Knowing which of these relates to the recent legislation makes all the difference.
To understand the financial meltdown through the clutter and self-serving rhetoric, it’s helpful to know how it started - in everyday language. With that understanding, the panicked noise of the past several weeks may have better context - also in plain language.
Mortgage lending, traditionally, was relatively basic stuff for lenders, mortgage companies and borrowers. Lenders provided funds for home purchase based on things like; amount of down payment, borrowers’ debt as a percentage of income, credit history, and employment stability. They were encouraged to lend larger sums than they would for unsecured ‘personal loans’ or credit cards because the borrower’s down payment assured them that the property held as security was worth more than the loan.
Lenders knew that home prices would increase significantly over the long term (15 years or more), but would be subject to market fluctuations in short term (7 years or less). They also knew that interest rates were at historical lows and were more likely to increase than decrease.
During the mid 1990’s, mortgage lenders wanted to capitalize on the cash from the dot com boom and the financial industry expansion. Rather than use those traditional lending practices, they invented new products that ignored basic lending principles. They lent 100% of the home value, with no money down and interest-only payments to eager home buyers. ‘McMansions’ dominated the landscape because paying only the interest meant that people could afford a much larger home for their reduced monthly payment. That meant that the lender had no equity in its collateral. It also meant that if home prices went down, the homeowner would owe more than the home was worth…and would not be making any reductions in the principal.
Mortgage lenders also offered ‘low-doc or no-doc’ loans. That meant that they offered loans without proof of income, and sometimes without verification of employment and other normal requirements. These products abandoned all traditional safeguards for the lender and dramatically increased the risk.
Why did they do it?…Because many of the companies who were selling the loans to consumers didn’t keep the risk. They sold their loan portfolios to mortgage servicing companies and other financial institutions thereby leaving the new owner of the portfolio with all the risk. Those companies, in turn, bundled the portfolios of mortgages to sell as securities to investors who believed the mortgages were sound and secured by real estate. The risk moved again to a new set of investors (Wall Street)…and so on!
Then, real estate values dropped and interest rates increased.
- The mortgages lost value because the loans were no longer fully secured.
- Interest rates increased, so monthly payments on interest only loans grew higher than people could afford.
- Delinquencies and foreclosures grew, increasing the number of houses on the market and further lowering property values across the board.
- Elimination of ‘sub-prime’ loan products further reduced the number of borrowers able to qualify and acted as a ‘brake’ on new home construction.
- Financial institutions with an increase in ‘sub-standard’ loans were forced to increase their reserve for bad debts which decreased their profits, reduced their capital (cash) and led to declining stock prices. In some cases, the impact was large enough to force mergers or bank failures.
- Those who invested in these mortgage portfolios found themselves with an asset they couldn’t sell because the value had deteriorated dramatically. Their net worth plummeted, confidence in their ability to recover disappeared and they teetered on or fell into bankruptcy.
Finally, the impact of all these factors led to the high profile failure of major financial institutions long thought to be stable and a virtual panic in our government and world financial markets.
When President Bush and the Treasury Secretary proposed the initial plan to prevent further collapse, it was certainly structured for speed, the infusion of cash to major institutions to prevent collapse, and the removal of damaged asset portfolios from those financial institutions most at risk. The problem with that proposal was that it sacrificed taxpayer protections, independent oversight and specific justification for the number $700,000,000,000. The Administration also failed to properly describe the activity as a purchase of assets (for later sale and recovery of investment) allowing most to assume it was a bailout of inside Wall Street execs whose greed caused the problem.
The other problem with the hastily drawn proposal is that the use of the word ‘bailout’ fatally flawed the ability to sell the need for a ‘rescue of the economy’ to an angry and shocked public. The initial bill recently defeated in the House of Representatives included significant taxpayer protections, appropriate oversight and a more deliberate approach to when and how the assets would be purchased…and in what amounts.
As the second round legislation passed, people should understand that the taxpayer money spent initially is an investment in undervalued real estate that will be held and managed until higher value can be restored. At that time the assets will be re-sold and the profits returned to the taxpayers, or the losses assessed to the financial institutions.
There will be accusations, panic, fear-mongering and taking of credit by almost everyone. That aside, failure to remove these damaged assets from the books of financial institutions would have had a ripple effect resulting in economic catastrophe. Not for the wealthy and greedy who caused the problem; they’re already quite well off. The business failures for lack of credit, the foreclosures that further depress the housing market and the layoffs that reduce income and spending…would have impacted every sector of the economy and every American. It would also have had a lasting effect on investor confidence here and in world markets.
We will still experience a downturn whose depth and duration are unknowable at this point. But both the depth and duration are mitigated by recent Government infusions of investment and capital. Whatever your political affiliation or ideology, this is about all of us and our economic future. This is a rescue, not a bailout…and it had to happen.
Art Campbell
Mr. Campbell is President/CEO of Cherry Hill Regional Chamber of Commerce and the former Chief Executive/Retail Banking at a $3 billion commercial bank.
