[The original motivation behind this post was the Occupy Wall Street movement, and how I felt it needed a clearer, more focused agenda to accomplish the change it envisioned. I thought providing a better understanding of the events that led to the global meltdown of 2008 that is still affecting us today would help. What I did nt count on was the more I looked into things, the more inspired I became to present a factual narrative on the primary elements that contributed to the crash. Hence, this one simple post evolved into a series.]
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Leading Up to the Crisis
I promised I would not address politics on this site. And I wont. However, I do feel compelled to comment on the “Occupy Wall Street” (OWS) movement that is rising around the country, and now even around the world. Not from a political, but a businessman’s point of view.
After more than 20 successful years in the debt management and settlement industries I have seen first hand what the economic crisis has wrought on so many. And no one empathizes with those facing financial uncertainty or struggling to meet their basic needs more than I. It is just another of the many reasons my wife, Jeannie, and I donate our time, efforts, and money to charities. There are a number of ways to spread the wealth, and when you have it, it is a human being’s responsibility to do so.
To protest is our right, and God bless America as around the world we cheer for those with the courage to rise against tyranny. I believe our system’s peaceful transference of power from George Bush to Barack Obama is what ultimately inspired and motivated the people of Chad to overthrow decades of totalitarian rule. Watching the American democratic process at work, how then could any with less liberties not demand, “Why can it not be the same here?” Their raised fists clenched a clear, definable agenda. As a consequence, Chad’s success led to Egypt’s, and now (finally) Libya. Unfortunately, the jury is still out on Syria, and I’m constantly looking over my shoulder at Iran. Yet, when an autocracy imposes violence and murder against the will and spirit of its own people, history proves it is only a matter of time before it, too, becomes a footnote in history.
To accomplish the same result, the OWS movement has to now take all that pent up frustration and emotion and focus it on making real changes in our legislative policies. Some rallies drew as many as 2,500 people, but then what? You can't have a concert every weekend.
I support their right to protest, even understand and agree with the frustration that created and motivates it. But to bring about the real change it envisions needs more than the nebulous “Corporate greed,” and “against the rich” rhetoric. It needs a clear agenda, even more important, it needs a true understanding of how the crisis really occurred in the first place in order for it to be addressed to keep from happening again. The on-going economic crisis is not just the result of corporate greed and “fat cat bankers,” but a cumulative tsunami set in motion decades ago that ultimately inundated our landscape. Interestingly enough, what caused the current mortgage and economic crisis is a near exact model of what led to the stock market crash of 1929 and the Great Depression.
It is said the crash of '29 and the ensuing depression were caused by commercial banks underwriting stocks and bonds with their depositors’ savings, and then promoting only those stocks of interest and benefit to the banks, rather than to the benefit of the individual investors; a serious conflict of interest. So in 1933, President Roosevelt enacted the Glass-Steagall Act. This law forbid banks, insurance companies, and brokerages from consolidating and operating under one corporate umbrella. It also stipulated that commercial banks had to be separate from investment banks to protect depositors’ money from being invested in high risk securities. Glass-Steagall also established the Federal Deposit Insurance Company (FDIC). Sure makes sense to me, and it withstood the legislative passage of time for nearly seven decades.
Then in 1938, the Federal National Mortgage Association (FNMA)--Fannie Mae--was established. Simply put, the more mortgage loans the banks gave, the less capital they had to lend. Fannie Mae bought those mortgages to free up the banks’ capital and liquidity so they could turn around and make more loans, and the cycle continued. Fannie Mae created the first secondary market, and post WWII was a prosperous time.
For 30 years after its inception, Fannie monopolized the secondary mortgage market, and its profits were astounding. Then in 1970, the government authorized Fannie to purchase private mortgages--mortgages not insured by the FHA, VA, or FmHA--while it also established the Federal Home Loan Mortgage Corporation (FHLMC)-- Freddie Mac--to compete with Fannie and create a more dynamic secondary mortgage market.
To conform with Fannie’s guidelines, loans had to be insurable by the FHA, that is they had to be for owner-occupied, single family residences only, with a maximum of 80 percent loan to the property’s value (LTV), and borrowers’ debt to income ratios could not exceed 36 percent. That left neighborhoods of low- and moderate-income families without much hope of ever owning a home.
So in 1977, Jimmy Carter enacted the Community Reinvestment Act (CRA), to encourage local commercial banks and savings associations to meet the needs of low- and moderate-income borrowers in their communities, and reduce or eliminate “redlining,” a practice the banks used to discriminate against lower-income neighborhoods they considered to be higher risks.
