime or Alt-A mortgages that they could find, eventually acquiring around $1 trillion of the paper. The market responded. In 2003 subprime mortgages made up less than 8 percent of all mortgages. By 2006, they were over 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever increasing amounts of subprime mortgages into the MBSes, they could juice the returns and so earn bigger fees. The rating agencies, thinking they were simply dealing with traditional mortgages, didn't look under the hood.

Unfortunately, after several years of a housing boom, the available pool of households who could responsibly use the more exotic financing products had dried up. In short, there were no more people who traditionally qualified for even a subprime mortgage. However, Fannie and Freddie were still signaling that they wanted to buy these products. At the same time, activist groups were agitating for more lending to low-income families. Banks realized they could make even more exotic loan products (e.g., interest-only loans), get the activists off their backs, and immediately diffuse their risk by selling the mortgages into MBSes. After all, Fannie and Freddie would buy anything.

Everything worked as long as housing prices continued to rise. The most pessimistic scenarios on Wall Street showed a leveling off of housing prices; no one foresaw an actual decline in prices. Suddenly, though, there weren't enough buyers. In hot real estate markets, builders raced to bring inventory to market that they thought was inexhaustible. But at this point everyone (essentially) who could possibly qualify for a mortgage had received one. At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable rate mortgages moved higher—the Fed was finally tightening the money flow—and mortgages that were initially interest-only were close to resetting, with monthly payments jumping to include principal. A not insignificant number of these mortgages moved into default and foreclosure.

The overall numbers moving into foreclosure were small. Someone simply looking at housing stats could be forgiven for wondering what all the fuss is about. Nationally, the number of mortgages moving into foreclosure is just around 1 to 2 percent, suggesting that 98 to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the MBS market.

Then the MBS market collapsed. The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as they moved through the system—being bought and sold by different firms—they were sliced and diced in varying ways. A MBS owned by one firm could be very different when it was sold to another.

No one fully understood how exposed the MBS were to the rising foreclosures. The market for them dried up. No one traded them. The market became effectively "illiquid." American accounting standards, however, required firms to use "mark-to-market" to value their assets. This means that you value your assets based on what you could sell them for today. Because no one would trade MBSes, most had to be "marked" at something close to zero.

This threw off banks' capital requirements. Under U.S. regulations, banks have to have a certain percentage of assets to back up the loans they make. Lots of banks and financial institutions had MBS assets on their books. With these moving to zero, they didn't have enough capital on hand for the loans that were outstanding. They rushed to raise capital, which raised fears about their solvency and compounded into a self-fulfilling prophecy.

We should pause here to note that two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (you could use a 5-year rolling average instead, for example) would have shored up the balance sheets. And a temporary easing of capital requirements would have provided banks breathing room to sort out the MBS mess. Although it is hard to fix an exact price for these in this market, they aren't worth zero.

Alas, the Fed and the Treasury decided simply to provide the capital to meet the regulatory requirements. They moved into crisis mode, making a series of tactical moves to deal with specific, present challenges. The first misstep, in March, was to force a hostile takeover of Bear Stearns. The Fed put up $30-40 billion to back JP Morgan's takeover of the investment bank. In the long term, it probably would have been better to let the bank fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for MBSes. From this established price, banks could sort out their balance sheets.

It is worth noting that immediately after the collapse of Bears Stearns, rumors quickly circulated on the Street of trouble at Lehman Brothers. Lehman went on a PR offensive to beat back those rumors. The company was successful, but then did nothing over the next several months to shore up its balance sheet. Their recent demise was largely their own doing.

The collapse of the MBS market now started to pollute other financial products. (The Fed moves did nothing to deal with the MBS market, but simply provided temporary means to cope with it.) Credit default swaps and derivatives, both of which amount to hedges against the risk of bonds defaulting, came due. Suddenly, stable firms like AIG were overexposed. Insurance companies regularly sell these swaps, as an insurance policy against bonds defaulting. Traditionally they are fairly conservative investment products. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but iron-clad accounting regulations precluded this. So the government stepped in.

The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 seriously spooked the Street and the Bush administration. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the MBS weakness would spread through the entire financial system. There was a big sell-off on the Dow. The next day, the government announced there would be a bold rescue plan. The market rebounded. Details emerged over the weekend. On Monday, the Dow had another sell-off. But, the most important signal was the rise of oil. The spot price for October delivery of oil jumped $25 a barrel. Some of this was covering trades, but a sizable amount of this appreciation was probably a "flight to quality," a place to park money while everything was sorted out. It was also a signal that the government's plan might not work.

The original plan crafted by Treasury would authorize the department to spend up to $700 billion to buy MBSes and other "toxic" debt and thereby remove them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the MBS market was "illiquid," the government would become the buyer of last resort for these products. There is a certain simple elegance to the plan.

Except that no market is truly illiquid. It just isn't liquid at the price you want to sell. This summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' bad debt, just not at the price the banks would prefer. Enter the government, which clearly intends to purchase MBSes at some premium above the market price. That was the nature of the bailout that failed on Monday.

Congressional leaders have vowed to bring a new proposal for a vote, possibly as soon as Thursday, proving yet again that Washington is fertile ground for really bad ideas. But with the market rebounding—as of this writing the Dow was up almost 300 points—and public opposition hardening, signs are emerging that banks are starting to clean house. The crisis may have already peaked. Of course, Congress' ability to further screw this up can't be overstated.

Mike Flynn is director of government affairs at the Reason Foundation.

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  1. So congress tacks on a tax cut to appease the angry americans, and therefore we now have a smart piece of legislation???

    At what point does this money printing bubble pop???

  2. That is the oddest photo of Mike Flynn I have seen to date.

  3. Buy GOLD! Buy GOLD!

    Great article…Nice to see the story laid out. For more entertainment go to You Tube and watch the hearings in Congress when they (Bush and Allies) were trying to fix Freddie/Fannie…Hilarious viewing. People said things like “these are 100% safe investments” they don’t need more oversight…

    WOW!

  4. Yes, great article.

  5. Not seeing how rescinding ‘mark-to-market’ rules will fix this. Wouldn’t that be akin to polishing a turd?

  6. It was “228 to 205” not “208 to 205”.

  7. Very good piece. I am a libertarian voter, and I am just beside myself that the revised bailout/rescue plan is going to pass…and I do believe that it will pass. I believe in limited government…and a believer that politicians are politicians for a reason. I am not here to say that this plan is a bad idea from an economic standpoint…I just believe in limited government…yet, I would be chastised for not doing more to help the people on Main Street out — if I was a Congressman. No, I just believe that the road connecting Main Street and Wall Street have a better sense of how things are going, and the necessary steps that is required to soften our fall…that’s all.

    By the way, we are a nation who loves our credit and our debt to no end. When you take on increasing amounts of debt, eventually, the debt becomes magnets! Whatever happens, I pray that our attitude about money will change, but it will not. Is there a person out in the world, that can save America?

  8. I repeat: The C-SPAN crawler mentioned adding “mental health benefits” to the “rescue”!!!

    I am thinking for Wall Street, K Street, and Capitol HIll, the best mental health curative would involve about 155 grains of a dense/soft metallic alloy traveling at around 3200 fps.

  9. so basically it started with the FED. thanks for at least putting that in.

