In 1933 Congress created the Glass-Steagall act to restrict the size and scope of banking operations, thus preventing the creation of mega-banks (that are now thought to be “too big to fail”). In 1938, Congress created the mortgage agencies referred to as Freddie Mac and Fannie Mae that created a source of mortgage financing, but placed certain reasonable credit restraints on borrowers and lenders.
This seemed to work well. Until Congress, in effect, repealed Glass-Steagell and pressured Fannie and Freddie, made private in 1968, and others to purchase loans made by individuals who entered into mortgage obligations they could not afford that required no money down and no credit checks. The previous standard of 20% down and credit checks for sufficiency of income protected the lender and had a self-limiting effect on unqualified borrowers. Meanwhile, the banks consolidated into giant holding companies after Glass-Steagall was repealed in 1999 with a bill initiated in the House and signed into law by President Clinton; this allowed them to enter into businesses that were lucrative through enormous leveraging of assets, but were vastly different from traditional banking.
The bright boys on Wall Street saw an opportunity to repackage these newly minted mortgages that were enabled by new unrealistic standards of credit into financial derivatives called Collateralized Mortgage Obligations. CMOs were divided into segments called "tranches" based on the credit worthiness of the underlying securities. Everybody made money. The Wall Street traders made money, Fannie and Freddie made money. The mortgage originators made money. The real estate salespeople made money. And the home owners used the collateral of their home to refinance and take out money that made them rich—for a while—or sold their real estate at a price inflated by easy money. Of course politicians, who enabled these transactions to take place, looked like white knights to an electorate that was previously unqualified for a loan and to everyone in the food chain that profited from the easy money.
Then interest rates went up or were reset higher by the terms of the mortgage and the whole thing went up in smoke.
The people who should not have purchased or refinanced (and would not have acted under prior restraints) a home could not pay on the mortgage. Since the value of the underlying asset for the poorest tranches became unknown, the market value for these instruments went to nearly zero. And since easy credit dried up the demand for homes (either for habitation or for speculation) declined dramatically, thus lowering the sale price which exacerbated the default problem, and increased the uncertainty over the value of the assets underlying the CMOs.
The only recent information that has become public about the sale of these distressed derivatives is the $31 billion dollar (A billion dollars is a LOT of money) asset sale from Merrill Lynch to a company in Texas for 22 cents on the dollar despite the fact that 80% of the assets are paying current interest and principal.
As I write this on September 30, 2008, banks that two months ago sold agency securities to buy CMOs are receiving great cash flow from these same CMOs but cannot sell the securities because there are no buyers for them. Certain entities must carry the value of these securities on their books at “market value” in a process know as “mark to market.” Since these assets have no buyers the market value is unknown. Accounting convention, however, requires that these CMOs be carried on the books at a value of ZERO but since 80% of even the worst of these assets are paying current interest the Zero valuation is unrealistic. The result is that the institutions that hold these securities indicate a net worth of far less than reality would indicate and are therefore unable to borrow or lend as freely as would be possible if the rules allowed for a realistic appraisal of those assets.
This is a key cause of the “liquidity crisis.”
Since the ability of these institutions to borrow and lend becomes more restrained and the value of these businesses become uncertain, other institutions are unwilling to take the risk of transacting business with these companies or anyone else—locking up the entire system.
Beginning with Bear Sterns in March to the latest failure by Wachovia, the Federal Reserve has made preemptive and arbitrary strikes to resolve individual liquidity problems with commercial and investment banks. This has included guaranteed loss protection by the Fed for the acquiring entity, and has resulted in losses to equity and, in some cases, debt holders of the target companies. The remaining few enormous banks have been transformed by the government actions from thousand pound gorillas to ten-ton rogue elephants that are certain to stifle competition and dominate the marketplace for years to come.
Following, and coincident, with these actions that destroyed billions of dollars of wealth, everyone from the President, to the Treasury Secretary, to the Chairman of the Federal Reserve, to our leaders in Congress, to the talking heads on TV, told us that a liquidity crisis is at hand and that unless the government buys distressed mortgages from the private sector, we are certain to have another great depression. Politicians helped create the mess and now they are promising to fix it.
What we now have is a federal government that owns 80% of Fannie and Freddie. Fannie and Freddie own 50% of the mortgages in the country and insure another 20%. Now the President and Congressional leaders propose to own even more mortgages by purchasing up to $700 billion dollars of failed mortgage assets. Who would have ever guessed that our government would become the largest mortgage company in the world!
All of the hysteria by the politicians and by the talking heads on TV has made the impending crisis a self-fulfilling prophecy. If the deal to socialize the real-estate market is not done as promised in Congress then panic will undoubtedly follow, and the market place will self-correct in a way that is certain to be painful but will be resolved as buyers eventually step up for distressed assets when the price is right. The package, as it is presented, does not solve the liquidity problem and adds another bizarre element, the federal bureaucracy, into the mix. Since we all know how inefficient governments (no matter how enlightened) are at dealing with real problems, why are we looking to this program for salvation? Because we will grasp at any straw when told by our leaders that we face the prospect of drowning. If the deal in congress does get done, heaven help us. We are doomed to an economic death by a thousand cuts and will be saddled with a truly socialist government.
There are many ways to solve the underlying problem of liquidity and panic. There are no simple solutions but a few things can be done to resolve current conditions and still allow for the transparency that complete information provides. Two easy fixes come to mind.
1. Mark to market should be eliminated and replaced with a valuation based on cash flow or some other criteria. This will immediately improve the balance sheets of many financial entities and unlock working capital.
2. Eliminate the existing cap on FDIC insurance, a program that is now well funded by the member institutions. This will take cash out of short-term treasury bills, put it back into the banking system where it belongs and eliminate the panic mode over the safety of cash that has gripped the nation.
Modifications to other existing programs are available and should be considered. What should be off the table is the nationalization of the mortgage industry by the federal government.
But the bottom line is, that despite the scare tactics of many both in government and in the private sector, the availability of college loans will be there—if only by the college endowment funds in support of their overpriced tuitions.
Brian Smith has owned and operated businesses in a variety of fields for more than 40 years. He retired fifteen years ago a self-made millionaire but still consults on general business issues "when the spirit moves him" at a day rate of $6,000.00.