The Financial Crisis – Cause and Effect

2008-10-15T23:32:00.001-05:00

Fanny Mae, the Federal National Mortgage Association (FNMA), was founded as a government agency in 1938 as part of FDR's New Deal to provide liquidity to the then depressed mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the U.S.

To get Fannie Mae out of the federal budget, it was converted to a private corporation in 1968. Freddie Mac, the Federal Home Loan Mortgage Corporation (FHLM) was created in 1970.

They were two private investment banking companies formed under charter by the federal government to do interstate and international banking, specifically to provide liquidity to mortgages and mortgage-backed securities. In other words they bought individual and packages of mortgages from the primary lenders and sold them to investors in the form of stock in their companies or other securities.

They were publicly traded corporations (NYSE: FNM and FRE) known as Government Sponsored Enterprises (GSEs). Under federal regulations they received preferential treatment such as tax exemption and lowered reserve standards which other banking institutions were not allowed. In other words, they were stockholder-owned corporations authorized to make loans and loan guarantees. They received no direct federal government subsidies. Nevertheless, the corporations and the securities they issued were widely believed to be backed by the U.S. government, giving investors a false sense of security.

They were the leading participants in the U.S. secondary mortgage market, which enables mortgage companies, savings and loans, credit unions, banks, and federal, state and local housing finance agencies to obtain funds to lend to home buyers. The primary lenders could sell their mortgages to Fannie Mae or Freddie Mac, giving them the cash to fund more mortgages which they could sell to get cash for yet more mortgages, repeated over and over until virtually everyone eligible for a mortgage had one.

To keep the Ponzi scheme going, the federal government under Clinton (1999) required banks to lower their lending standards to allow lower income renters to qualify for loans to buy their first homes. With the aid of lower interest rates from the Federal Reserve Banks, banks were willing borrow more from the Fed to loan out at only slightly higher rates. Fannie and Freddie lowered their standards in order to buy up these sub-prime loans.

As more and more buyers entered the housing market, they gobbled up existing homes and created a boom in new home building as the sellers of these older homes moved up to larger and fancier new houses. Home prices rose rapidly in heavily populated areas.

The stockholders (foreign as well as domestic investors) were happy because their investments in Fannie Mae and Freddie Mac provided the funds for these mortgages that were backed by rapidly appreciating real estate assets. Their investment strategy was based on the pipe dream of a never-ending appreciation in the real estate market when, in fact, they were merely fueling the fire under the biggest real estate bubble in history.

I've lived through 3 such bubble-burst cycles since I started buying fixer-uppers in the late 1960s. None of them as bad as the Roaring Twenties boom and bust that (along with other factors) led to the Great Depression.

As prices rose, home owners anxious to take advantage of the rising equity in their homes refinanced to pull out cash which they quickly spent, causing a short-term "economic boom."

Owners of investment properties refinanced to pull out cash to invest in more income properties. Speculators bought up multiple properties with interest only or adjustable rate, 100% or even 125% loan-to-value mortgages, expecting to make a good profit fixing them up and reselling them, a practice called "flipping." And for a few years sellers were making a killing. Local governments were thrilled that their tax base was expanding, and they quickly reassessed property at higher and higher values. Happy days were here again.

But by 2006 home prices had gotten so high in some parts of the country that buyers who could qualify for even the "no-qual sub-prime" loans dried up. Housing prices leveled off. The seller’s market became a buyer's market, and some owners who needed to sell were willing to take less than "market" value for quick sales, and speculators, seeing that the party was over, started dumping their properties on the market. Prices began to fall.

All of a sudden many home owners and most speculators found themselves upside down—they owed more on their recent mortgages than the property was worth in the market.

If they were to sell their properties, they wouldn't get enough to pay off the balance on the mortgage. So rather than sell and still owe money, they quit making their payments on the mortgages and allowed the property to be foreclosed or signed them over to the lender in lieu of foreclosure (which has no negative affect on their credit ratings). They could walk away with no cash (other than the several month's worth of mortgage payments they hadn't made) but owing zero.

The lender is now holding the physical property at its current appraised value on its balance sheet rather than the higher-valued mortgage amount, having to write-off the difference as a bad debt expense. In addition they are not getting paid monthly mortgage payments (mostly interest), so their available cash is reduced. Too many of these transactions and the lending institution shows a loss on its income statement, and the balance sheet net worth goes negative when their liabilities (money owed to their depositors) and equity (money invested by their stockholders) exceed their assets (loans outstanding, cash on hand, real estate owned, and other investments).