  10. In the long term, it probably would have been better to let the bank fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for MBSes. From this established price, banks could sort out their balance sheets.

    This is probably the best summation I’ve read about this whole mess since it started. But because the Fed and Congress and the Senate won’t allow this to be sorted out, we’re gonna get burned very badly. Now I’m angry again. Gonna have to get my email on again…

  11. I am thinking for Wall Street, K Street, and Capitol HIll, the best mental health curative would involve about 155 grains of a dense/soft metallic alloy traveling at around 3200 fps.

    No, this mess requires something more… exotic. I’m thinking a fuel-air explosive.

  12. Except that no market is truly illiquid. It just isn’t liquid at the price you want to sell. This summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks’ bad debt, just not at the price the banks would prefer.

    This should be shouted from the mountaintops. This is the reason Wall Street demands this bailout. And any politician that votes for it (I’m looking at you, Democrats) are tools of Wall Street. I don’t care how many ‘mortgage relief’ riders you put on this bill. You’re a Wall Street tool if you vote for any bailout, whatsoever.

  13. Once again, the voice of Reason rings true. The question I have is, is any of this being drilled into the blockheads on Capitol Hill? The more Congress and the White House dither over the bailout, the worse it will because Wall Street will wait to see how much of their risk will be socialized.

  14. I think this package stinks and that if its rejection causes a great depression, so be it. There are kids in Iraq risking their lives for this country. I certainly am willing to risk my capital.

  15. The present economic mess affects us all in a very immediate way and the American public has a right to know how we got to this point. I urge you to watch the you tube video listed below with an open mind, as an independent thinker. If you feel it has value, please pass it along. http://www.youtube.com/watch?v=1RZVw3no2A4

  16. Are you kidding? You write an article with the title “The Roots of the Crisis” with no mention of Carter, Clinton, the Community Reinvestment Act, Franklin Raines or Jim Johnson?

    WHAT A JOKE.

  17. Did you come to these conclusions in a roundtable of economics whizzes? Did you personally talk to a builder, a car dealer, a retailer, a meat producer, a commercial property developer, or a realtor? If so, name them? For you do say present data is a verification of future results is ridiculous. All segments are struggling and this situatiion is leading to a major depression. Or to be politically correct, a ‘recession.’

  18. Brilliant, factual and concise presentation in a way that your average person can comprehend. I wish everybody in the country would read this article

  19. @ Janet Lovelady

    Rickroll?

  20. Main Street is not in nearly as good a shape as Mr. Flynn claims. The actual unemployment is considerably higher; the Feds’ have a number of ways of computing it, and always choose the lowest figure, not the most accurate. Inflation is up, in real terms the economy is contracting.

  21. I agree with “Steve” Are you kidding? You write an article with the title “The Roots of the Crisis” with no mention of Carter, Clinton, the Community Reinvestment Act, Franklin Raines or Jim Johnson?

  22. Great article!!! I say no to any bail out. Let the big guys take the hit. They reaped profits early on, now that they have F***ed-Up let them pay the price of lost wealth and lost jobs. Let the Wall Street criminals be punished by their greed and stupidity.

  23. This is the most reasoned article I’ve seen on this. At last someone is starting to lay out all the pieces. One small refinement I would suggest is to expand the section on Bush’s attempt to better regulate Fannie Mae and Congress rejection of this attempt. We wouldn’t have had this blow up if the regulators had been permitted to act as they desired. Seems like the Dems in congress had a chance to act in a responsible way and failed. The sad thing is all of the fallout from this. The lower level people at all the financial firms whose life savings, 401k’s, blew up due to the failure in Fannie Mae.

    You might also expand Fannie’s lobbying efforts to keep the regulators off their backs. That is a causal factor as well.

    By the way, what was your reaction to speaker Pelosi’s speech where she tried to shirk any responsibility for the mess off the democrats back.

  24. How did this happen? Idiot!

    Bush handed his administration, lock stock and barrell over to the zionists and neocons.

    They used the barrell in iraq and the greedy
    New Yorkers did their thing with the stock (s).

    Americans are the only ones who seem not to realize it. or are they afraid of not being PC. Short answer.

  25. It is disingenious to lay all the blame for the growth in subprime and alt-A MBS on FNM and FRE’s door. In fact neither of these companies is allowed to issue subprime loans for repackaging as MBSes – that is the definition of ‘subprime’. And while alt-A are allowed, they still never represented a significant percent of either’s book. They do hold other banks’ subprime and alt-A MBSes in their _portfolio_, however, but again this never was a significant portion. The main originators and main holders of alt-A and subprime MBS has always been the banks that are now suffering.

    As for the fundamentals of the American economy being sound, that is also weakly supported.

    In fact, the Depression of 1929 started much the same way as this crisis is occuring. GDP growth was down just slightly before the crash, but didn’t seem anomolously so. The final economic collapse occured later on as banks failed and spending stopped, and was further aggravated by the Fed’s contraction of the money supply. So in fact the present actions by Paulson and the Fed are in the right direction – increasing the money supply and keeping banks and markets liquid. It is only a shame that the benefits will all accrue to the parties that are the main sources of the debacle. Soros’ plan is better.

  26. Clear, succint, accurate article. Why have I never heard of Mike Flynn before? I will certainly track him in the future.

  27. ACORN too!

    What!?!? This isn’t 1929, silly.
    And where’s my goddamned internet money!!!

  28. What I meant to say was
    *ahem*
    Excellent Article – I feel illuminated and effervescent now. Awesome.

  29. How is it you fail to mention Barney Frank as the cause of the crisis? You almost allude to him when you mention that the Bush administration tried, and nearly succeeded, in reining in Fannie and Freddie – but that “a deal was cut and Fannie would focus on low-income buyers” — ie, under Barney Frank’s blackmail – or collusion with Frank Raines (however you want to characterize it) – Fannie started lending to people it KNEW could not afford to repay their mortgages. Then those lousy loans were shifted off the books by packaging them into “instruments” that were sold to greedy and or gullible parties. Unfortunately, at some point, people who can’t afford to pay do indeed stop paying – and then the whole stack of cards falls down. Shame on Barney Frank and the Dems who risked our entire economy on the alter of political correctness and affirmative action. Keep this in mind as you consider our next affirmative action president.

  30. Fairly good article, however, what is so taboo about naming the names of the DEMOCRATS that created this problem as well as the [same] DEMOCRATS that are trying to rush through this bailout for their big donor financial industry-crook buddies in the guise of “fixing” this problem? (Dodd, Obama, Frank, Pelosi, Reid, [Bill] Clinton etc.) You “fix” traffic tickets; oh, I forgot, Blarney Skank was good at fixing tickets, too! Let all these clowns fall on their face. There should be investigations, indictments, convictions and jailtime for the Wall St.-Fannie/Freddie crooks as well as the DEMOCRAT politicians who facilitated and benefited from this scandal. There should be NO bailout to reward those who swinled milions! Let the guilty pay.

  31. I am no longer in the securities business, but used to hold a fairly senior position at my firm-head of bond sales and trading. This article is just about right on the money. Greed, especially on the part of investment bankers who came up with all this garbage, a strong lobby always in the face of key legislators (including Barney “It’s not my fault” Franks), FNMA and FRED both becoming portfolio trading and arb accounts,Lehman failing to clean up it’s act while paying Fuld an obscene amount of money…I could go on for hours. And of course once this is all behind us and the year 2014 or so rolls around there will be another ticking time bomb.

