Help me understand this financial crisis

[Matt Pascoe]

I?m trying to get my head around the current financial crisis. The more I think I understand, the more confused I?m getting by the comments made by our media, and especially those made by McCain and Obama.

Specifically Obamas comments that the crisis is a result of a ?flawed free market economy? and is the result of 8 years under the Bush administration. What really baffles me is McCain seems unable (or unwilling) to argue those points.

I never studied economics, and have only recently tried to understand parts of it. So I?m sure my logic is flawed and I?m messing up some facts, but heres how I see it -

Lets say I wanted to buy a home for $100K but only had $10k. I ask Joe to borrow $90K. Joe looks at the value of the home, my past ability to repay loans and decides the ?risk? is worth a 10% interest rate and offers me a loan. If Joe?s risk assessment was correct he may go on to make other loans and become a successful lender. If not, his lending days may be over.

This is free market, correct?

Now what if the government sponsors an entity (Fannie Mae) that tells Joe that they will buy any loan that Joe can make as long as it conforms to their ?guidelines?. This company now guarantees the loan and sells it as a package to investors (Mortgage backed security).

Joe no longer sees any risk and tries to make as many loans as possible and investors are buying MBS backed by guaranteed mortgages.

Hasn?t this screwed up the free market economy?

Now lets say the government directs Fannie Mae to loosen up its standards to allow more loans to conform ? enter the sub-prime (late 1990?s Clinton Administration).

This really is no longer a free market economy, right?

Housing market crashes (big surprise) Fannie Mae goes belly up and all the companies that had the bulk of their balance sheet assets held as mortgage backed securities find themselves illiquid and bankrupt.

So, how exactly does this crisis prove that the free market economy doesn?t work and why is it Bush?s fault? Why isn?t McCain crying foul? Something sure smells foul?

And now all this talk of 700 Billion needed for a bailout, but NONE of the parties seem willing to discuss the problem OR the solution. They just need the money to make it all better

Any of you guys understand any of this?

Matt

[Jeff Weston]

I won't even pretend to speak as an authority on this matter, but the nature of the job is that the guy in charge is ultimately responsible. My own personal experiences of buying homes and refinances since 2000, is that lenders always wanted to approve and push for loans higher than finances and common sense would dictate and that they really did push interest only, neg am and other hinky stuff around 2004 I noticed. I know on one of my refi's, they gave me a full-doc rate with a no-doc paper trail based solely on FICO. I can see how somebody could get themselves into a fix if they didn't know better, had a disruption in income, became ill, etc.

Whether the president is to blame is up for debate. Undeniably, the economy is in trouble and our stature as a nation in the world community has been battered. Whichever candidate wins, he has his work cut out for him.

[mrblaine]

Originally Posted by Matt Pascoe

I?m trying to get my head around the current financial crisis. The more I think I understand, the more confused I?m getting by the comments made by our media, and especially those made by McCain and Obama.

Specifically Obamas comments that the crisis is a result of a ?flawed free market economy? and is the result of 8 years under the Bush administration. What really baffles me is McCain seems unable (or unwilling) to argue those points.

I never studied economics, and have only recently tried to understand parts of it. So I?m sure my logic is flawed and I?m messing up some facts, but heres how I see it -

Lets say I wanted to buy a home for $100K but only had $10k. I ask Joe to borrow $90K. Joe looks at the value of the home, my past ability to repay loans and decides the ?risk? is worth a 10% interest rate and offers me a loan. If Joe?s risk assessment was correct he may go on to make other loans and become a successful lender. If not, his lending days may be over.

This is free market, correct?

Now what if the government sponsors an entity (Fannie Mae) that tells Joe that they will buy any loan that Joe can make as long as it conforms to their ?guidelines?. This company now guarantees the loan and sells it as a package to investors (Mortgage backed security).

Joe no longer sees any risk and tries to make as many loans as possible and investors are buying MBS backed by guaranteed mortgages.

Hasn?t this screwed up the free market economy?

Now lets say the government directs Fannie Mae to loosen up its standards to allow more loans to conform ? enter the sub-prime (late 1990?s Clinton Administration).

This really is no longer a free market economy, right?

Housing market crashes (big surprise) Fannie Mae goes belly up and all the companies that had the bulk of their balance sheet assets held as mortgage backed securities find themselves illiquid and bankrupt.

So, how exactly does this crisis prove that the free market economy doesn?t work and why is it Bush?s fault? Why isn?t McCain crying foul? Something sure smells foul?

And now all this talk of 700 Billion needed for a bailout, but NONE of the parties seem willing to discuss the problem OR the solution. They just need the money to make it all better

Any of you guys understand any of this?

Matt

Where does the Federal Reserve figure into your scenario for failing to bump interest rates that would have slowed down the runaway junk mortgage train? They kept lowering them which helped to inflate home prices artificially.

