Bottom Line: The Financial Crisis Explained

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I had a great chat today with a very smart person named Lara and she compared the current crisis we are seeing to the S&L crisis over 20 years ago.  I think that she is right.

My good friend Anton Wahlman wrote this great post see below

Financial Crisis 2008 Explained by Anton Walhman

1. Why did the financial meltdown happen?

2. Who is to blame for it?

3. What, if anything, can be done to fix it?

I know many of you don’t have the patience to read more than the absolute minimum, so I start by giving some of the briefest answers possible:

1. Cause? The price of housing – and therefore mortgages – was too high, which in combination with high leverage (such as >30:1) caused those institutions who bet on the wrong direction of the market to go bankrupt in an accelerated fashion.

2. Blame? Most of the blame is simply in the hands of those who were too optimistic on the housing/mortgage market. Those who shorted those markets made lots of money.

3. Solution? Basically nothing. Asset bubbles happen every few years (remember the Internet boom 1999-2000?) and they will happen again. Prices must simply be allowed to adjust down.

Here is more detail:

Why did the financial meltdown happen? In and around 1997, the US Congress – supported by President Clinton – did two things. One was the real estate capital gains tax cut, which eliminated the capital gains tax on primary home real estate held over two years up to $250,000 for a single filer and $500,000 for a married couple. This may be the biggest tax cut ever, and it made real estate the most favored investment class. Small wonder, then, that real estate prices rose in an unprecedented manner for approximately ten years in a row. At some point, however, as in any bubble rising, it went too far. It became easy to see at some point after year 2000 when in many places it had become cheaper to rent than to own, pointing to over-inflated prices.

Around the same time, Congress was persuaded to pressure the mortgage industry to provide loans to those it claimed it had been unjustly denied loans in the past – the poor, blacks, et.al. The mortgage companies were basically told to make loans with lower standards than in the past…or else. If they played ball, unlimited funds would be available from Freddie Mac (FRE) and Fannie Mae (FNM). If they didn’t play ball… well, John Edwards is a great trial lawyer going after those evil big corporations.

At the center of what turned into a highly unsound feeding frenzy were Freddie Mac and Fannie Mae, ostensibly private companies but ones where the leadership were politically appointed. Basically, these two institutions were run by political hacks from both parties, feeding the mortgage industry with billions of dollars earmarked for loans to those who previously didn’t qualify for home ownership.

Around 2003, Fannie/Freddie admitted that their financial statement couldn’t be relied upon, and it’s not clear that they ever put them in order since. There were several proposals from The White House in recent years to change this system drastically, but efforts to do so were rebuffed by Congress and in particular Chris Dodd and Barney Frank. As long as home prices kept rising, these highly unsound practices didn’t bother most people. In fact, the companies who originated the mortgages managed to sell them to Wall Street firms such as Bear Stearns and Lehman Brothers (LEH), who were looking to obtain higher yields on their proprietary trading portfolios. Leveraging up over 30:1, this became very profitable for those firms, until the bubble burst. Remember, at 30:1 leverage, you are bankrupt at as soon as losses exceed 3%.

Who is to blame? If by blame you mean losing money, obviously everyone who were long real estate after the peak in or around 2005 are to blame. But losing money isn’t illegal; it happens in the market every single day – for every buyer, there is a seller, but the market only goes in one direction. Per definition, after the fact, every trade has a winner and a loser. What about doing something illegal? If there is something illegal here, I haven’t seen it. Lots of stupidity and the usual bubble mania, but those things aren’t illegal.

Certainly Congress is at fault for having created the monster organizations Freddie Mac and Fannie Mae. Neither one should have been created to begin with, because the government has no legitimate role in conducting commerce. It is equivalent to the government starting airline companies for the purpose selling subsidized airline tickets. In addition, the pressures Congress put on the mortgage organizations to make loans to those who didn’t deserve them were extremely complicit in this debacle. Some of the investment banks shot themselves in the foot by taking on bad mortgage paper and leveraging up, leading to their demise.

What’s the solution now? Sadly, the milk has already been spilled, because some people who didn’t deserve mortgages already received them, and others bought homes at prices too high. There is simply no painless solution to this fundamental situation; prices must be allowed to fall. Those who are heavily exposed – indeed leveraged – to overvalued financial instruments, will have to take losses and some may go bankrupt.

One final word of caution and moderation: We had a 10-year real estate boom in which more wealth was created than in any previous boom or bubble. In the last 18 months, we have given back some of those gains, but far from all. Booms and busts do happen, but as with the Internet boom a few years earlier, on balance more wealth was created than destroyed as the bubble burst and some of the gains given back. It’s happened before, and it will happen again – just like Summer turns to Fall, Fall turns to Winter… bubbles and business cycles are part of economic – and therefore human – nature.