  32. How did Wall Street get into this mess?

    See the video in the post linked below for some important historical perspective that addresses that question.

    http://greensrealworld.blogspot.com/2008/09/market-crisis-truth-congress.html

  33. Wromg!

    Fannie Mae and Freddie Mac caused this. As directed by Bill Klinton.

  34. Decent article but this understates a couple of very important factors. First, market liquidity IS UNDOUBTEDLY the main problem. One of the main jobs of “Wall Street” is to make a market. This market making ceases to happen in times of extreme duress. This begets irrational selling, which begets more, and more, etc…

    Second, the author completely IGNORES financial leverage. The problem isn’t with the bad loans themesleves per say… it is teh financial leverage of many of the instiutions involved. Investment banks levered 25:1. The proliferation of hedgefunds which rely heavily on margin (i.e. the investors in these securities). All of this leverage forces hands in a way that is AGAIN a viscious circle of panic selling. We need more regualtion of financial leverage– this is the root of the extreme nature of this crisis.

    Finally, he cites historical avaiability of credit as growing… we are not worried about the past– clearly the current course and the future is what we are worried about. No, we are not in the great depression. That is valid to bring up. But we want to avoid even approachjing this.

  35. Bravo! Finally a true explanation of exactly what happened.

    Hope our congress people read this!

  36. This is the first article I have read on this whole mess that actually made sense. Thank you!

  37. And why would they relax lending standards to increase the number of mortgages made to people who could never pay them back? The author wants you to think it was because of greed. Take a look at this HUD testimony to find out the real reason:

    http://hwvauwp340.hud.gov/offices/cir/test031507a.cfm

  38. Like everyone else analyzing this market correction (read mess) the author hits some home runs and some near misses. Good explanation though of all the market forces at work. But the revelation is in the details not sweeping statements so for clarity it helps to look at specific cases versus overall theories. Fortune does just that in an article that details how Goldman Sachs lost big on mortgage-backed securities but won big betting against itself on those losses. Incredible! at http://money.cnn.com/2007/10/15/markets/junk_mortgages.fortune/index.htm?postversion=2007101609. For a

  39. What happened, did RedState link to this?

  40. This is the few internet articles other then talk radio that have told the complete story of this mess. The main stream media has failed again to be a reliable, honest, professional and a responsible source for news.

  41. May I suggest a better idea than a “bailout.”

    If you accept the premise that the economic crises was triggered by bad loans causing foreclosures, causing a further lack of liquidity?etc.

    Then the answer is to simply put a moratorium on foreclosures for 180 days to stop the hemorrhage. During the moratorium, each UPCOMING foreclosure/short-sale gets analyzed, homes remarked to market, and interest rates returned to market rates.

    That will allow the hemorrhage to stop, the housing market to stabilize at admittedly a reduced value, and the only “harmed” entity will be the banks with a lot of bad paper. They took the risk.

    I would love to see a newspaper accounting of which banks hold what percentage of toxic loans. My personal bank is still loaning, and there are a number of banks I know that are still loaning – admittedly to people of good credit, who are the people to whom loans should be made.

    I analyze the housing market daily because I am “in the business” but do not depend upon that market for my income. No home I have EVER sold in 31 years is now, has been or is threatened by foreclosure. I have never sold a home in foreclosure or short sale. It is just not my market.

    There is one Realtor in North County who, according to a NCTimes article, sold more than 70 homes now in foreclosure. Yes, he needs to be perp-walked, along with the banker he used, and the people who fraudulently signed their loan papers IF they lied about their income.

    Before pointing fingers, let’s stop the bleeding without using taxpayer money to bail out Wall Street. Work at the other end – it is the root cause of the problem. Wall Street is bleeding because of the hemorrhage at the street level.

    This is a manageable “crises.”

    In Zip Code 92026 (North Escondido) an average of about 8 homes come on the market each day. While there are no specific statistics, few people even try to sell right now unless they are in economic distress – but that definition extends to illness, age, job transfers, etc. – so let’s say six of those eight are short-sale, foreclosures or something just short of that.

    Of those six, I would be willing to bet no two are with the same bank or other lender.

    Those are manageable numbers for a case-by-case analysis. Wall Street has a headache because we have foot trauma and are bleeding profusely, so Washington (both political parties) are prescribing aspirin for the headache – that is because to a carpenter every problem is a nail. Washington wants to do what it always is inclined to do – throw money at the problem, and it often papers over the problem.

    In this case the initial bailout proposal was 4 pages – it is now 110, and growing. Few Legislators have read the proposed Bill, and still fewer have the mental capacity to understand it. In most cases, elected Legislators have the intellectual capacity of a half-dozen Rhode Island Reds.

    What they do have is a hammer, and they swing it wildly hoping to find a nail – and as luck would have it, they do on occasion.

  42. Good Article.
    Anything congress does will only make things worse in the long term. Government undertakings always backfire with catastrophic results. Beware of the unintended consequences.

  43. Excellent and balanced piece. Like others, I regret your not going back further to show how the deregulation during the Clinton Era, pushed by the very institutions that are failing and the very people who are leading this bail out, planted the seeds of this debacle. I was for the bailout before I am against it. You cannot have the guys who were smoking in bed play firemen. Before we have any deals involving tax payer monies, let’s expose who did what when (like congress did with Nixon), throw them out of office, let the banks fail, let country go thru a tight time (call it charater building), and not put this mess on the backs of our children. We must stop borrowing money to pay for our sins. We must be brave and pay the price now for “the sake of the children” later.

  44. For a WORKABLE plan that addresses the financial crisis without socializing the markets or giving corporate welfare to Wall Street, see http://starboard.blogtownhall.com.

    How much is $700 Billion?

    More than the government spent COMBINED in Fiscal 2006 for:

    Medicaid $180.6 in Billions
    Education $118.6
    Health $ 63.9
    Transportation $ 70.2
    Veterans Benefits $ 70.0
    Community Development $ 54.5
    Food & Nutrition Assistance $ 53.9
    Justice System $ 41.0
    Housing Assistance $ 38.3
    TOTAL: $691.0

    Source: Budget of the United States Government, Fiscal Year 2006

    According to CNN August 14, there were 750,000 homes in foreclosure. In addition to hurting the homeowners, these assets set the value of the banks’ capitol plummeting due to Mark to Market Accounting rules.

    $700 Billion divided by 750,000 homes = 933,333 PER HOME!

    This is not the WORKABLE plan at the link above, but it facetiously points out the FOLLY of the Paulson Plan, with or without tweaks:

    Forget the Paulson plan. Instead, why not give each homeowner $100,000 toward their mortgage to keep them in their home and reduce or eliminate their balance. Refinance any remaining balance for 15 years at 7% fixed. This will cost taxpayers only $75 Billion, the homeowners keep their homes and reduce or eliminate their house payments. The banks get instant liquidity. Balances under $100,000 are paid off. They convert bad loans over $100,000 balance to smaller, better risk loans at a nice fat 7%.

    The only loser… the guy who bought a home he can afford, and who continues making his payments, on time.

