Market Meltdown • What Happened?
By Travis Baugh (10-03-2008)

People are understandably upset about the current financial crisis, and the proposed $700 billion “bailout.” We are hearing a lot of posturing by politicians about getting even with those persons who are responsible for creating this problem. Well, they don’t have to look farther than the closest mirror.

The ultimate event that has cascaded us into the current financial crisis was the failure of two government-sponsored entities (GSE’s), Fannie Mae and Freddy Mac. The underlying cause of their demise was the Community Reinvestment Act (CRA) passed in 1977 under the Carter Administration which forced banks to provide mortgages to persons with too low of an income to be able to afford a home under the banner of “equal loan access.” It did not really do much until 1995 when the program was dramatically expanded by the Clinton Administration through the authorization to securitize CRA loans containing sub prime mortgages. Bear Stearns was the first investment bank to package and sell securities, which were collateralized by subprime mortgages. Fannie Mae began buying and/ or guaranteeing these CRA mortgages in 1995. As a GSE, the markets believed that debt issued by Fannie Mae and Freddie Mac was as good as gold. These GSE’s were able to borrow virtually unlimited amounts of money to buy CRA securities, with implicit US government guarantees.
As Fannie Mae’s and Freddie Mac’s appetite for these securities grew, banks had to dig further into the barrel to find new borrowers. They could not qualify these new borrowers under the traditional criteria of (loan to equity, % of income, etc.), so they started qualifying people under gimmicks such as zero down payment loans, adjustable rate mortgages (ARMs) or interest only loans, knowing full well that these borrowers would never be able to pay the higher interest rates contemplated in these mortgages.

One can only assume that the banks counted on rising home prices to take care of the problem. Of course, by throwing in a whole lot of new buyers into the market place, home prices started to rise inordinately in relation to inflation, which temporarily made everyone happy but ultimately caused a bubble in the housing market. The problem is, when the money stopped flowing, the music stopped and there were many more sellers than buyers. The subprime and Alt-A borrowers started defaulting on their mortgages in massive numbers, causing huge numbers of foreclosures and putting more properties on an already depressed market.

Now everyone is pointing fingers at each other, especially at the Bush Administration. But the “inconvenient truth” is the Bush Administration proposed setting up a new division within the Treasury Dept. to start supervising Fannie Mae and Freddie Mac in September 2003. These plans were thwarted by the Democrats who believed that efforts to regulate the two entities would hamper their ability to provide financing for lower income families. Rep. Barney Frank (D-MA), a leading proponent of these practices, stated at the time “the more people exaggerate these problems [Fannie Mae’s and Freddie Mac’s unregulated expansion into subprime mortgages], the more pressure on these companies, the less we will see in affordable housing.” John McCain sounded a warning bell about a possible collapse in the mortgage market in 2005. He co-sponsored the Housing Enterprise Regulatory Act of 2005 with Charles Hagel (R-NE), Elizabeth Dole (R-NC) and John Sununu (R-NH), which would have regulated Fannie Mae and Freddie Mac. It was never even scheduled for debate. An attempt to resurrect it in 2007 also was thwarted.

In hindsight, the fact that Fannie Mae and Freddie Mac had a lot of friends in Congress was not surprising. A few months ago, revelations began surfacing about “sweetheart loans” made to several members of Congress from Countrywide Financial, the largest purveyor of subprime loans. Recipients of these sweetheart loans included Senators Chris Dodd (D-CT), chairman of the Senate Banking committee, who reportedly saved $75,000 on his inside deals from Countrywide. Fannie Mae and Freddie Mac were also active campaign contributors. During 1989-2008, the two persons who received the most were Senator Dodd ($165,000) and Senator Barack Obama ($126,000). To be fair, it should be noted that during the same period, John McCain also received contributions from Fannie Mae ($862!). Obviously calling for regulation of Fannie Mae and Freddie Mac does not pay!

Given the above facts, the latest tirade from Nancy Pelosi that these problems were caused by “right wing ideology” is at best disingenuous. What we need now is leadership from our leaders, not political grandstanding.

But what to do now? The House of Representatives rejected the $700 billion plan put forth by the Bush Administration and Secretary of Treasury Henry Paulson. This would have restored some liquidity to the credit markets (i.e. banks) allowing normal lending practices to happen (anyone tried to get a loan recently?). With their ability to lend money decimated by their stagnant mortgage portfolios, banks are unable to make loans even to credit worthy customers. All commerce depends on credit, so shutting down the lending capacity of banks essentially shuts down commerce. Which will lead to a recession or even depression.

We can learn from a similar situation that occurred in 1986-1987 when real estate located mainly in the southwest US declined 20-40% in a short time. This was totally due to a liquidity issue, similar to what we are facing today. During that period, virtually every major bank and savings and loan in Texas and the rest of the southwest failed or merged in distress. Their loan portfolios contained large numbers of non-performing mortgages. In that situation, many banks and savings and loan organizations were taken over by the government and the mortgages and repossessed properties were transferred to a new government entity called the Resolution Trust. However, rather than sell the properties in an orderly fashion, the Resolution Trust dumped all of these mortgages and properties as quickly as they could, compounding already soft market conditions. The results were some real bargains: investors from California and the East Coast swooped down and picked up some prime real estate for pennies on the dollar. And guess what? Within 2-3 years, values rose back to within spitting distance of the original basis of the mortgages. These investors made a ton of money. All because they did not get caught up in the hysteria of a liquidity crisis.

Remember the depiction of the panic in the film “It’s a Wonderful Life” where only the fictional Mr. Potter did not panic and ended up owning most everything? Now we have the same situation and the same opportunity for calamity or stability. We can either exacerbate the problem by doing nothing or put some liquidity into the market and allow the real estate markets a reasonable amount of time to self-correct.

The media has inappropriately labeled this legislation as a “bailout” of financial institutions. Nothing could be further from the truth. Virtually every major Wall Street investment bank is now either bankrupt, closed or merged into regular banks at pennies on the dollar. Several of our large banking institutions (Wachovia being the latest example) have also failed. The investors and employees of these institutions have all lost virtually everything they had. So it’s too late to bail them out. As hard as it may seem to swallow a $700 billion rescue, the alternative is much worse. The only ones being bailed out are us.

Travis E. Baugh is a CPA and President and CEO of LifeCap Resources LLC, a medical technology consulting organization. Travis and his wife Darlene reside in Great Valley, New York.