One of the main topics of interest from the water cooler to the halls of Congress is the current US economic situation. Several times a week and at practically all the presentations I have been making across the state and nation, the main questions asked are “What’s going on with the economy?” and “How did we get into this mess?”
Most people know of the difficulties, especially when they examine their portfolios or check their 401(k) plans. However, because things had been rocking along so well for such a long time, few people had really noticed what was happening. The problems we are now experiencing have brought the situation to our attention, and we want to know why it has occurred.
Our economy, of course, did not falter suddenly; it has been a slow process and can be traced back to financial and credit problems that began more than a year ago. In fact, the roots of the current situation can be traced back to the boom-and-bust high-tech bubble in the 1990s.
A few years later, when the nation underwent a mild recession, the Federal Reserve lowered interest rates, an action designed to mitigate the severity of the economic downturn. The lower interest rates naturally created an opportunity for cheaper mortgage rates, which in turn rapidly increased the desire for home ownership. The lower rates also widely expanded the practice of refinancing existing mortgages.
With the ramping up of the housing industry and diminished government oversight, the quality of mortgages fell dramatically. Unfortunately, credit was granted to new homeowners who eventually were unable to meet their mortgage obligations. As a result, default and delinquency rates soared, and by 2006, they seemed to be on an unstoppable upward spiral.
Despite this negative rampage, major banks and financial institutions continued to provide unsubstantiated loans and failed to respond by enforcing limitations. Investors and lending partners assumed the quasi-government-backed system that had been in place for so long would continue to be supportive, so they sliced and diced through a complex financial system to strengthen and improve their profit margins.
This situation was also impacted by laws designed to provide more equitable and fair access to credit. It was an excellent concept that initially allowed many worthy individuals and families to purchase homes for the first time. However, driven by political pressure to let even unworthy borrowers into the game, Fannie Mae and Freddie Mac (and then private underwriters) issued larger and larger volumes of mortgage-backed securities which pumped more money into the system to support weaker and weaker loans. In many instances, so-called “credit default swaps” were used to translate a portfolio of weak mortgages into AAA-rated financial instruments.
Credit default swaps are similar to insurance contracts designed to pay off if those assets default. Congress had decided in 2000 not to regulate credit default swaps, believing that investors would abide by their natural desire to keep their own risks at a minimum (or at least at a reasonable level). However, in the aftermath of the corporate accounting scandals that made investors skittish of the equity markets, these seemingly safe securities were gobbled up with a vengeance.
This phenomenon in and of itself wouldn’t tank the entire system because mortgage lending is only a small part of the vast international financial system. However, more problems occurred when major investment houses, unleashed from reserve limitations by a fresh round of deregulation in 2004, began to issue huge amounts of derivative securities.
Basically, these instruments are not backed by mortgages, but are designed to mimic the performance of their secured counterparts. In other words, if a group of bad mortgages are transformed into a highly rated bond through the hocus-pocus of credit default swaps, the potential loss is still no more than the presumed value of the underlying assets, and the investment can only be held by one entity at a time.
Through derivatives, however, a virtually unlimited number of eager buyers can bet on whether or not those mortgages get repaid. Thus, a relatively small (by the standards of a multi-trillion dollar market) amount of “mortgage-backed” securities can generate an enormous volume of “mortgage-related” securities, and much of this brouhaha can occur outside the realm of public disclosure.
The initial round of failures of large mortgage lenders and write-downs by major purchasers of their assets was only the tip of the iceberg of what was to come. The growing weakness of the mortgage-related investments would, over a period of several months, lead to the collapse, purchase, merger, and realignment of various financial institutions. Government rescue plans were put into place, interest rates were lowered, more money was made available by the Fed, and major banks took on government partnership. Similar phenomena occurred all around the world.
Additional plans for strengthening the economy and quelling the economic damage are now on the drawing board. They will take a while to implement, of course, and even longer to stem the tide. Still, credit is already beginning to flow, and there is little doubt that the nation’s economy has the resilience required to make a rebound over time.