    As crazy as this proposal would be… it works better and protects the taxpayer better than any proposal currently on the floor of either house of congress!

  45. As an FYI, the author is stating that the current situation is nothing like what was being faced during the great depression in ’32 and that our economy is still moving forward and unemployment is nothing like back then. The statement, however, is misleading. 1932 was well into the Great Depression. The generally accepted start date for the Depression week starting with Black Thursday on October 24th, 1929 and the following Monday and Tuesday. At that time the market was still doing quite well despite some volatility that year, unemployment was also reasonable and industry while slowing after a boom period for mass produced consumer goods was still expanding slowly. So asserting that our economic situation does not track with the depression era is disingenuous at best.

    While it is not known if the credit crunch will continue to spiral causing a meltdown similar to ’29, it is important for people to understand that there are stark similarities between the economic periods and understand the risk that is faced.

  46. The author has no clue of the economic linkages. The state of the economy at the moment (fragile) if far less relevant that what will happen if the short-term borrowing markets don’t start to function.

    Cities and hospitals are having to pay 5% to 6% for short-term borrowings — a few weeks ago they were paying 2% or less. Companies like AT&T and Deere have reportedly had difficulty rolling over short-term commercial paper that is normally purchased by money market funds.

    So far money is available at a price. The risk is that we are headed towrad the monetary equivalent of the Arab Oil Embargo of the 1970s. That is to say that money is not available at any price.

    If businesses cannot get access to cash for day-to-day operations, they will cut hours worked, reduce staff or in extreme cases shut down.

    The Great Depression became so severe because credit-worthy borrowers could not get access to money. That is the outcome that the government is trying desperately to avoid.

  47. What?
    No mention of the Community Reinvestment Act that clinton and the Liberal Left actively pursued to make this disater a reality.

    Socialism does not work whenever it is tried.

  48. Interesting article, and one of the few I’ve seen that lays out a more comprehensive theory of what happened, but I did notice one glaring problem.

    One of the key points is in the section that starts “Fannie and Freddie then went on a subprime bender.”, but if you actually click on the link, it takes you not to a study or news article, but to an opinion piece!

    Where is the actual data/evidence backing up this point? Without it, the rest of the argument doesn’t hold together.

    Some people say FNMA and FRE were instrumental to this problem, others dismiss that point of view, but neither side provides good evidence. Without it, how can readers determine where the truth lies?

  49. where did this get linked to? feel like i’m in the twilight zone.

  50. Let them fall. They screwed up and when we screw up, NO ONE BAILS US OUT. I don’t feel like we have to bail them out, excuse me “RESCUE” them. Same as bailout. We are not dumb!! The sky is not falling on us like way back when. This administration has put us so DEEP in debt that it is a crying shame. Recoup some of that money from those rich CEO’s and whoever worked for them.. Are they really worth the money they get paid? Give us, the American citizen, the money to get out of debt. We’ll spend it and jump start the economy again. Our mortgages will get paid and we will have $$ left over to spend on things that we need. Stop spending all that money on the war. It’s a shame we were in the black when this administration took over, now we are so deep in “DOO DOO”. Are the politicians afraid that their retirement is in jeopardy? Heck, they retire and have darn good benefits that we the taxpayer pay for. Ours should be so good!!!

  51. Then the answer is to simply put a moratorium on foreclosures for 180 days to stop the hemorrhage. During the moratorium, each UPCOMING foreclosure/short-sale gets analyzed, homes remarked to market, and interest rates returned to market rates.

    I really don’t see how this helps with the valuation of the derivative securities that is supposed to be at the root of this mess.

    And, of course, by forgiving debt when revaluing homes and reissuing mortgages, you are rewarding the bad behavior of the defaulting homeowners and increasing the cost of borrowing for everyone in the future, by making mortgages riskier to issue.

    Instead, why not give each homeowner $100,000 toward their mortgage to keep them in their home and reduce or eliminate their balance. Refinance any remaining balance for 15 years at 7% fixed.

    Two problems with this:

    (1) at least some of these homes will go straight back into default, as the owners won’t be able to afford the payments on their new loan either. This is, at best, a partial solution.

    (2) why shouldn’t I just skip a few payments until I qualify for the $100,000 handout? The bad sectors of the housing market are going to continue to churn out defaults/underwater houses for awhile yet.

    Not to mention, of course, the moral/political problem of taking money from the prudent to buy houses for the imprudent.

    No thanks.

  52. Amazing how these distressed economic times are actually helping Obama when it’s clear that Democrat policies killed our economy.

    If anything, our current situation should be a case against socialism and call for us to go back to the roots of capitalism where everyone is held accountable for their balance sheets and aren’t forced into politically correct business practices.

  53. Great article!

  54. this article leaves out have of the truths that caused this mess and the description of the securities involved is truly incorrect – articles like this are have of the problem with why people have misconceptions of the facts

  55. Unfortunately, after several years of a housing boom, the available pool of households who could responsibly use the more exotic financing products had dried up. In short, there were no more people who traditionally qualified for even a subprime mortgage. However, Fannie and Freddie were still signaling that they wanted to buy these products. At the same time, activist groups were agitating for more lending to low-income families. Banks realized they could make even more exotic loan products (e.g., interest-only loans), get the activists off their backs, and immediately diffuse their risk by selling the mortgages into MBSes. After all, Fannie and Freddie would buy anything.

    *All* the ‘exotic’ loan products (including I/O) were part and parcel of the boom; they did not create new ones in late ’06 as house prices peaked.

    And I’m pretty sure that the CRA loans that the ‘activists’ wanted were not securitized.

  56. This wall street crisis is definitely going to affect the American taxpayer. I would call that an economic crisis in the making. Fannie and Freddie are proof that socialistic programs DO NOT WORK. If you youtube fannie mae crisis, you will see how the Dems pushed hard to make banks give loans to risky borrowers, the low income family. Several top Dems received 10’s of millions, all the while knowing that Fannie was headed into an economic collapse. Where is the investigation? The pro-Obama media might mention a name or two, but only after the election. I hope McCain and Palin tear into Obama and the Dems during the debates. Most American people are not aware that the Dems and their socialist policy are the ones who created this monster and it really pisses me off to see them hurling lies at the Republicans, brainwashing the American people to believe it’s the fault of Bush and Republicans for the collapse of Fannie and Freddie. Hey Barney, we are NOT that stupid. I hope you guys go to jail just like the Enron group.

  57. Why it happened is easy to understand. Banks did not loan to poor people. Gee I wonder why. Bill Clinton looked at the race of the people being denied and concluded that banks were discriminating based on race even though they were being prudent and discriminating based on risk for paying the loan. Fannie Mae and Freddie Mac were insured by the federal government (translation: taxpayers). Banks went on a binge to sell mortages and sold the mortgage securities to Fannie and Freddie-thus transferring the risk from the bank to the taxpayer. After about 15 years of this-and trillions of dollars of mortgages later, the sh*t hit the fan.

    Banks were simply making use of the rules put in place by the U.S. Congress.

  58. it’s clear that Democrat policies killed our economy

    I’ve never heard of this Democrat Party and would like to learn more about it. I hope it’s not like the Democratic Party.

