The Current Credit Crisis

By Dr. Paul Lockard

Professor

Black Hawk College

Brief Summary

• NOT THE FAULT OF THE GOVERNMENT FORCING BANKS TO LEND TO MINORITIES!!!!!!.

Brief Summary:Factors Causing Crises

• Bank deregulation

• Adjustable rate mortgages

• Transformation of lending industry

• Exploding housing prices

• No market checks

• Creation of incredible financial devices

BackgroundOld Style Home Mortgages

Background: Old Style Mortgages

• Traditionally, from the 1930’s to the 1980’s, banks lent money for mortgages in a simple fashion.

• Home mortgage loans were for a fixed time and a fixed rate: 15 to 30 years.

Background: Old Style Mortgages

• A fixed rate mortgage meant that the interest rate was fixed, and therefore, so were the monthly payments.

• Predictable mortgage payments meant predictable revenue for the bank.

Background: Old Style Mortgages

• Predictable mortgage payments meant predictable payments for the homeowner.

• But it was all a bit boring for bankers…

Background: Old Style Mortgages

• Banks and Savings & Loans were careful about who they lent to, since they kept the mortgages themselves.

• Local banks – local lending – more care in lending, and more interest in helping homeowners.

Financial Deregulation

1980’s: Saving and Loan Crisis

• As a result of 1970’s inflation, banks were losing money on most older mortgages.

• In addition, state laws banned usury: excessively high interest rates.

Solution to the Saving and Loan Crisis

• In 1980 and then in 1982, the Savings & Loan industry, and the other banking industries, were deregulated.

• Republicans overwhelmingly in favor, and had large majority of Democrats with them.

Result of Bank Deregulation

• With no legal limit on home mortgage interest rates, mortgage interest rates jumped, up to 15% in a few cases.

• Also, banks could now offer different types of mortgages.

Result of Bank Deregulation:Adjustable Rate Mortgages

• The main type of home mortgage since then is the Adjustable Rate Mortgage (ARM)

• Usually begins with low interest rates, and then the bank is free to raise or lower the interest rate as it sees fit.

Result of Bank Deregulation

• Changing interest rates meant changing monthly mortgage payments: hard for consumers to budget!

• Later, to help homeowners, laws put in place to slow down how fast rates could rise.

1999 Gramm-McCain Bill

• Later, the last remains of Federal regulation were eliminated.

• This was with the support of President Clinton, the Republicans, and plenty of Democrats.

Results:1999 Gramm-McCain Bill

• Banks freed to create all sorts of types of mortgages, and to create all sorts of financial “instruments”.

Transformation of Financial Industries

New Lending Industries

• There was also a tremendous change in home mortgage business, beginning in the late 1980’s, and through the 1990’s.

Old Style to New Style

• The mortgage process was completely taken apart and rebuilt into many different stages, with more companies at each stage.

• Everyone was making a profit up front, and passing the borrower to someone else.

New Style

• Banks no longer generated home mortgages, and no longer kept them.

• They made their money upfront in application fees, and then sold the mortgage down the river to someone else.

New Style

• As long as your business made a profit, you didn’t care at all about the borrower, or whether they could really afford a loan.

New Financial Instruments

• The new technique was (and is) to combine a large number of similar loans (similar in dollar amount, interest rate etc.) into a packet.

• Then you sell the packet to someone else.

• And they sell it to someone else…

New Style

• So your home mortgage could be anywhere in the world.

Get the Government off our Backs!

• Normally, there are a number of credit rating agencies, that are supposed to rate banks, bank loans etc., very carefully.

Get the Government off our Backs!

• In the 1990’s they quit doing their job: everything a bank or a mortgage company did became prime (= top quality).

Get the Government off ourBacks!

• It became a wide open frontier, and all of the normal business checks and balances were thrown out the window, by businesses.

Housing Market

Meanwhile, back at the ranch…

Housing Market

• House prices normally increase at about the rate of inflation.

• But from 1995 to 2007, house prices nation- wide increased 70% more than inflation,

• On average, that is – some places were even worse.

