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

Background Old 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 our Backs! It became a wide open frontier, and all of the normal business checks and balances were thrown out the window, by businesses.

Meanwhile, back at the ranch… 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.