  59. I am dumbfounded. Your assessments couldn’t be more incorrect.

    It is not Wall Street and the MBS sector that has caused the problems we have. It is people that tried to buy more home than they could afford and the Mortgage companies that made them the loans without doing their due diligence or backgrounds on the people getting the loans.

    Wall Street bought loans that they thought were good loans. Turns out many of the loans were based on false information.

    What really ticks me off is that people want to blame Wall Street and not accept responsibility themselves.

  60. Did they get the LHC up to speed early? Did this thread pass through an alternate universe that replaced all the regulars with a completely different set of people?

    Granted, I’m not a fan of echo chambers, so always welcome new blood, but this is like stepping out of your bedroom and being in a completely different house.

  61. Let’s cut to the chase, proof has it the reason all this happened is due to a bunch of lying leftist, rule revising congressmen decided about ten years ago or more to get real serious about how to steal, lie and cheat the American taxpayers out of money that was to be used to take care of this nation. The money was paid out in good faith, the left leaning congressmen used their elected positions to abuse the trust the American people gave them.

    Now that’s saves a lot of words.

  62. I’ve feeling very disoriented.

  63. Flynn,

    Wait a minute…

    First you say that, because of illiquidity, based on bad accounting regulations these toxic MBSs are marked-to-market at a price of zero, despite actually being worth much more. You say the real problem is liquidity, and I agree.

    Then you say that the government would be stupid to pick up these assets at a “premium” over their market price. Wait…didn’t you just say that they are actually worth more than their market price, if only the market were liquid? That’s inconsistent.

    It seems the gov’t could pay a premium over the current market price of zero, thus inserting liquidity into the market, thus increasing the value of the MBS paper they just bought – possibly over what they paid.

    This is one of governments few opportunities to buy low, sell high. Although the Paulson plan even manages to screw that up.

  64. Great analysis and reporting re: how we got to this point. I would take exception to one point of logic: while it is true the 1932 #’s i.e. unemployment are in no way comparable to today’s, in other words it is not so bad today, you must keep in mind that those 1932 #”s were a result, partially, of the seeds planted in Oct 1929 and the stock market crash. So be careful, we could still end up somewhere in that 1932 neighborhood a year or two from now, especially if the Government arrives, hat in hand, to “help” us.

  65. If the government wants to bailout somebody, I have a better suggestion. Take the 1 trillion dollars (we all know its not going to stop at 700 billion) and do some long division. Take the 1 trillion, divide that by the number of citizens that pay taxes, that should come out to about 500-600k per person. With that kind of money, hell I will help jump start the economy.

  66. Drudge linked to this so that might explain some of the comments so far.

    I think Mr. Flynn’s analysis is largely correct, if perhaps not detailed in certain areas. More could be said about the inevitable malinvestment problems a fiat currency/Fed system creates, but he implies that in the article. Even if the collectivism of ACORN and the Community Reinvestment Act didn’t significantly contribute to the approval of bad loans, it did provide a moral backing for people who defended such loan practices. That cannot be forgotten, for being shouted down as racist, bigoted, callous, exploitative, and so on is the principle method for advancing socialism at the expense of freedom.

    A lot still needs to be said about the total failure of the ratings agencies to keep an eye on things. There is ample room for new competition in that market.

    But the reality is that the state collaborated with pressure groups to put in place incentives that mislead the honest into making titanic mistakes and spurred the avaricious to ignore common sense.

  67. It’s linked on Drudge, for the regulars who are wondering wtf is going on here.

  68. Where do your stats on lending activity come from? As someone in the real estate development business, and with a brother who’s a loan officer with a commercial bank, real estate and other loans have been incredibly difficult to get for at least 12 months. And it has gotten pregressively worse. Only those who don’t need a loan, are able to get them.

  69. Wait…didn’t you just say that they are actually worth more than their market price, if only the market were liquid? That’s inconsistent.

    I didn’t get that at all from his article. Flynn points out that because of mark-to-market accounting rules, the assets are valued at $0, when clearly, these assets are worth more than $0. Flynn postulates that these assets should be market priced, but that market price is more than likely displeasing to the holding entities. So these financial institutions are hoping for a government bailout to purchase these instruments at much more than the market would probably bear.

    Except that no market is truly illiquid. It just isn’t liquid at the price you want to sell. This summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks’ bad debt, just not at the price the banks would prefer.

  70. Bravo Mr. Flynn…there is an old joke that says that “one definition of greatness is the ability to explain a complex idea to the common man, and based on this definition of greatness, good engineers are common, great lawyers are rare, great scientists are rarer still, and a great insurance salesman is a contradiction in terms.” Mr. Flynn has written a great article that unfortunately will be shouted down by the political finger pointing that is for the most part pointing in the wrong direction. Compound this with a mass media that is employed more for their appearance on camera instead of their knowledge and integrity and we are faced with a situation where the people who caused the problem are going to be rewarded and soon have greater control of the government. I say nuke them all then shoot them in the dark.

  71. BBVDD,
    unfortunately many bankers lent more than the recipients could afford. This is not only the borrowers fault. It’s the lender/underwriters responsibility to maintain standards. If I ask you for a million dollars even though I have no job and you give it to me – my fault or yours when I inexplicably default.

    The article does a good job of explaining why the securities came into existence (Fannie/Freddie/Frank) but not why broken MBS tanches cause the commercial paper markets to seize. The reason for that is because banks hoard cash because to lend it is very risky if your counterparty vanishes overnight. Which they will if their own cash hoard dwindles and no one will lend to them. It dwindles because of capital requirements and writedowns caused by M2M accounting as explained. Kind of like that scene in “It’s a wonderful life” – which ought to be required viewing tonight

  72. Mike,
    Thanks loads. This is the best piece I’ve read in the last two weeks on the whole scam.

  73. Great article – good solid facts.

    The bailout plan is just a bad idea on so many levels; seems no one is asking the tough questions about this plan.

    Dave
    Just Say No to the Bailout Plan

  74. “mental health benefits” = chill pills for panicking Wall Street investors.

  75. real estate and other loans have been incredibly difficult to get for at least 12 months. And it has gotten pregressively worse.

    Every metric I’ve seen shows that only higher-end real estate loans are getting difficult. This is arguably because the higher end loans are more likely to end in default.

    And as for this:

    Only those who don’t need a loan, are able to get them.

    Back in the 70’s, my dad once told me an adage about markets and finance: It’s always easier to get a loan when you don’t need one.

    The fact that the lending business is tightening up does not a crisis make. It just means that too many non-credit-worthy players have been getting loans, and the banks and financial institutions are pulling back to reasses. This is a market correction in every sense of the word. Again, while our leaders are screaming “Market Failure”, I’m seeing market success.*

    *And I’m able to say this with confidence while my 401k bleeds. But sometimes I’m referred to as a “market fundamentalist”.

  76. re my previous comment, Sorry for a slight error…I meant to say

    “nuke them all TILL THEY GLOW, then shoot them in the dark”…

    Not sure however that we have enough bullets!!

  77. illiquid vs. true value

    You and neighbor both buy $50k Mercedes with 10k down and 40k on credit. A month later, he needs cash in a hurry and sells it for 30k just to get rid of it. The dealership hears of this and knocks on your door and asks you for 10k since the Mark to market value of your car is only 30k now, and you have negetive equity in the car (need to have more capital). So you decide to sell your other car – in a hurry: the guy at the door is waiting for his money. Your sale forces someone else in the neighbor hood with the same car to get M2M below their equity.

