Thursday, 9 October 2008

Strictly Business: A Rough History of the Credit Crunch

The Dow is still down, way down, and fear stalks the land like a great big stalking thing, and folks don't really know what's going on.

I had a chat with a friend of mine who writes about politics, and we talked about the roots of all these problems, and he told me a few things, being a history and policy wonk, then I did a little research of my own and came up with a rough explanation of how the world got involved in this.

Now this isn't a political blog, so I will forgo naming any specific party or politician as being to blame, this is a business blog, and I will look at it from the perspective of money.

Let's get started...

1929- Stock market crashes, thanks to margin buying which leaves people in deep debt because they borrowed heavily to buy stocks. The money supply dries up, there are runs on banks, and most importantly, around 40% of houses are foreclosed on.

1930s- 1970s A new president starts a new policy to try to stem the foreclosure tide, by creating government backed support for loans. However, with this policy comes another policy, called Red Lining.

Red Lining denies this federal backing to mortgages made in neighbourhoods with high African-American and Hispanic populations no matter how good the applicant's credit. There were two reasons for this. One reason was systemic racism denying a key element of capitalism, credit, to people based on race, another was a trend among city planners and bureaucrats called Urbanism. This was based on the ideas of European architects and intellectuals like Le Corbusier and Walter Gropius, to clear out the densely populated urban neighbourhoods and move people into car-centric, new communities, where everything is based on traffic flow, rather than livability.

The twist about red lining, was that not only was the African American small businessman rendered unable to buy the building he rents his store-space from, or the Hispanic factory worker from owning his own home, their landlords couldn't get credit to buy new properties, nor could they get credit to renovate, or even maintain the properties they already owned.

So we got a mix of urban blight, white flight, suburban sprawl, crippling traffic jams, and the only way property developers could profit in red-lined neighbourhoods was to build sub-standard public housing and pawn it off on the state for a quick profit. And since that was the only way to do business, since small businesses were forbidden in most public housing, even more capital fled from America's inner cities. Downtown cores became economic and spiritual wastelands.

In the late 70s the government tried to stop red-lining with the Community Reinvestment Act. Now it didn't make much of a difference, since property values had declined in these neighbourhoods, as well as job and business opportunities, so very few people could actually qualify for mortgages without government involvement.

1990s-2000s- The government decided to take advantage of a strong economy and booming housing market, by pushing banks to expand their qualifications beyond the bare numbers they used to use. Political activists got involved in pressuring banks, and banks were willing to do it, but only with help to create what becomes known as "sub prime mortgages."

Enter Fannie Mae & Freddie Mac, two Government Sponsored Entities, essentially private companies whose profits are private, but their risks are carried by the government. They found a way to promote sub-primes, buying up the mortgages from the banks, bundling thousands of them together as Mortgage Backed Securities (MBS), and then selling those securities on Wall Street.

Wall Street was looking for something stable after the shady shenanigans of Enron and other boondoggles, and figured that real estate, the only product they're not making any more of, was a steady and stable investment.

Interest rates went down, and housing prices, even in previously red-lined neighbourhoods, went up. So with money cheap to get to loan, the government backing their risk, and Wall Street eager to buy these MBS, the banks started loaning to everyone and anyone who just showed up, regardless of credit rating.

Then the flipping fad went into overdrive.

People started buying properties, lots of properties, all mortgaged up to the eyeballs, with the intent to sell for a quick profit. While many professional developers succeed, the field is also overrun with amateurs, chasing dreams of instant wealth. And for a while the good times rolled, with prices going up and up and up and loads of people making loads of money.

However, there were flies in the ointment. Certain developers and financial institutions didn't care about the applicant's ability to actually pay a mortgage, because they were just going to sell it to Fannie Mae anyway, and that became the central goal of their business. It stopped having anything to do with home ownership and economic stability, it all became about getting lots of mortgages to sell up the food chain. You didn't even need a down payment anymore, with many developers paying that for you, just to get that mortgage sold and bundled. This became a magnet for fraud, with thousands of bogus mortgages made out to people who didn't exist, for land that didn't exist. The good times were rolling and nobody cared to look.