Most corporations in that condition file bankruptcy. Their assets (right down to furniture and fixtures) are sold by the bankruptcy trustee, and the proceeds paid to the creditors (depositors in the case of banks) who accept whatever their share of the proceeds is (pennies on the dollar) and write off the difference as a bad debt or capital loss. If there is anything left over (almost never), the stockholders divvy up the rest. Usually the stockholders get zip.

In the case of a bank going under, the depositors are protected somewhat by the Federal Deposit Insurance Corp (FDIC) which will theoretically cover the depositors' losses, but if too many banks are involved the FDIC hasn't enough funds to cover even a small portion of the losses.

As of 2007, Fannie Mae and Freddie Mac owned or guaranteed about half of the $12 Trillion in mortgages in the U.S. As a result, the mortgages held by these corporations were backed by decreasing assets. Stockholders started selling their shares in an attempt to get some of their investment back before these financial institutions went belly-up, creating a mini panic in all mortgage-backed stocks. Without new funds to provide cash for more new mortgages and other loans, lending slowed and the "credit crunch" began.

Under federal law and the charters of these GSEs, the U.S. Treasury was authorized to "advance" funds for the purpose of stabilizing Fannie Mae and Freddie Mac, limited only by the congressionally authorized National Debt Ceiling.

On 7/30/08 in a law expanding regulatory authority over Fannie Mae and Freddie Mac, Congress increased the debt ceiling by $800 Billion, to a total of $10.7 Trillion, and allowed the Treasury to support the federal home loan banks.

Less than six weeks later, before any support plan drafted by the Treasury could be implemented, on 9/7/08, under terms of their charter, Fannie Mae and Freddie Mac were placed into conservatorship of the Federal Housing Finance Agency (FHFA), a federal takeover called by commentators "one of the most sweeping government interventions in private financial markets in decades." CEOs and boards of directors were dismissed and each company was required to issue preferred stock to the Treasury Department and suspend future dividends, leaving the common stock holders out in the cold and causing additional unrest on Wall Street.

When the unrest grew to potential panic, the House of Representatives quickly put together an official bailout bill as requested by Bush and the Treasury Secretary for $700 Billion to shore up Fannie Mae, Freddie Mac, and AIG (which carries most of the mortgage insurance issued in the U.S. and, through pension funds it manages, is heavily invested in FNM and FRE and other mortgage-backed stocks).

Part of the House bill to authorize this monstrous bailout stated that the national debt ceiling would be raised by another $700 Billion. Congress was inundated with pleas from constituents not to pass the bailout bill, and for once the majority of our representatives actually listened to their constituents and the bill was defeated on 9/29/08.

Meanwhile, the Senate had devised its own bailout plan which they intended to work into the House bill once it was passed by the House. When the House bill was defeated, the Senate pulled a sneaky and blatantly unconstitutional trick on the voters. They attached their version of the bailout to a continuing budget resolution already passed by the House and sent it back to the House for a revote “as amended.”

This was all done within three days; not long enough for anyone to read either the original House bill or the continuing resolution, or for the People to be informed and allowed to react. The House voted for the combined bill the same day it was received from the Senate and in about the same ratio of yeas to nays as they had on the previously passed continuing resolution, only now instead of being $150 Billion, it included the $700 Billion bailout package for a total of $850 Billion.

Whether that bill raised the National Debt Ceiling again, or was included in the 7/30/08 increase I have yet to figure out, but I will as soon as I can.

By the way, not one home owner is being “saved” from foreclosure by this bailout. The money is going to the lenders, not the borrowers. These institutions are in trouble because of the number of foreclosed properties already on their books that they can not sell in the current market unless they have the cash to lend to the potential buyers. A Catch-22 if there ever was one.

Under the bailout plan the Treasury will purchase these foreclosed properties (or the mortgages of those not yet foreclosed) from the lenders and carry them on the federal balance sheet until the real estate market recovers and they become salable, supposedly at higher prices than the Treasury purchased them for.

This is a bill of goods they’ve sold the taxpayers so that they believe they will actually benefit from the bailout. If there was any chance these properties would be worth more in a year or two, the speculators would be buying them by the thousands from the banks, rather than selling the ones they currently own or letting them go to foreclosure now. This will become another Resolution Trust Corporation (RTC) as in the early 90’s after the notorious Savings and Loan bailout, and the properties will go for ridiculously low prices to attract investors willing to hold them for 5-10 years until property values rise enough to turn a good profit.

Investors are not stupid. With maintenance and property tax expenses and low rental values (rents did not increase much during the boom because there were so many vacancies due to renters becoming home-owners), they would have to be nuts to pay anywhere near current market prices for them.