[Matt Pascoe]

Originally Posted by mrblaine

Where does the Federal Reserve figure into your scenario for failing to bump interest rates that would have slowed down the runaway junk mortgage train? They kept lowering them which helped to inflate home prices artificially.

My understanding of the Federal Reserve Bank -

We practice Fractional Reserve Banking - Banks are required to keep a certain fraction of their deposits liquid, the rest they invest (banks never have enough cash to cover all of their deposits). The Federal Reserve Bank dictates this fraction and lends the banks any amount they may be short at the federal funds rate. The federal funds rate is calculated based on the amount of reserve available (a market driven rate). The Federal Reserve bank can manipulate this rate by dictating the amount of reserves (the fraction) that the regional banks are held to.

From my (very narrow) perspective the Federal Reserve did nothing wrong. The interest rates that they were charging made sence.

Our mortgage crisis wasnt caused by the interest rate, but by out of control lending practices condoned at some leval by our government.

If the Federal Reserve raised interest rates, couild it have avoided this problem? I doubt it. The average Joe was allready borowing more than they could afford to pay back, whats a couple extra points?

I know I'm missing something, but it sure seems to me that the root cause was the Clinton Administration allowing sub-prime mortgages to be gauranteed by Fannie Mae.

[mrblaine]

Originally Posted by Matt Pascoe

My understanding of the Federal Reserve Bank -

We practice Fractional Reserve Banking - Banks are required to keep a certain fraction of their deposits liquid, the rest they invest (banks never have enough cash to cover all of their deposits). The Federal Reserve Bank dictates this fraction and lends the banks any amount they may be short at the federal funds rate. The federal funds rate is calculated based on the amount of reserve available (a market driven rate). The Federal Reserve bank can manipulate this rate by dictating the amount of reserves (the fraction) that the regional banks are held to.

From my (very narrow) perspective the Federal Reserve did nothing wrong. The interest rates that they were charging made sence.

Our mortgage crisis wasnt caused by the interest rate, but by out of control lending practices condoned at some leval by our government.

If the Federal Reserve raised interest rates, couild it have avoided this problem? I doubt it. The average Joe was allready borowing more than they could afford to pay back, whats a couple extra points?

I know I'm missing something, but it sure seems to me that the root cause was the Clinton Administration allowing sub-prime mortgages to be gauranteed by Fannie Mae.

What started the frenzy, the way I remember it, is the historically low mortgage interest rates. That snowballed, once the normal correctly qualified quantity of good loans for homes was about tapped out. Then the re-fi, neg am, rev am, 50 year, and interest only crap kicked in to fill the demands and needs of the frenzy in an inflated housing market.

I think the economy would be in much better shape had the vast majority of re-fi-ers not pulled money out and spent it unwisely on toys for the desert, boats, RV's, Tow Rigs, and similar.

The large amount of those who did that produced an artificially high spending rate which mimicked a booming economy that was doomed to start a downward spiral in a couple of years once the shiny wore off the toys and the extra income that wasn't there was needed to support that lifestyle. About the same time the adjustable rates kicked in which drove mortgage payments up.

So, you had rising and high fuel costs, income that didn't increase or if it did, it only covered the higher fuel costs, toy payments, higher mortagages and falling housing prices which reduced wealth only on paper. It became easy to default and walk away when you're looking at a home with zero or negative equity, and higher payments than income. Remember, the low interest rate also made it easy to purchase many big ticket items.

If the Fed had starting ticking up the rate to slow down the loans, would it have made any difference?

[Lawrence]

Here are my $0.02.

Financial institutions have always provided loans to “prime” and “subprime” borrowers. Nothing new, and all was good because of the responsible lending practices.

But when the government started to push the notion that every citizen shall live the “American Dream” and should own a home, greed settled in, the subprime market took off, and we all know what happened.

With that previously untapped resource now available, greed came from all levels. From the financial institutions making billions by making loans; from the construction companies being busier than ever with new developments popping up like mushrooms; from borrowers living the lifestyle they couldn’t afford; from shady brokers cheating the system and pushing these borrowers into homes they couldn’t afford; and from investors buying those loans hoping to cash in on this new “Gold Rush”. All was good and everyone cheered on our so-called booming economy, especially those government officials who were at the source by relaxing lending rules.

Now, everyone is pointing fingers at each other, expecting a bailout. My questions are, why should the government bailout private or public companies? Why aren’t there more financial executives wearing orange jump suits?

As far as the bailout, why is this the government (read ours) responsibility to pay for this mess? Those are publicly traded companies, not government owned ones. Is this the fear that our banking system would then be owned by foreign banks, most likely Asians since a great number of European banks were those investors buying loans hoping to benefit from this?