The merchant banks certainly weren't looking, for fear that any questions may upset the apple cart in a business where it was essential to sell MSBs in bulk quantities fast.

Lots of inner city neighbourhoods became gentrified, forcing the long residents to accrue massive debts to buy homes in these neighbourhoods whose rents, unless government controlled, were rising. Small businesses, and the job and business opportunities they represented, could no longer afford to operate in these neighbourhoods, and are chased out, in favour of large chain operations with large overheads.

And people who weren't interested in selling their homes got into the mess, getting home equity loans, and second mortgages, and spending the money on renovations and conspicuous consumption, confident that their home prices will keep going up and up, and they'll be in clover.

However, what comes up, must come down.

Prices go beyond the point of insanity into the realm of complete fantasy, making home ownership next to impossible for all but the super rich, or the super-indebted. This can't go on, especially with thousands of flippers getting into massive debts over multiple properties.

Mortgage defaults tripled, rising to around 6% of all mortgages. Many of these are multiple properties, owned by flippers, realising that they won't make their money back and walking away from their investments. However, many families and individuals, overextended and underinformed, are also caught up in it too.

This sparks panic, causing prices to collapse, bailout packages to be rejected, and then accepted once enough pork is larded on, several major merchant banks collapse, and many banks start getting gun shy about giving credit. This causes a spike in unemployment, causing more panic, more government flailing and blaming, and even tighter credit standards.

Now all is not lost. Watch the fight over Wachovia between Citigroup and Wells Fargo. Both are willing to spend billions and fight like dogs to gain control of a company whose assets are considered worthless. That's because while according to the "mark to market" accounting rules, the MSBs owned by Wachovia are worthless, the mortgages are still being paid. At the prices being offered, the winner could, in the long term, stand to make over a hundred billion dollars even in the worst case economic scenario that doesn't involve a zombie holocaust. Even the defaulted mortgages still represent properties that still hold value greater than the "mark to market" price.

Now you're not getting this sort of feeding frenzy with Lehman Bros. which I think is what inspired the FBI and SEC to start investigating the company, especially with the CEO taking over $500 million in compensation from a company sinking like the Titanic. To quote an old southern sheriff I once saw: Something don't pass the smell test with that one.

There were also many questions raised about the management of Fannie Mae, ranging from profit claims turning out to be bogus, to management overcompensation, and its extremely risky overextension. However these questions were quashed, because Fannie Mae was a major political donor to major politicians involved in overseeing the institution.

So, we have the big stinking pile we have now, a cycle of panic, profiteering, and political interference, mad short selling, and 5 years of stock growth is lost in a few weeks.

I think the roller coaster will continue, there will be mergers, acquisitions, and more ups and downs than you can believe. But eventually, everything will calm down. Prices will settle into more realistic realms, and business, and life will go on.


  1. You might try and find another source for your history. "Red lining" while distasteful had nothing whatsoever to do with the depth of the great depression. I can see, however, with today's racially obsessed culture that a little revisionism would be slipped into the ol history books.

    I would suggest a book by the nobel prize winning economist Milton Friedman "Free to Choose" as a little more accurate information on the actual mechanics of that collapse.

  2. I think you may have misunderstood, because I wasn't blaming Red Lining for the Great Depression.

    I was blaming Red Lining for preventing economic development in downtown areas, leading to the flight of people, businesses, and facilities from urban downtowns. And later leaving those same areas, and the people living therein, unable to properly buy into the gentrification of their neighbourhoods during the real estate boom without massive and potentially crippling debts.

    And I have the audiobook of Free To Choose. And I'm sure Milton would have called Red Lining unwarranted government interference.