  78. “It’s linked on Drudge”

    Damn you kids! Get offa my lawn!

  79. Brilliant, factual and concise presentation in a way that your average person can comprehend. I wish everybody in the country would read this article
    *********************************************

    Right on!! If every person of voting age were made to read this and then had it explained to them this bailout horsesh*t would go south and more importantly the culprits that got us here would be hung out front and center for the world to see.

    A secondary benefit would be the utter destruction of the Obama campaign along with any chance the empty suit had of getting eloected.

  80. Well done article!!When do we hear about the notable politicians participating in these schemes? The Treasury Secretary should be removed immediately, for poor judgement and unsatisfactory performance. Just another Bush league move!!!

  81. I don’t claim to know a whole lot ablout the market but here are a few observations:

    Congress was in session Monday and everyone thought the bill would pass;the market takes a nose dive. Congress leaves town on Tuesday;the market goes up-third biggest gain ever. Congress comes back to town to vote for the bill on Wednesday;the market goes back to red. Anyone see a pattern?

  82. Still praying for a do-nothing congress.

  83. It is not Wall Street and the MBS sector that has caused the problems we have. It is people that tried to buy more home than they could afford and the Mortgage companies that made them the loans without doing their due diligence or backgrounds on the people getting the loans.

    DUE DILIGENCE (IT’S LEVEL), AS YOU PUT IT, IS DETERMINED BY THE REQUIREMENTS OF THE INSTITUTIONS WHO WILL BE BUYING THESE MORTGAGES FROM THE BANKS. THE RELAXATION OF THE REQUIREMENTS NECESSARY TO OBTAIN MORTGAGES CAME ABOUT BECAUSE FNMA, FRMAC ETC SIGNALLED THE BANKS THEY WOULD BE BUYING LESSER QUALITY PAPER.

    THE BANKS JOB IS TO MAKE MONEY AND AS LONG AS THERE WERE BUYERS FOR THE MORTGAGES THEY PUT ON THE BOOKS THEY DID WHAT THEY HAD TO DO. THERE FIRST RESPONSIBILITY IS TO THE SHAREHOLDER, NOT THE GOVERNMENT AS YOU SEEM TO THINK.

    THERE WERE ATTEMPTS IN THE EARLY PART OF THIS DECADE BY REPUBLICANS TO TIGHTEN UP THE REGS AT THESE QUASI GOV’T AGENCIES (FNMA AND FMAC) AND A BILOL WRITTEN BY JOHN MCACIN TO DO THE SAME IN 2005 WHICH WERE SHOT DOWN BY LIBERAL PROCEDURAL MOVES IN THE CONGRESS.

    WE CAN LAY THIS DEBACLE ST THE FEET OF THE DEMOCRATS

    Wall Street bought loans that they thought were good loans. Turns out many of the loans were based on false information.

    SURE BECAUSE THE AGENCIES THAT PURCHASED THE MORTGAGES TOLD THE BANKS THAT NO VERIFICATION LOANS AND NO DOWN PAYMENT LOANS WOULD BE ACCEPTABLE TO THEM. THE BANKS MERELY FOLLOWED THE GUIDLINES OF THE PURCHACING AGENCIES AS THEY HAD DONE IN THE PAST.

  84. Wall Street got into this mess by re-packaging, amongst other things, Government Sponsored Enterprises (GSEs) put forth by Fannie May and Freddie Mac.

    FM/FM encouraged banks to stop “red lining” and give as many new potential homeowners who really couldn’t afford a home to get a mortage anyway.

    FM/FM is a Democrat piggie bank, rife with corruption, in need of FBI investigation.

    Barney Frank and Chris Dodd should be hung by their testicles in the public square for their condoning this pile of sewage for the past few years.

  85. In order for the housing market to come back into any sort of historical parity, many people need to be foreclosed on their houses so the house can be sold and the proceeds can be released back into the market to find a decent return somewhere else. The government is talking about adding additional “foreclosure protection” to this bail out law which would exacerbate the problem as it would cause underperforming capital to stay put. Ironically the bail out that failed earlier this week will probably be resurrected as a worse bill and then pass. Welcome to France.

  86. As someone who spent 5 years structuring MBS and subprime ABS, this is the most complete explanation I have heard and it puts to writing some of the major developments that led to this crisis. I left the industry in 2006 as Fannie and Freddie were regularly bidding against each other to buy our subprime deals. All of us on the desk knew that the loans being originated were junk, we regularly called mortgage brokers as pranks to ask them to explain the terms of pay option ARM loans. A few people were talking about how the income ratios and debt ratios were out of whack, but most people rebutted that negative research with historical evidence that home prices never decline. If any good came out of this, it is people’s awareness of fundamentals, monetary policy, and other rules that drive the overall economy, not just our little piece of the pie. Great article.

  87. As some of the comments indicate, Main Street is not doing as well as the government’s statistics seem to say. That doesn’t mean there isn’t a large disconnect between Main Street and Wall Street. The credit crunch began to hit most of America 12-18 months ago. At this point, the fact of a tightening of credit is old news to most of us, and we have adapted as well as possible. This bailout benefits no one who deserves to be benefited.

  88. This is a great article, but one exception I would take is to be wary of assuming that public opinion is hardening or that a second, highly similar, bailout bill won’t get passed.

    Right now the MSM are in high gear, screaming for the bailout with every ounce of their strength. And it is having an effect. Rumor has it that calls to congress went from 50-1 against to 50-50 after the bailout failure on Monday.

    Read the NY times editorial page. They are in a compelte and total panic that the bailout (and hence socialist takeover/free-market downfall) may not actually happen.

    They have been editorializing for weeks that the crisis spells the death knell of free-market ideology. Their editorial on the subject yesterday degenerated into an psychotic screed against Republicans and capitalism in general. They are freaking out. Bob Herbert’s op-ed was the same. David Brooks is shilling for facism, instead of socialism, but also pushing the line that we’re witnessing the downfall of the capitalist system too. Every op-ed writer is pushing for it. I haven’t seen a single editorial or op-ed critical of it at the NY Times. Or a single one that lays an ounce of blame on anything other that free-market economic theory.

    Do not bet on the public not being swayed by the overwhelming bias being put out by the most influential news sources in the country.

  89. It’s a very good piece. However, when you say this:

    “The one-two punch of Lehman’s failure and the government’s $85 billion bailout of AIG on September 16 seriously spooked the Street and the Bush administration.”

    Aren’t you admitting that the Street expected a bailout. In other words, the people playing this game all along were counting on a bailout.
    If everyone is actually assuming, no matter what they say in public, that they know that the government, whichever party is in power, will not let a crisis like the current one occur without government intervention, shouldn’t that figure into our real world expectations.

    In the same way, when you say:

    “One of the major factors pushing investors into these securities…”

    Was someone putting a gun to the heads of these investors? Whatever the government does, are they absolved of stupidity?

    The real question is whether or not government will intervene in situations like the current one. Without an answer to that, it is very hard to determine what will actually occur in the real world, or what a rational policy should be.