Now, where does the Treasury Department get the cash to buy these foreclosures? Every penny of the $700 billion would be “borrowed” from the Federal Reserve to be repaid (plus interest) by future taxes.

What that means is the Treasury will issue an IOU to the Fed in the form of Treasury notes, bonds and bills which the Fed and its banks can either hold or sell to the highest bidders. The US Treasury (read taxpayers) is responsible to redeem (pay off) these debt instruments at the face value plus interest at the stated rate, regardless of who holds them. The Fed will have the Treasury print up $700 Billion in Federal Reserve Notes (fiat dollars) to cover the total amount of the “credit created” to hand over to the bailout recipients.

These fiat dollars will then enter circulation in the global economy, thus diluting the value of all dollars currently in circulation, so that it will require more dollars to purchase every product or service we consume. This won’t happen immediately but as the devalued currency trickles down to the consumer level.

The hapless masses will see prices rise and bitch and moan about “money grubbing big business” raising prices and never think to blame their own “benevolent” government for devaluing the dollar—again.

When Bush entered office in 2001, the national debt was just under $6 Trillion, as of October 2008 it is $10.7 Trillion (not counting long-term obligations such as Social Security, Medicare, and Medicaid), perhaps $11.4 Trillion with the bailout—that’s $11,400,000,000,000.00, an astronomical amount of money for a population of 300,000,000 to repay.

Considering the gross domestic product (GDP) of America is around $14 Trillion and not rising anywhere near the rate of government spending, this is absurd. GDP was about $10 Trillion at the start of the Bush administration, so the debt under Bush has gobbled up more than the entire increase in American production for the past eight years and has left America nothing to show for it but higher prices now, higher still tomorrow, and much more debt to pay off later.

Bush submitted and Congress approved a ONE YEAR budget of $3.1 Trillion for Fiscal Year 2009, which began 10/1/08, up more than a Trillion Dollars (50%) from the FY2001 budget he inherited from Clinton.

Has your spending risen 50% in the past eight years? If it has, you are probably living on borrowed money, too.

The winner in November’s election will inherit that budget, along with the $10.7 or $11.4 Trillion debt. McCain would keep the status quo, and Obama would raise taxes for even more spending.

The so-called Presidential Debate on 9/26/08 was merely an argument between the Republican and Democratic candidates, rated by the media as to which scored the most points on charisma and one-upsmanship, not on their understanding or even their stand on the issues. Only two issues were addressed (Iraq and the Economy) and the answers of both candidates were noncommittal other than McCain would keep us in Iraq indefinitely and Obama would support a withdrawal with an indefinite date. The other presidential candidates weren’t invited.

In rehashing the debate over the next several days, the media showed its colors. CNN reporters repeatedly said things like: “We know the next president will be a senator,” “…whether Obama or McCain is more suitable to RULE the United States” [emphasis mine]. On and on, they bought into and sold the two party system which offered no choice at all. Either elect a military spender or a social spender.

It’s disgraceful. I hope the voters have enough common sense to throw out both major parties (except Ron Paul who repeatedly warned Congress that this sort of thing was absolutely wrong and would result in just what we are seeing today) and put some fresh blood and more responsible representation in Congress and the White House as well as local and State offices.

This election is going to see some major attacks on the two party system and the bipartisan tax and spend statists currently in office. Until we can convince enough people that voting for a third party is NOT “wasting your vote” and that voting for more of the same when both major parties are wrong IS wasting your vote, we cannot start the process of getting government back to serving the People rather than enslaving them.

The real wasted votes are those of the registered voters who stay home on election day because they don’t believe one vote matters and those who vote for one of the major party candidates because they are “confirmed” Republicans or Democrats even though they don’t approve of the candidate they are voting for.

As for me, I’m voting Libertarian, wherever one is running, as the Libertarian Party is the only one committed to reduce spending, eliminate borrowing, reduce the size and scope of government at all levels, eliminate crippling regulation of everything from unneeded licensing to regulations that are clearly unconstitutional, repeal all outdated and unenforceable laws, fully enforce those laws that are both constitutional and necessary, and end these undeclared wars and police actions all over the globe that are costing us over a Trillion a year.

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Please enter your comments on this situation and similar issues. Ask your friends to participate as well. This is not just an American problem. Most of the world's governments and banking institutions operate this way, with fractional reserve banking, creating credit out of thin air, fiat currencies backed by nothing but the taxing power of the government, and spending the taxpayers’ money without restraint. We are in serious trouble worldwide if we allow this to continue.

I hope this has made sense to you.

Joy and abundance,

Cory Layne

San Benito, Texas, USA

Take Back Your Government

The Financial Crisis – Cause and Effect