Housing Market

• With the surge in housing prices from the 1990’s on, people became more desperate for a loan to be able to buy a house.

• E.g. $950,000 for a two bedroom ranch in parts of California.

Housing Market

• Lenders came up with ever more creative loans.

• They usually were ARMs of some sort, and the interest rates were set to automatically increase after a couple of years, or even 6 months.

Housing Market

• They also started to go after people that they knew should not borrow money for a house: the sub-prime market.

Housing Market

• Housing prices reached insane levels in many parts of the country.

• In economics, what goes up must come down!!!!

Housing Market

Not good news…

Housing Problems: Double Whammy

• First: Prices started to drop.

• And once they start dropping, they don’t go into reverse for awhile.

Housing Problems

• Once prices started to drop, they dropped almost as fast as they went up.

• Now many people find they have reverse mortgages: a mortgage worth more than the house.

Housing Problems:Double Whammy

• Second: All of those new ARMs started to increase their interest rates, which meant that suddenly, large numbers of mortgage rates jumped.

Housing Problems: Double Whammy

• Very quickly, starting with the subprime loans, large numbers of people found that their monthly mortgage payments were jumping.

• It wasn’t long before increasing numbers of people couldn’t afford the monthly payments.

Housing Problems

• Between rising interest rates, falling house prices and rising difficulties with job market:

• Large number of people defaulted on sub-prime loans.

Housing Problems

• And now in 2008 the problem as moved up through the line to all types of loans, including prime and commercial loans.

Housing Problems

• Suddenly, around the world, lots of US home loans are “non-performing”.

• Lenders around the world have bad loans from US banks, and are losing enormous sums of money.

Banking Crises

Not good news…

Global Financial Crises

• Banks and investors around the world have always trusted the US financial system:

• If Lehman Brothers is selling the product, its American – its safe and it must be good.

Global Financial Crises

• So banks and investors around the world purchased large quantities of home mortgages and other financial instruments from US banks.

Global Financial Crises

• So when the sub-prime crises hit, all of a sudden banks and investors around the world found that their investment bundles contained “toxic waste”.

• Now many of these investment bundles are losing money.

Global Financial Crises

• All of a sudden banks and investors around the world found that they are losing unbelievable sums of money.

• Everyone panicked, and are currently lending as little as they can.

Global Financial Crises

• Global, and local, banking systems are built on trust: if BlackHawk Bank buys something from Kewanee Bank, there is a trust that it isn’t a rattlesnake. (Of course they do their homework).

• Now a lot of that trust has evaporated.

Global Financial Crises

• We have a vicious cycle in place: falling housing prices leads to more falling prices,

• Which leads to more bank losses,

• Which leads to banks not lending to each other or extending credit

Global Financial Crises

• Which leads to financial companies that need help are cut off from other financial lenders,

• Which leads to more failures,

• Which leads to more pullbacks and lack of trust

Main Street Woes

• Meanwhile, a recession has been triggered by high gasoline prices

• Which leads to a fall in consumption

• Which leads to layoffs

• Which leads to more defaults on loans

Brief Summary, Again

• NOT THE FAULT OF THE GOVERNMENT FORCING BANKS TO LEND TO MINORITIES!!!!!!.

Analysis

Community Reinvestment Act

• Many conservatives, and the banks, blame the government for forcing them to lend to unqualified minorities.

• This is blamed on Community Reinvestment Act of 1977.

Logic Question

• Logic question:

• Please explain how a law passed in 1977 could cause the problems of 2007?

Logic Question

• Logic question:

• The financial industries lobbied for deregulation (= no government supervision) and won.

• So how is it the fault of government?

Logic Question

• Logic question:

• The financial industries restructured themselves in the 1990’s.

• How is it the fault of the government?

Logic Question

• Logic question:

• The financial industries had high profit margins through the creation of financial instruments that no one can understand.

• How is it the fault of the government?

Current Situation

• Due to the deregulation of financial industries, the failure of credit rating industry, and easy money we now have a major bank crises.