The financial tsunami engulfing Wall Street threatens to drown markets and to tank the economy. The effect is being felt locally. Three factors brought this about:
1. Sub-Prime Loans Fed by Complex Financial Instruments. It was like a financial merry-go-round. A person went to a local bank, obtained a loan for a home purchase at an absurdly low introductory rate and left happy as a pig in mud.
The bank, though, did not hang onto that mortgage note. It worked with financial ‘wizards’ on Wall Street, who repackaged those mortgages into bond-like securities. Those securities were then traded in the financial markets. At that point, the borrower no longer knew who actually held the debt. Neither did the bank. In fact, neither did the ‘wizards’ of Wall Street.
These derivative securities allowed banks to off-load entire mortgage portfolios. By getting those loans off their balance sheets, banks and their Wall Street partners were able to slice and dice loan portfolios and to push them out into the bond markets. This enabled a continual remarketing of loans, thereby providing even more cash to fund housing construction .
2. Over-Extended Consumer Housing Demand. Hundreds of thousands of consumers, if not millions, were lured into buying homes at temporarily low teaser rates. The mortgage agreements specified that these initial rates would rise to normal market levels. However, many of those contracts were well below the repayment ability of borrowers who should have exercised far more prudence and restraint than they did. These were not good deals. When the hammer came down, too many of those borrowers found themselves unable to meet the higher monthly mortgage obligation.
3. The Federal Reserve. When, in the early 2000’s, Alan Greenspan, then Chairman of the Federal Reserve depressed interest rates to their lowest levels in 50 years, he set up the conditions which led to the current mess in the housing market. His purpose at the time was to stabilize the stock market and to stem any further damage to the economy. It was a good strategy because it pulled the country out of a pit. But Greenspan kept rates too low, too long -- he admitted as much in his post-retirement book.
Those artificially low interest rates had a corollary effect. They fueled a boom in the real estate market. Lured by the availability of easy money, Wall Street firms kicked into high gear to market an alphabet soup of derivative instruments (CDO’s, SIV’s, MBS’s, etc.) to keep the party going. But it could not be sustained.
Ben Bernanke, the current Fed Chairman who inherited today’s housing market bust may be repeating Greenspan‘s mistake: Lower interest rates quickly and hope that it doesn’t create more problems than it cures.
What Greenspan and Bernanke seemed to have glossed over is that existing legislation authorizes the Federal Reserve to prevent the errant behavior of financial institutions. Prudent regulatory oversight would have pre-empted the excesses of banking and financial houses. Both chairmen were asleep at the switch.
Opinion. The conservative behavior and fiduciary responsibility which America should be able to expect from its large financial institutions is a myth. If it were not, the deplorable condition of some of the biggest U.S. fiduciary establishments would not require a Federal Reserve bail-out and infusions of cash from Middle-East kingdoms
London-based Breakingviews.com is harsh on some of those bearing responsibility. Quoted in Saturday’s edition of the The Wall Street Journal, it refers to, "…the periodic recurrence of banker stupidity." Enough said.
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