The Financial Accident Chain

With a tip of the hat to Mark the Pilot, the financial collapse was a confluence of unforeseen events in various sectors of the economy, all of which are largely regulated!

1. The mortgage backed securities business begins in the 80’; led by Salomon Brothers and largely due to the savings and loan industry collapse. S&L’s found themselves lending long at modest rates when they made mortgages and paying higher rates for short-term depositors and got squeezed out. The creation of mortgage backed securities allowed lenders to off-load the mortgage paper, a good thing, but also took some creditability out of the underwriting process and institutions were no longer directly impacted if the loans failed.
2. In the early 90’s there were concerns raised that banks and others were not lending enough in distressed areas (a process called redlining). Studies proved there were similar foreclosure rates across all neighborhoods suggesting the same underwriting criteria were being applied equally – basically the borrower needed a down payment and good credit. The problem wasn’t banks were overly protective in lending in distressed areas; there simply weren’t enough viable borrowers. Not good enough said the Clinton administration – we need more loans. Thus the relaxation of normal underwriting guidelines and the birth of sub-prime loans.
3. Meanwhile our friends on Wall Street determine sub-prime loans which carry a slightly higher interest rate can be bundled up, packages and also sold as mortgage backed securities and we are off to the races, so to speak.
4. Foreign emerging nations, China in particular, are now piling up hoards of US cash as they provide goods to the US. Typically investing in US Government securities, they are discouraged by low investment yields – Wall Street says have we got a deal for you – mortgage backed securities, particularly those backed by Fannie Mae and Freddie Mac – which – wink,wink – may have some form of Federal guarantee. Further, securities are broken into “traunches” which carry varying levels of risk and return. For example, the first 80% of the principal value carries a lower rate, as there was less likelihood of default.
5. The credit rating agencies (S&P, Moodys and Fitch), relying on historical data driven by tradiotonal lending – a down payment and good credit – improperly rate the newly minted securities giving a false sense of security to bond purchasers.
6. The Bush Administration makes home ownership a priority and does nothing to rein in the making of sub-prime mortgages prompting the beginning of Fannie Mae and Freddie Mac excesses. Congress also does nothing not wishing to squelch the American Dream for those who can’t afford it anyway.
7. The banks and Wall Street firms recognizing the profitability of the mortgage-backed securities leverage their own capital to unprecedented levels.
8. Alan Greenspan keeps the Fed rate low – banks borrow at 1-2% and invest in 5-6% mortgages. The new paradigm of the 3-6-3 rule: borrow at 3%, lend at 6% and on the golf course at 3:00.

Finally, as the economy slows, homeowners walk away from homes, the collateral value for mortgage-backed securities diminishes rapidly and the upward spiral in housing prices reverses to the detriment of all.

Who’s to blame: no one and everyone. As of July 2009, there have been no major scandals or indictments related to the collapse of the economy.