Author: John

Entrepreneur living in Palo Alto California and the Founder of SiliconANGLE Media

35 thoughts on “Bottom Line: The Financial Crisis Explained”

  1. Thanks, John, for another great article. As one of the presidential candidate has said, this is not rocket science. I am old enough to remember the S&L crisis. In fact, old enough to remember the housing slump in the early 80’s that led to the deregulation (my first house was financed with 20% interest at the end the Carter years). Since then I have experienced a few more bubbles that were even more personal (Asian crisis, Y2K, dotcom, telecom, etc.). And every time we go through one of these, I am reminded of my friend Paul who grew up in Germany during World War II. When he returned to his village after the Berlin wall came down, he was surprised that everyone in Germany who were old enough to be in the Hitler army had fought in the Eastern front. In other words, no one would ever admit that they fought the allies, only the Russians. My point is that selective memory is convenient and understandable. With regard to latest bubble, there were enough blame to go around and I believe everyone was responsible, not just the CEO’s, not just the politicians. In some way, the recovery of the Silicon Valley in the last five years was in part financed by the housing boom. In any case, the fat lady is no where in sight so as with the last bubble, this will get a lot worse before it gets better. No one should expect recovery until the next presidential election.

  2. “We had a 10-year real estate boom in which more wealth was created than in any previous boom or bubble”

    How exactly was wealth created?

  3. Great article. I put down the real cause of the financial crisis to over LEVERAGE just like you mentioned as point #1! As I wrote recently, What really caused the magnitude of the current financial crisis was the amount leverage used in the housing market and mortgage backed securities derived from it. Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. The collapse or bailout of some of our most highly regarded financial institutions – Fannie Mae, AIG, Lehman Brothers and Merrill Lynch – was squarely due to leverage.

  4. Surely there were many mistakes made by numerous parties along the way. At the core of it was that people bid prices up too high, which is no different than any other major asset bubble such as the
    1999-2000 Internet. Nobody complains when prices go up, but when they eventually deflate, Wall Street is suddenly filled with criminals. In the debate last night, “greed and corruption on Wall Street” was heard every other second, but no politician saying it is ever called to specify any act of criminality. That’s because there probably wasn’t any. People simply lost money, which is never a happy event, but it’s the nature of the market every single day — for every trade there is a winner and a loser.

    The appraisers weren’t accountable, the rating agencies were paid by those they rated, Washington force-fed the system to lower the lending standards, many financial institutions leveraged up, individuals speculated in rising home prices and lost, lenders dropped the ball –etc, etc, etc.

    On a separate point, we hear from the V.Lenin/J.Carter ticket that
    “For the top 5% of income earners, we would just be raising taxes to
    where they were in the Clinton and Reagan years.” Apart from being
    factually incorrect (they’re not counting social security, etc), that
    argument doesn’t hold water anyway. 15 and 25 years ago, the U.S. had some of the lowest taxes in the world, so when they increased to
    narrow the gap, there were few places people, factories and capital
    could flee. This time, however, we are surrounded by dozens of
    countries with much lower taxes — Albania (10%), Estonia (13%), Hong Kong (15%) Russia (17%) and many more such as Ireland and China. The problem in the US now is that we are already dramatically overtaxed, which would mean a tax increase would be catastrophic as capital and business would flee rapidly. What’s the solution? Massive cuts in spending, well beyond what anybody in Washington (except Ron Paul) would ever dare talk about. The 3 big ones — Social Security, Medicare and Medicare — need to be dramatically cut or even abolished, because we are going to continue to lose our competitiveness otherwise. The Federal budget is some $3 trillion per year now, and it has to decline closer to the $1 trillion mark in order for this country to be able to compete.

  5. Early Halloween
    Hunger, starvation and finally anarchy in the streets with a “Kent State” style incident a day in American cities, Instructions on the net for marauding gangs on how to render fat American corpses into bio-diesel in back lanes to fuel their SUV’s used to move about, raping and plundering well to do folk. Large Hippie – like groups of people in communes trying to feed and care for each other in city parks, a revival of religion based compounds, fortified, armed, and run under their own laws popping up by the minute. Death, destruction, sorrow and hardship as to make the Depression of the thirties look mild and short, Urban types committing suicide, home after home, Our 401k savings worth nothing, our stock markets crashed to a historical bottom, George Bush, what have you done to us? What have you left as your legacy? Why do you hide in Dubai and fail to come back to America and stand trial? Who are these powerful protectors of yours, and where did they get all that money? Was it ours at one time? Why did you do this, we were a peaceful, trusting, good people before you and the likes of McCain, Delay and Abramoff changed things. Why George, Why? Are you just a very sick bastard?