  90. Franklin Raines and the CRA

  91. While I agree with all of your points, I think that it’s silly to look at markets this week and last as anything other than tracking government policy. They went up today because people rated the chance higher that they’d get a bailout – nothing more. I agree that eventually the markets will price all the assets and eat all the losses and move on, but I don’t know if today’s rally was really anything other than a prediction market for government policy.

  92. They went up today because people rated the chance higher that they’d get a bailout – nothing more.

    This is correct, just as the market drop was emotional reaction to the chance that they wouldn’t get a bailout.

    Offer Wall Street free money: market goes up.

    Threaten to take free money away: Market goes down.

    Boo-fuckity-hoo

  93. What happened, did RedState link to this?

    Drudge did.

    Hi republicans and welcome to reason. Now quit your retarded party and become libertarians!!!

    Now!

  94. 50-1 against to 50-50 after the bailout failure on Monday.

    Rep Larsen said his calls were running 50/50 as well.

    50%: No
    50%: Hell no

  95. Actually, I’m for helping out the private mortgage originating banks who are stuck with loans they would never have made if left to their own business judgment. Just as a moral matter, the federal government, representing you and me, basically forced these people to originate these subprime loans, so the federal government (you and I) should help them get out from under the untoward result of what the government made them do. Otherwise, let the two FMs (and their shareholders), the people who voluntarily bought the high-risk mbses and the people who took out loans they knew they could not afford reap the harvest of their behavior, like adults.

  96. Whoda thunk that in this high pressure environment the libertarians in the GOP could stand against the tide?
    Y’all should watch Rep Thasseus McCotter laying it all out
    http://ca.youtube.com/watch?v=gNlXgzzdJQA

  97. Mr. Flynn:

    How can you describe what went on to create and exacerbate this crisis without mentioning S.190, the Senate bill sponsored by four Republicans including McCain which would have virtually taken over control of Fannie & Freddie in 2005 and avoided this mess? I understand the Liberal media burying this story but what’s your reason?

  98. Coal Miner | October 1, 2008, 5:01pm | #
    “As someone who spent 5 years structuring MBS and subprime ABS, this is the most complete explanation I have heard and it puts to writing some of the major developments that led to this crisis.”

    My, that’s a rather large lie.
    You’re suggesting the most complete explanation you’ve read is an article which avoids acknowledging what the “credit crisis” is, where that crisis is occurring and that states flat out that this is a problem which resides only on Wall Street.

    I don’t know which. It could be you’re lying about having any familiarity with the topic rather than just lying about the article. Either way, it’s a big one.

  99. Sorry, but most banks aren’t “marking to market” at all, because there is no market, because they won’t sell at the actual market-clearing rate. Banks are “marking to model”, a model which grossly overstates the value of the securities. The banks don’t want to admit the extent of the losses, which is why many aren’t evicting people even after a year or more of nonpayment.

    And the problem isn’t just bad loans — it’s the vulnerability to them based on insane leverage (i.e., minimal reserves), and interlocking webs of credit default swap derivatives, all of which work well when no one goes into default, and most of which were based on historical mortgage default rates of under 2%, not the 9% and rising we currently face.

  100. Peter | October 1, 2008, 2:49pm
    I am no longer in the securities business, but used to hold a fairly senior position at my firm-head of bond sales and trading. This article is just about right on the money.

    And another one.
    So you’re someone who has worked in a senior position in financial markets and thought the article which suggested the commercial paper market freezing only effects Wall street was accurate. Did I get that right ?

    Nobody here is a senior professional in a credit card firm. Somehow though, they do all understand that if nobody is able to get a credit card, this doesn’t just effect Delaware where all the credit card HQs are. When a credit market freezes it’s not about the institution, it’s about the people who rely on it.

    When banks won’t lend, that either effects banks or everyone who needs to borrow from them. As you can discover when you listen to bank analysts telling businesses that if they need money they are out of luck.

    McDonalds is telling franchises that there is no lending available for store upgrades. Either Wall Street is REALLY well off for fast food stores or this may involve streets with other names that businesses operate on.

    But you’re the expert. So why don’t you disagree with this and tell us why the article which doesn’t mention what triggered the publication of articles titled “The Week the Economy Almost Died” when explaining what the problem is, is just so accurate.

    Because, you know, if someone claiming to work in the nuclear industry recommended an article about Chernobyl that didn’t mention nuclear power when talking about the problem, I’d like to hear more from them too.

    Have at it pal.

  101. AIG wasn’t burned by “iron clad accounting rules” — the rules are a joke. AIG was burned by exposure to derivatives, which required it to pony up billions more in cash when its credit rating was dropped, long after it should have been and to a much lesser extent than would have matched reality.

  102. Maybe this is outside the scope of the article, but how these properties got overvalued in the first place is definitely relevant to the final cost – Homes in Florida, California, and elsewhere were going up 30-45% per year. For this to happen, the banks had to lend the overage. For banks to lend the overage, appraisers had to support the prices that crazy sellers were asking. If appraisers hadn’t done this, the only way a seller would have been able to get 45% more than the year before would have been to find a cash buyer, which is rare, and therefore, overall price inflation would have been much lower.

    Would this have averted defaults by people who weren’t qualified in the first place? Of course not. But it IS making the losses even worse.

  103. Here is what has happened to commercial paper rates (unmentioned in the article) while crap like oil prices and the stock market (mentioned in the article) have moved in ways that count for sheet….

    blogs.wsj.com/marketbeat/2008/10/01/sp-launches-commercial-paper-index/

    Al Gore had nothing to do with that graph.

    As it explains:
    “companies have been scaling back their use of the commercial paper market, fearing they won’t be able to raise cash for everyday activities like buying inventory or paying staff if the fragile market falls apart. The market all but shut down two weeks ago when Lehman Brothers Holdings Inc. (LEH) filed for bankruptcy.”

    Pfffft. It’s only those fat cats on Wall Street that deal in things like inventory and wages or “everyday business operations” as these elitists call it.

    It must be just the wages and stationary cabinets of Wall Street firms, after all we’re told by Mr Flynn:

    “The overall economy doesn’t even face a liquidity crisis in the current turmoil. Consumer, commercial/industrial, and real estate loans are all up over last year. Main Street is doing fine. The liquidity crisis is confined to Wall Street, between and among investment banks, insurance and securities firms, and hedge funds.”

  104. From what I’m gathering, the dire warnings about credit freezing up aren’t exactly true: lenders can get money to lend, it’s that that money got much more expensive in the last week, something like 2% going to 8%, so they’re going to have to pass the rates on to end users like you, me, and businesses. This would reduce the number and $ amount of loans, reducing lenders’ profits. This would also contract the money supply, maybe causing deflation, and deflation would really tighten the money supply and possibly put us in a recession. The cynical side of me says that Wall Street and the Fed both see it as better to stick the taypayer with the bill and keep interest rates low. I don’t know what to think. Maybe they’re right, maybe they’re not, but my borrowed dollar says that betting on government intervention instead of markets just makes the inevitable pain worse when it finally comes.

  105. “The crisis may have already peaked. Of course, Congress’ ability to further screw this up can’t be overstated.” I think you nailed it there. This is not a huge problem for the average American, and would not be sans bailouts.

    Excellent article, thank you.

  106. For an article about the roots of the crisis I’m amazed that deregulation was totally ignored. There’s the true root from which this mess grew.

