Commentary
How Did We Get Here?
There's a lot of talk about the word "greed" right now. Taxpayers talk about the greed of Wall Street investment bankers. Bankers talk about the greed of home owners who bought more house than they could afford. And now, after a decade and a half of record profits, the financial sector has gone hat-in-hand to the government looking for a $700 billion handout.
But how did we really get to this point?
The answer, of course, is complex. So complex in fact that there are scores of analysts and economists trying to untangle the mess. But the meltdown of the financial markets can be simplified by taking a long view of history.
In 1929, the roaring twenties came to a screeching halt with the crash of the stock market and a run on the banks. The depression affected the vast majority of Americans and had lasting economic consequences through World War II. Most Americans today know well the story of the "Great Depression" as told by our grandparents. But most don't know the back story and the lessons learned then that can be applied now.
The roaring twenties were fueled by an unprecedented number of Americans gambling on Wall Street -- not bankers and traders, but everyday Americans. The lubricant of this financial machine was something called "margin." Basically you could buy stock on credit, purchasing a thousand dollars worth of shares with just a hundred dollars down. Once the stock went up -- and it always did in the years leading up to 1929 -- you could sell it at a huge profit and pay off the loan and keep the rest. So long as the market kept going up, everyone made a lot of money.
But then stocks started going down. There was a mass "margin call" -- time to pay up for the stock you bought for 10% down. But who had that kind of money, especially since they'd have to sell the stock at a huge loss? Not enough had the money, and the margin call accelerated the collapse of the market and the banks that funded all that buying. As the banks started to buckle under the weight of all that unpaid debt, depositors ran to get their money out. That hastened the fall of the banks and left millions of Americans broke. The FDIC was born of that crisis, insuring individual deposits up to $100,000 in all commercial banks.
What does this ancient history have to do with the problems gripping our economy today? We all started treating our houses as investments rather than places to live -- and we bought them on margin.
You could buy a house (or two, or three) for 10% down or less. Sound familiar? You didn't need a million dollars to buy a million dollar house, just a $100,000, and they'd even let you borrow that. People started making fortunes virtually overnight as they bought Miami Beach condos pre-construction and "flipped" them for a profit before they were even built. That's right, a hole in the sky could be sold half a dozen times before anyone even moved in. With the profit, people started buying yet more properties, or larger ones. Tick, tick, tick....
Home prices shot up. And that was a good thing for just about everybody, or so it seemed. So long as the market kept going up, banks and sellers reaped huge profits. And, because the house I'm living in is suddenly worth more, why not take out a huge HELOC (Home Equity Line of Credit) and take that vacation to Europe? The buyer of our house will eventually pay off the loan when we sell! It's like free money -- what could possibly go wrong? Tick, tick, tick....
The banks got creative to make this dream (now nightmare) a reality. They started offering "exotic" loans with little or no money down. You could buy a property with an "interest only" loan and live in a mansion for less than you were paying in rent. Even at a time of historically-low interest rates of less than 5% for a 30 year fixed rate mortgage, people were opting for ARMs (Adjustable Rate Mortgages) that would lock in an even lower rate for five years before eventually rising. "But who is ever going to have to pay those higher rates?" we asked. We're going to flip the house for a huge profit before then. Tick, tick, tick...
All Americans wanted to get in on this bonanza, so the banks relaxed rules for loan approval. Don't have enough income or have too many blemishes on your credit? Don't worry, we'll just charge you a higher interest rate after five years. The "sub prime" market was seen as very profitable because of those higher interest rates. Tick, tick, tick....
Wall Street took notice. All these average Americans were making fortunes in real estate. How could the investment bankers get a piece of the action? They started cutting up mortgages and repackaging them as so called "derivatives." Investors could suddenly invest in a sure thing -- the American home -- which historically always goes up and is secured by bricks and mortar. Tick, tick, tick...
Then home prices stalled. They didn't drop, they just stopped ballooning. Many home owners feared they would lose their profit (not their house, just the money they'd "earned" over the last five to ten years). "The Jones's sold for $500,000 last year." Suddenly, thousands of home owners, then hundreds of thousands, put their homes on the market to get out while they still could. The market was flooded with supply and demand dried up while frightened buyers took a breather. Tick, tick, tick....
Home prices plummeted. A panic broke out first on Main Street. "For Sale" signs started cropping up like weeds as home owners tried to sell the roof over their heads before prices hit the basement. This was like a run on the bank. Simultaneously, millions of adjustable rate mortgages were getting to that five year point when the interest rates would jump. Many people couldn't afford the new rates and they couldn't sell. Tick, tick, tick...
BOOM! Or rather, "bust."
Then came the margin call. Banks said pay up or it's foreclosure time. Millions of people faced the prospect of losing their only home, albeit one they couldn't afford in the first place. A new term was coined: "jingle mail." Many home owners just dropped the keys in the mailbox and walked away.
The bust quickly spread to Wall Street where those derivatives that looked like such a good idea were suddenly worthless. The banks (including Fannie Mae and Freddie Mac on the secondary mortgage market) couldn't sell foreclosed properties for enough money to cover the original inflated loan and the huge home equity lines. Three of the five top investment banks, plus Fannie and Freddie, either failed or were taken over.
Fannie Mae and Freddie Mac were created to supply liquidity to the market. We keep hearing the word, "liquidity." It simply means cash or its electronic equivalent. Banks make mortgage loans to you and me, but then they have to wait up to 30 years to get that money back, so they sell your debt to Fannie or Freddie. That infuses them with fresh capital, allowing the same bank to make more loans (keeping the market "liquid").
The credit crunch became a true crisis last week when there was zero liquidity in the market. Fannie and Freddie weren't buying mortgages and banks weren't making loans to each other or anyone else. Those transactions are the engine of the entire economy. The credit cycle had ground to a halt -- the financial equivalent of going to the mall and finding all the stores either closed or refusing to sell.
The home was once the very symbol of the American dream. But now it might as well have the Enron "E" in the front yard. We gambled with the one thing we couldn't afford to lose. And now we're all going to pay for it, one way or the other.
