Tuesday, October 7, 2008

Economic Mayhem--A Little Simplification

Please excuse my absence from the fray. My wife and I just returned from a two week visit to France, a long delayed trip celebrating my retirement some year and one-half ago. This won't make you feel any better but people are as confused and distraught in Europe as they are here about the economy. I may not be able to make you feel any better but at least I hope I can help reduce all the mass media and political excrement to plain English. Think of it all as what happens when you throw a rock into water--it sets up a rippling effect of ever increasingly larger waves. The rock in this case was composed of tens of thousands of mortgages of which some 5 to 10 percent were much larger than the recipients could afford and became foreclosures. (We'll come back to the cause(s) in a minute.) Most banks sell home mortgages to secondary markets and make their money in origination fees. Larger banks and some pure home mortgage lending companies, retain many of the mortgages they make, thus increasing their margins by keeping the origination fees plus the interest paid by homeowners. The largest home mortgage lender in the nations were quasi government- owned "Fanney Mae and Freddy Mac." When large numbers of homeowners begin to default on their loans, those institutions holding the mortgages begin to lose revenues. Unfortunately, home values also began to decline in a number of geographies and this trend accelerated. Therefore, a large percentage of mortgage defaults left lenders with assets (houses) that had values less than the money owed on these houses by defunct homeowners. In other words, lenders were left with collateral worth less than the amount of money they had loaned and continuing to decline in value. And the number of defaulted home loans was increasing dramatically.

So, who's at fault? In this election year, each political party is pointing fingers at the other. Here are the facts. In the late 1990's during the Bill Clinton administration, Mr. Clinton decided that more low-income Americans ,particularly minorities, should have an opportunity for home-ownership and directed Fannie Mae and Freddie Mac to lower their requirements(income, credit record, down payment). The result was-- guess what? thousands of previously unqualified borrowers were given home loans. But this is only part of the problem. Greed was the real culprit as home values had been dramatically increasing for a number of years and "everyone" wanted a piece of the action. After all, one could borrow more money than one could afford but not worry because the value of houses was going up so fast that borrowers figured they could always sell at a large profit. Flipping houses became the game of the day. Meanwhile, banks wanted in on the action because they viewed such loans as virtually risk free because of the accelerating values, thus if a borrower defaulted on their loan, the bank would gladly foreclose and sell at a nice profit. In this atmosphere of greed, banks and other mortgage lenders relaxed their loan qualifying requirements. The situation was this--borrowers were willing to take chances beyond their income and many lenders were encouraging them to do so.

Meanwhile, investment banking firms, like lehman Brothers, were like greedy sharks smelling the blood of profits to be made off all these mortgages. They bought the mortgages and bundled them into marketable securities. Further, to tempt investors, they also created and issued instruments that amounted to insurance against potential defaults, though they did not label them as insurance to avoid regulatory issues. Banks and other investors all over the world were also tempted by these enormous potential profits from mortgages and/or the securities made up of mortgages. Thus, such mortgages, so many of which were made to borrowers who were not qualified, became leveraged many times to investors all over the world.

Therefore, when defaults began flowing like water over Niagra Falls and home values began tanking from unrealistic and non sustainable levels, the tentacles of disaster ran wide and deep, resulting in the demise of investment and commercial banks around the world, as well as major insurance companies, like AIG, who also had succumbed to the temptation of greed. The result has been a "drying up" of available capital--banks just don't have the money to lend or are unwilling to do so in this environment. Without capital, our economy cannot be sustained, let alone grow. Thus, we have seen the federal government step in with several actions designed to increase liquidity of funds and try to avoid the greatest recession/depression since the Great Depression. Many citizens and small business owners have been and remain under the impression that the government funds being infused are simply "gifts" to bankers and big business. That simply is untrue. The government is receiving assets for these cash infusions. Granted, no one knows what the present or future value of these assets is or may become, but they are not gifts. This misunderstanding is the fault of the media to a great degree, calling such actions "bailouts" and other terms implying that they are free and clear gifts. Even the government only has so much money it can put into the fray and it must choose where it does so based on getting the biggest positive impact toward restoring a healthy economy. Clearly that is the banking industry which must supply needed capital to fuel big and small businesses and thus attempt to restore economic vigor. Government interference in a free economy such as ours is difficult medicine to swallow. Unfortunately, it's the only alternative.

Let us hope that in tonite's debate, both candidates will quite pointing fingers and put forth concrete ideas and detailed implementation plans to help solve our economic crisis. Neither has done so to date. We continue to hear a lot about the need for change but never details as to what that means. Distortion is rampant at this stage in the campaign. Unfortunately, that is nothing new. It's time to force some specific answers from the candidates. Let's hope tonight's format of voter participation in the questions will hold their feet to the fire and maybe, just maybe, someone, whether voter or moderator, will have the guts to say, what the hell are you talking about and what do you mean and not let them off the hook until they give a full ad detailed response.

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