Banks lend money to people and businesses. The money is used for investment purposes and consumer purchases such as food, cars, and houses. When these investments are productive, the money eventually finds its way back to the bank, creating the overall liquidity of a well-functioning economy. Money cycles go round and round when the economy is working effectively.
When the market is disrupted, the financial markets tend to go up sixteen. The liquidity cycle can slow down, freeze up to a certain point, or stop altogether. This is true because banks are highly leveraged. A well capitalized bank is only required to have 6% of its assets in core capital. The residential mortgage collapse is estimated to cause credit losses of about $400 billion. This credit loss is about 2% of all US equities. This hurts the bank’s balance sheets because it affects their 6% core capital. To compensate, banks have to charge more for loans, pay less for deposits, and create higher standards for borrowers, leading to fewer loans.
Why did this happened? Once upon a time, after the great depression of the 1930s, a new national banking system was created. The banks had to come together to meet high standards of safety and soundness. The purpose was to prevent future bank failures and prevent another disastrous depression. The Cajas de Ahorro y Préstamo (which still exist but today are called Banks) were created mainly to lend money to people to buy houses. They took their depositors’ money, gave it to people to buy houses, and kept these loans in their portfolio. If an owner did not pay and there was a loss, the institution took over the loss. The system was simple and the institutions were responsible for the construction of millions of houses for more than 50 years. This changed dramatically with the invention of the secondary market, collateralized debt obligations that are also known as collateralized mortgage obligations.
Our government created the Government National Mortgage Association (commonly known as Ginnie Mae) and the Federal National Mortgage Association (commonly known as Fannie Mae) to buy mortgages from banks to expand the amount of money available in the banking system to buy homes. Wall Street firms then created a way to expand the market exponentially by bundling mortgage loans in clever ways that allowed originators and Wall Street to make huge profits. The big broker-dealers were mortgage-backed securities securitizers and resecuritisers who sliced and diced different parts of the mortgage loan pools to be bought and sold on the stock market based on prices set by the market and market analysts. Packaged as securities, mortgage loans are bought and sold like stocks and bonds.
In the quest to do more and more business, the standards for getting a loan were lowered to the point where, in at least some cases, if a person wanted to buy a house and could claim to be able to afford it, they got the loan. Borrowers with weak or poor credit histories were able to obtain loans. There was little risk to the lender because, unlike the days before, when mortgage loans were held in their portfolios, these loans would be sold, and if the loans defaulted, the losses would be borne by the investors or buyers of these loans, i.e. , not the bank that granted the loan. The current result is the tumult in our economy from the mortgage collapse that has disrupted the financial system in general and affects all lending in a negative way.
Who is responsible for this situation? All loan originators, including banks, are responsible for turning a blind eye to loans that were based on poor credit criteria. Under the label of “subprime” loans were low-documentation loans, no-documentation loans, and very high loan-to-value loans, many of which are the foreclosures we read about every day. Wall Street is responsible for propelling this system into a financial disaster that may grow from the current estimate of $400 billion to over a trillion dollars. Real estate agents, mortgage brokers, home buyers, and speculators are responsible for their willingness to pay higher and higher prices for homes in the belief that prices will go higher and higher. Basically, this fueled the system for the mortgage collapse.
Are there similarities to the savings and loan crisis of the 1980s? Between 1986 and 1995, Savings and Loans (S&L) lost about $153 billion. The institutions were regulated by the Federal Board of Home Loan Banks and the Federal Savings and Loan Insurance Corporation. These entities passed laws requiring S&Ls to make fixed-rate loans only for their portfolios. The rates that could be charged for these loans were determined by the market. Imagine an institution with $100 million in loans at 6% to 8%. For years, interest rates on deposits were also regulated by the government. The differential interest rate between the two institutions made it possible to obtain a small profit.
In 1980, the United States Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). A committee was established in Congress. Over a period of years, the committee deregulated the rates S&Ls could pay on savings. Nothing was changed with respect to what could be charged for mortgage loans. Many institutions began to lose large amounts of money because they had to pay market rates of 10% to 12% on their savings, but were stuck with their old 6% to 8% loans. Some executives in the savings and loan business referred to this committee as the bloody idiots in Washington.
Many books have been written about these events. There is documented evidence of material wrongdoing by S&L executives attempting to invest funds to save their institutions, sometimes for personal gain. Some were sophisticated criminals. Congress recognized its mistake in 1982 when the Garn-St.Germain Depository Institutions Act was passed to allow S&Ls to diversify their activities to increase profits. It also allowed S&Ls to make variable rate loans. He was too young, too late. After the government liquidated the failing institutions, the surviving S&Ls were valued at billions of dollars by the Federal Deposit Insurance Corporation to replenish the fund that insures depositors of all US banking institutions.
The mortgage collapse and savings and loan crises are similar with respect to the presence of greed and criminal activity. They are very different from the fact that the S&L crises originated from a broken government-mandated regulatory system and the mortgage collapse has been caused primarily by a system run amok with greed.
This has affected non-bank lenders, such as private commercial finance companies that provide hard money real estate loans, purchase order financing and accounts receivable financing. Most of these firms have raised their prices and their origination standards for the safety and solidity of the operations.
The bottom line: Bank loans can be superseded by other sources, such as commercial finance companies, to some extent. Hard money, purchase order financing, and accounts receivable financing will help some businesses grow during these tough times. But for the average borrower, businessman, or business owner, these are tough economic times, brought on by the collapse of mortgages, that are here to stay for several years.
Copyright © 2008 Gregg Financial Services