Blaine and I talked about this the other day, and here is a perfect example we discussed. Let’s say that tomorrow, the execs at Ford wake up and think the best idea since slice bread is to start producing a V12-twin-supercharged-double-sized Excursion. So, they stop R&D and production on every other product to solely concentrate on this beast, which will be the “wave of the future”. Now, they don’t sell a single unit, and Ford is on the verge of going bankrupt. Should the government bail them out? Should taxpayers really be responsible for their stupidity, especially when it is a publicly traded company?

Now, about the other question. Following the Enron debacle, Sarbanes-Oxley was put in place so that every officer of a company becomes responsible for the company’s actions. So, why aren’t there more investigations into this whole mess?

Believe me, there were some shady deals going on, and one might call them plainly illegal. Real estate agents were in bed with brokers; brokers were falsifying documents left and right; banks were buying these loans without questioning anything, sometimes with full knowledge; banks owned, and most still do, construction companies and appraisal companies; and I can go on forever.

These same individuals made millions while creating this mess, washed their hands off of it, and are not being held responsible. Am I the only one seeing something wrong with this picture? Can anyone tell me where I can sign up for a gig like this so that I can finally be independently wealthy?

[TObject]

Another good question, I think, is how we can benefit from this ordeal. For example, should I go out and take the most outrageous loan I can find, and not pay for it?

[Kiwi]

Originally Posted by TObject

Another good question, I think, is how we can benefit from this ordeal. For example, should I go out and take the most outrageous loan I can find, and not pay for it?

You're a little late to the party, that's sorta what started the mess

[Art Welch]

Credit default swaps are at the root of alot of it:

http://en.wikipedia.org/wiki/Credit_default_swap

When mass defaults were deemed unlikely this was an easy way to make money. Many / most entities had some balance in their exposure, AIG didn't and had written a huge amount of insurance in this area with no balance on the other side, kaboom. I read a story recently about a hedge fund that agreed to insure something like a 1 billion dollar portfolio of mortage assets against default for something like $2mm, great, the only issue is that they only put up like $3mm of assets against it. That won't work.

Leverage is another enemy. Investment banks such as Bear Stearns and Lehman Brothers borrowed money to the extent that they were leverage 30 or 40 to 1. In other words for every $1 of their own that they invested they were actually on the hook for the gains or losses for 30-40 times that. Great when it is gains, not quite so much of a party when it is losses.

I'm a free markets guy but the situation was indeed screwed up by woefully inadequate government oversight. I don't know enough about the history to attempt to trace the root of it to a particular administration.

As for the bailout, it sucks, but in my opinion it is necessary. Without credit our economy grinds to a halt. As it is now it is getting harder and harder by the day for any person or entity to borrow money. People are scared and banks are scared and want to hold on to the money they have to protect themselves.

The only blessing may be that the "in the know" people that I know seem to think that in the end the american taxpayer may end up making money off of this and it may turn out to be the trade of the century. We will see I guess.

[Gunnys TJ]

There are quite a few of us waiting to see if the bill passed. We all bought 1000 shares of FNM at .82 last week just to see what happens. Today may work out very well in our favor.

Edit: Well tomorrow, its 5 AM monday morning here.

[TObject]

And this is it? They predicted the end of days if we don't pony up $700 billion dollars. Where is the end of days? The Dow is still over 10000 points.

[Art Welch]

It isn't about the Dow or even really about the stock market at all, it is about the credit market. Much of the media trys to present it in a way that indicates it is about stock prices since that is all they understand and all that their readers understand. It isn't correct though.

Some believe that we are now on the verge of seeing an even bigger round of bank failures:

http://www.reuters.com/article/busin...e=businessNews

For a good but something lengthy discussion of the issues around the situation check out the article "Who's Afraid of a Big, Bad Bailout?" at this site. You do have to provide your email address to read the article unfortunately but it is worthwhile:

http://frontlinethoughts.com/gateway.asp

[TObject]

My credit card still works.

[Art Welch]

Originally Posted by TObject

My credit card still works.

Along those lines:

http://online.wsj.com/article/SB1222...googlenews_wsj

http://consumerist.com/5056487/ameri...-25000-to-1800

[Lawrence]

Originally Posted by TObject

My credit card still works.

1RUR=US$100,000 so you're good

[Matt Pascoe]

Originally Posted by Art Welch

For a good but something lengthy discussion of the issues around the situation check out the article "Who's Afraid of a Big, Bad Bailout?" at this site. You do have to provide your email address to read the article unfortunately but it is worthwhile:

http://frontlinethoughts.com/gateway.asp

Thanks for that link Art.

Thats the first discussion of a bailout (excuse me, Economic Stabilization Plan) I've seen that specifically addresses the problem AND shows that the solution may not be that bad of a deal to taxpayers. Almost makes me want to run out and buy some of these AAA rated RMBS's at pennies on the dollar. Sure they are not worth what the banks paid for them, but they do have value and there seems to be zero buyers for them at present.