The crisis: The explanation

It is as complicated as trying to trace one noodle in a plate of spaghetti.

I was asked during a recent television interview, “Who is to blame?” That is like asking who is to blame for a bowl of tangled pasta. The guy who invented spaghetti, the cook, the sauce and the one who is eating. No one is to blame; everyone is to blame for “The Crisis.”

What is the root cause of this global financial crisis? There isn’t any. This crisis is the result of a progression of events. US government policies created a legal framework that the financial institutions maximized for their business interests, and consumers participated so they could get wealthier, all for the purpose of a long-term housing boom.

Home ownership is a critical part of Western economies. This is why government policies are geared to keeping a continuous boom in the housing industry.

In the United States:

• Housing contributes about 14 percent of US gross domestic product (GDP).

• Home equity is the largest share of household wealth.

• Residential assets are worth nearly $10 trillion, equal to one year of US GDP.

• About 40 percent of monthly consumer spending is housing-related.

• Annually, more than $1 trillion exchanges hands from home sales.

However, in the West, no one “buys” a house. They borrow the money to purchase one.

During the Bill Clinton administration, lending institutions were strongly encouraged to broaden the base of homeowner borrowing. The power of government-backed financial institutions Fannie Mae and Freddie Mac to guarantee these loans was greatly expanded so that much lower-income people could buy a house. With more people being able to borrow-to-buy, the housing sector boomed as housing prices increased continuously over a decade and individual wealth grew fantastically as the value of their homes increased.

During the Clinton presidency in 1999, Congress passed the Financial Services Modernization Act (FSMA) that repealed the Glass-Steagall (GS) Acts of the 1930s. In response to the Great Depression, GS separated commercial banking and investment banking. The Great Depression was caused, in part, by banks loaning money for speculative buying in the stock market. When the market fell, those loans could not be repaid and the banking system failed.

Commercial banks borrow money from depositors and loan money to businesses and consumers. Investment banks and stockbrokers use client funds for speculative investments like the stock market. GS prevented the banks from acting like stockbrokers and the reverse.

Since the 1970s, banks and investment brokers often crossed lines of their respective businesses. Brokers were paying interest on uninvested funds (money-market funds). Banks were offering brokerage services through affiliates and subsidiaries.

However, with FSMA, the line between banks and brokers was officially and legally eliminated. Investment companies such as Merrill Lynch and Lehman Brothers could now act as a bank would, offering depositor services, but using those funds for investments way outside of simple business and consumer loans. Banks bought out and took over investment companies, as Smith Barney (broker) becoming part of Citigroup (bank/insurance). Banks were brokers and brokers were banks. Now they were called “financial-services companies” (FSCs). And they were incredibly successful.

Although accounting for less than 3 percent of the total US GDP, FSCs eventually booked 30 percent of all US corporate profits.

Government policy was to increase homeownership and the lenders were making a fortune cooperating. One way to get more borrowers was to lower the credit standards to receive loans. These were called “subprime” loans, meaning the borrowers had less than a “prime” credit rating.

Government ignored these bad lending practices as they achieved the goal of more homeowners. The private sector did not care because it was making lots of money. Existing homeowners were happy because home values were always rising and, with more credit available, they could buy home number two or three as an investment.

As lending criteria loosened significantly, the natural progression was the kind of loans finally made in the last two to three years: “Ninja” loans, or “No Income, No Job or Assets” loans. Home lending became almost like a pyramid scheme, with a constant demand for new participants to keep the pyramid of rising home prices going, and these new “investors” were brought into the pyramid through borrowed money.

When the line between banking and investing disappeared, the banking side of the FSCs that loaned the money put many of these loans in investment packages and “sold” them to investors on their brokerage side. This increased the amount of money available for lending.

Institutions around the globe bought these packages as a good, safe investment vehicle. After all, Fannie Mae and Freddie Mac guaranteed almost half of all US housing loans. Further, the “packages” included thousands of individual loans spreading the risk of loan default.

Housing prices had increased almost without hesitation for more than a decade, so the underlying collateral of the loan was solid. These were home loans and people will do almost anything to pay their loan to avoid losing their homes. Increased lending was also fueled by decreasing interest rates from 2001 (6.5 percent) to 2003 (1 percent), and rates remained flat for a year.

By mid-2004, the picture could not have been any better. The US stock market rose from 8,000 to 10,000 from 2003 to 2004. There was an almost unlimited amount of global funding for housing loans. Home-loan interest rates were at the lowest level in 25 years. Home sales had never been any higher.