  107. This is the best article (read: only article) that I’ve read covering the details of this “crisis”. It’s a sad commentary on journalism, but this is Pulitzer material if only for being so comprehensive in its presentation of the facts – something the MSM has completely failed to do.

  108. Let’s be clear – this IS a national crisis! No doubt about it. As you sit here reading this email Mom and Pop America are taking there money out of the banks. 401K and IRAs continue to lose value and your home equity is still going down. The price you pay for groceries and energy to fuel your vehicles and heat your house has gone up. The debt market we created to fuel our economy has imploded.

    “The overall economy doesn’t even face a liquidity crisis in the current turmoil”

    If you are not Citi, BOA, or JP Morgan, and you are a bank sitting on pile of shitty MBSes your ability to find or make liquidity has been extremely hampered. Meanwhile your deposits are dwindling! The Xmas retail numbers will tell the average American’s story.

    The Fed made a lot of mistakes, but the biggest one was not regulating the repackaging of the MSBes.(they learned nothing from the Junk bond fiasco). When they changed the accounting rule 2 years ago to “mark to market” it was the right idea at the wrong time. Interest rates were rising and these loans went toxic and the liquidity started to disappear. Hence no market to mark against. Balance sheets crumbled and CEOs became deer in the headlights (but so did the Fed).

    “The spot price for October delivery of oil jumped $25 a barrel. Some of this was covering trades, but a sizable amount of this appreciation was probably a “flight to quality,” a place to park money while everything was sorted out.”

    The $25 jump happened on the last trading day of the October Futures contract. Retail futures trades have Zero ability to make or take delivery and the dealers raped them with a broom stick in the last hour of trading. This was a text book squeeze play! The flight to quality is happening in Precious Metals and the family mattress.

  109. “Let’s be clear: This is a Wall Street crisis, not a national economic crisis.”

    If the problem is people can’t afford to pay off their loans so the money market is failing, that sounds like a “main street” problem to me. And if people can’t get loans anymore that sounds like a problem for everyone in the nation too.

    This article seemed to miss the major point of what’s going on…

    Bush and Republicans have created an environment of bad debt. The average person is hurting- at the gas pump, on taxes, while oil companies are making big bucks and the wealthiest are getting big tax breaks. Inflation is up. How are the current administrations policies helping America?

    Time for change- time for Obama!

  110. Kilo,

    Sorry if I was misleading, I was talking exclusively about the events that impacted the market for MBS. In that regard, the author captures the events accurately. I have never suggested that this problem only resides on Wall Street. A friend of mine who works for a trucking company said they are struggling to make payroll because they are lost a line of credit. I’m sorry for not clarifying what I meant.
    Coal Miner

  111. The main points of this article need to be distilled and diseminated quickly as widely as possible. I have seen pundits on cnn in the last few days that say the the supremacy of free markets over the last 20 years is over. This article really shows that the government really broke our leg and now thinks we need a crutch. The fact that an attempt was made to reform fannie and freddie failed, mostly because of big gov’t thinkers, needs to be put front and center. If we don’t do this, the big gov’t people are going to be calling the shots for the next 4 years minimum.

  112. Perhaps the dingus investment houses should sell the damn MBS’s to each other. “I’ll buy yours, if you buy mine, wink, wink”. They can set whatever “market” price they want… PROBLEM SOLVED! (A little collusion never hurt anybody)

    Damn, that’s a good idea!… I’ll start emailing the CEO’s…. Anything to stop the “bailout”

  113. What I find interesting is some comments here say the government “forced” the banks and mortgage lenders to lend money to low income groups. The government also “forces” people to pay their taxes. Do people or businesses eagerly pay their taxes? Do they show up at the tax office early and pay more than their fair share? I would say some banks eagerly took up developing sub-prime mortgages encouraged by the US government . Did the banks who refuse to deal in sub-prime get arrested or sued?

    It is easy to blame the Democrats, but the Republicans controlled Congress for six years. This is adequate time to amend the laws if they felt anything was wrong. Look guys, almost every Congressmen receives money from lobbyists, whether Democrat or Republican.

    I don’t agree with author in saying it is not impacting Main Street. It is, or he is living in Second Life. Car sales have in last couple of months have dropped to 1992 levels. Why? The lack of credit, only 60% of people with good credit ratings have their car loans approved now compared to 90% before. Suppliers are having a difficult time getting paid on time. Short term borrowing cost are going up.

    If the author spent more time in the real world he would realize that the credit crisis is already having an impact on the real economy.

  114. This article is very informative and concise. I appreciate hearing another voice of reason pointing out that increasing regulation is a backwards and bad idea! I cannot believe the steady flow of rhetoric from both parties in Washington trying to convince the American people that the only answer to government mess-ups is a bigger government. What is going on?

    Also, I would like to agree with William’s comment on the ‘main-street impact.’ I believe the credit crunch is a direct result of all of these bad mortgages and when credit tightens up, main-street feels it because credit is the heart of the economy.

  115. So what now? The down is down almost 40% from its peak last October, and 20% from the start of the month. Credit markets have tightened, and the crises has spread to Europe. The very premise of this article is incorrect.

    The comparison to 1932 also is incorrect. Conditions in 1932 were the result of the market crash in October 1929, more than 2 years earlier. The economy was cooking along in 1929 too.

  116. Here’s a good explanation of what happened and how to address it:

    “Systemic Risk”

    Georgetown Law Journal, Vol. 97, No. 1, 2008
    Duke Law School Legal Studies Paper No. 163

    STEVEN L. SCHWARCZ, Duke University – School of Law
    Email: schwarcz@law.duke.edu

    This article is the first major work of legal scholarship on systemic risk, under which the world’s financial system can collapse like a row of dominos. There is widespread confusion about the causes and even the definition of systemic risk, and uncertainty how to control it. This article attempts to provide a conceptual framework for examining what risks are truly systemic, what causes those risks, and how, if at all, those risks should be regulated.

    It begins by carefully examining what systemic risk really means, cutting through the confusion and ambiguity to establish basic parameters. Economists and other scholars historically have tended to think of systemic risk primarily in terms of financial institutions such as banks. However with the growth of disintermediation, in which companies can access capital market funding without going through banks or other intermediary-institutions, greater focus should be devoted to financial markets and the relationship between markets and institutions.

    Using this integrated perspective, the article derives a working definition of systemic risk. It then uses this definition to examine whether systemic risk should be regulated. To that end, the article examines how risk itself – in particular, financial risk – should be regulated and then inquires how that regulatory framework should change by reason of the financial risk being systemic.

    A threshold question is whether regulatory solutions are appropriate for systemic risk. The article argues they are because, like a tragedy of the commons, no individual market participant has an incentive, absent regulation, to limit its risk taking in order to reduce the systemic danger to other participants and third parties.

  117. I unquestionably understand what you have said. In fact, I browsed throughout your other articles and I think that you’re certainly right. Congrats with this site.

  118. This is the perfect blog for anyone who wants to know about this topic. You know so much its almost hard to argue with you . You definitely put a new spin on a subject thats been written about for years. Great stuff, just great!

  119. Awesome!for an article about the roots of the crisis I’m amazed that deregulation was totally ignored. There’s the true root from which this mess grew.

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