Then mortgage-backed securities came into play.
Mortgage-backed securities (MBS) are mortgage loans, and other contractual debt, such as commercial loans and auto loans, that are consolidated and sold as bonds, allowing the bondholders to participate in the cash flows generated by the payments made on those loans. Fannie Mae sold its first MBS in 1981.
When the Match Was First Struck
What launched sub prime mortgages? Basically, they became legal. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 allowed banks to charge fees and high interest rates to their borrowers. Then in 1982, The Alternative Mortgage Transaction Parity Act (AMTPA) enabled banks to charge variable interest rates and balloon payments. But what really boosted it was the Tax Reform Act (TRA) of 1986. Under the TRA you couldn’t deduct the interest paid on consumer loans, but you could on mortgages for primary residences and one additional home, such as a vacation home, which, for a lot of people, made high-cost mortgage debt a lot cheaper than consumer debt.
Six years later, in 1992, President George H.W. Bush enacted the Housing and Community Development Act (HCDA), amending Fannie and Freddie’s charter to "have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families." It wasn’t just the local community banks that were required to make loans in those communities, now Fannie and Freddie had to carry some of that responsibility as well. For the first time in their history, Fannie and Freddie were required to meet affordable housing goals, of which the first annual goal for each was 30 percent of their portfolios.
When the Match Lit the Fuse
It's 1998 when we have to revisit the Glass-Steagall Act of 1933, the law that forbid banks, insurance companies, and brokerages from consolidating and operating under one corporate umbrella, which was said to have caused the crash and Great Depression.
In April of that year, Travelers’ Insurance, Salomon Smith Barney, and Citibank, one of the largest insurance companies, one of the largest investment banks, and the largest commercial bank in America respectively, merged to form Citigroup. This deliberately defied the law under Glass-Steagall to form the largest financial service institution in the world valued at $140 billion.
Citicorp and Travelers were deemed so big they could pull off the largest financial merging of banking, insurance, and securities when legislation was still on the books saying it was illegal. And they pulled it off with the blessings of President Clinton; the chairman of the Federal Reserve, Alan Greenspan; and the secretary of the treasury, Robert Rubin. Then, interestingly enough, after it’s all over and done, Robert Rubin, now the former secretary of the treasury, became the vice chairman of the newly formed Citigroup. [source]
Corrupt politicians? Perish the thought.
However, Glass-Steagall did provide a grace period of two to five years to divest the assets that were prohibited by law to ensure there would be no conflict of interest, and here it gets even more interesting. When asked how Citigroup planned to stay within the law as regarding the assets, Sanford (Sandy) Weill, the Chairman of Travelers’ Insurance, and the now chairman of the newly formed Citigroup, said, “Over that time the legislation will change. We have had enough discussions to believe this will not be a problem.”
Throughout the 1990s, Citibank spent $100 million lobbying Congress to repeal Glass-Steagall. Combined with the resources of other financial institutions hell-bent on accomplishing the same goal, the total lobbying dollars were closer to $200 million. [source] Imagine, $200 million spread across how many lawmakers?
Sandy Weill was quite the prophet, for in October, 1999, President Clinton enacted the Gramm-Leach-Bliley Act (GLBA), aka the Financial Services Modernization Act. Thereafter, commercial banking, investment banking, insurance underwriting, and securities brokerage were allowed to consolidate under one very big roof. Essentially and very effectively taking the Glass-Steagall Act and throwing it right out the window--the same law that for 70 years outlawed the practices that led the to the '29 crash and depression. Afterward, it is purported that President Clinton gave the pen he used to sign GLBA into law to Sandy Weill.[source]
Meanwhile, back at the White House, the Clinton administration was pressuring Fannie and Freddie to increase the ratios of loans to low- and moderate-income borrowers. But this also increased the community banks’ ratio requirements as set by the CRA of 1977. So the banks and mortgage lenders pressured Fannie and Freddie to ease the credit requirements on the mortgages they were willing to purchase, enable them to make loans to borrowers with sub prime credit at interest rates higher than conventional loans. This increased Fannie’s risk exposure while at the same time its shareholders were expecting, and pressuring it, to maintain its record profits.
I’ve worked with many low- and moderate-income families who paid their bills on time and lived responsibly within their means, which therefore made them good credit risks. It was lowering the credit criteria that was the big game changer here. Now it’s not the amount of income or type of neighborhood, but the borrower’s credit profile, and the pressure put on Fannie and Freddie to purchase loans made to those with questionable credit histories.
The sub prime mortgage market was set to explode.
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