  6. Can any one please explain me the leverage point mentioned in the airticle. Can anyone please explain that in smple terms. I would be thankfull

  7. Jai, Leverage means you put in as little cash as possible to buy something. (Typically 2% ) and borrow the rest.You are then hedging that the thing you buy (Real Estate in this example) will increase in value. If your investment increases in value , you have an asset that you own that has increased in value and you can sell for a profit. (you pay off what you borrowed with the profit you have made.) If your purchase loses value now are stuck with something you need to sell for a loss. You may be asked to come up with more money to keep your investment, if you refuse you only lose the 2% you put up in the first place. (The lender you borrowed from may get stuck with what you bought and you will not get credit from that borrower if you need to borrow again later)

  8. I keep hearing from the Bush haters, that it was his policy of deregulation that caused this mess. I don’t bleive it for a minute but what deregulation are they referring to in blaming him?

  9. A lot has been said about regulators, wont we see credit rating were not tranparent. What about certifying people? Where are the public accountants? who will nail them for not being true at theirwork????

  10. Unruly elite groups created this mess, causing much hardship for the common man than the elite groups. Now the Govts. are trying to compensate the elite groups for the exxagerated losses projected by them, leaving the common man to suffer silently. The greedy deeds of bold and mighty created this and result of that is borne by all especially the common poor man, who don`t have anyone to lobby for him.
    The result of these greedy deeds of elite groups were known to many who were keeping things secret to avoid the wrath of mighty or to not get pessimist label on them.

    Anyhow, happened is happened and what measures are being taken to avoid the recurrance of such catastrophe in future is what we are looking at. There should be powerful mechanism were common man` forum can question the supposedly wrong decisions taken by bold and mighty which will have wide ramifications. We have to evolve a foolproof mechanism to forsee such catastrophes.

  11. Instead the markets yawned and there appeared to be more good news for consumers – at least for the short term. Although declining petrol prices have begun to edge up after falling from an average of US$4.11 a gallon in July to a low of US$1.65 on Friday, analysts at Tempeltoncapital believe oil’s decline could send them even lower.

  12. What do you think are the changes America is going to see with Obama coming to power?

    I know the question is a bit vague but I would just like to know the view of you guys.

  13. Good clean explanation. High leverage is what brought down the market in the great Wall Street crash of 1929.

    You wrote
    3. Solution? Basically nothing. Asset bubbles happen every few years (remember the Internet boom 1999-2000?) and they will happen again. Prices must simply be allowed to adjust down.
    ======================================

    The problem with this solution is that many people who did not have anything to do with either creating or exploiting the bubble are damaged severely when the bubble bursts.

    Your argument is roughly like saying “A plane has crashed, a few people die. Don’t bother to take the survivors to the hospital. People die every day. Let them die.”

    Unfortunately letting institutions the size of AIG, BoA and Citi die has consequences that are far worse then nationalizing them for a while, cleaning house and putting them back on the street with full transparency. Some thought might also be given to limiting the size of institutions though it is obvious that large projects (of a national and international scale) need large baaanks.

    For a long term solution think software and read Daaaniel Roth’s article in Wired.

    http://www.wired.com/techbiz/it/magazine/17-03/wp_reboot

  14. I appreciate your article, but nothing is mentioned about the derivatives market and credit default swap contracts that greatly have magnified the losses, and that contributed to the excessive liquidity that fed the housing market.

    Also the part about banks being “forced to lend” to minorities and others is really a false argument. Loans were made to these and others without sufficient credit, capacity and collateral, but there was incentive to reap huge commissions lending to these people and relying upon swaps to cover for the losses.

  15. Andy C. is right, people pointing at the forcing of sup-prime lending by the fed. gov. is incorrect. The lenders were lending to anyone they could, due to competition in the lending market, investment money was flooding in from everywhere because housing prices were increasing. The loans could be defaulted on by simply returning the keys, with no down payment. Often the lenders were lying to the lendees, trying to collect their commission. They were seeking out these people for their investors not for their governments.

  16. Yes eric and andy, that is only half the story. The greed that you talk of was born from the creation of the Community Reinvestment Act which required lenders to add risk to their lending portfolios to add more lower income households and in 1992 for the 2 Freddies to give a mandatory percentage (50%) of funding to said loans by Congress. Good initiative but bad long term judgement. Once someone cant pay that over leveraged loan, a domino falls and strikes another….

  17. everyone ignores the true cause of the housing price explosion simply put it was caused by tax increases. when local taxing bodies hit the wall on property taxes, they invented higher property values (inflation) in an effort to raise more revenue,at first it seemed that property owners were reaping the rewards of their investments.then the banking industry was co-opted into this deception in order to support the false increases, when the banks realized they could make money the bubble grew at rates even the government did,not expect .All bubbles burst!

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