the LYNCH report

The Power of Clear Insight

What Really Led to the Credit Crisis?

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While the US government tries to put a $1 trillion (yes, you read that right: trillion) bailout package together, and Mr. Barack Obama and others in favour of governmental economic interventionism call for greater regulation (without any specifics), there is plenty of discussion as to what got the economy to this perilous state.

The answer is very simple: risk has been divorced from financial underwriting decisions.

At the very heart of the current crisis are the so-called “sub-prime” mortgages. The banks who offered these mortgages faced no downside in the event a mortgage defaults. That not only makes for imprudent lending decisions, it rewards them.

Here’s why: a customer comes into a bank and requests a mortgage, the payments for which he or she can’t really afford. If the bank bears the loss in the event of a default, logic dictates the banker will very carefully scrutinize the customer’s finances and ability to repay the mortgage. Doing otherwise puts the bank at risk, so the mortgage application is diligently underwritten.

But that’s not the way the process actually worked.

Instead, the banker approved the mortgage application and issued the loan. The mortgage, meanwhile, was immediately sold to Fannie Mae or Freddie Mac. Fannie or Freddie guaranteed the mortgage against default, bundled it with other mortgages, and sent it to Wall St., where the bundle of (now guaranteed) mortgages was sold to investors as Asset Backed Commercial Paper.

On the surface, you have a winning combination: investors get a chance to invest in a product backed by real assets and with a guarantee against default. Banks get paid up front for the sale of the mortgage. The original customer gets to buy a house he or she never thought possible to afford. No one loses. The bank doesn’t care if the borrower ultimately defaults: it has cleverly divorced itself from the consequences of poor underwriting decisions. The investor who bought the ABCP doesn’t care much either: his or her investment is guaranteed against default by Freddie Mac and Fannie Mae who, it’s very widely believed, would never be allowed to collapse (which has since proven to be true). Even the borrower doesn’t care: the value of the house is sure to go up, building equity against which he or she can further borrow to buy that boat and big screen TV he or she has always wanted.

Except for one overlooked detail: the entire scheme is predicated upon housing prices never going down.

What might have prevented such a scheme from ever materializing? That’s easy: the linchpin of the whole dubious set up is Freddie Mac and Fannie Mae. That’s the point at which underwriting became divorced from risk. Without Freddie and Fannie guaranteeing the mortgages against default, the investors buying the ABCPs would have been confronted with the actual downside potential. That, obviously, makes them far less attactive investments, and acts as a natural braking mechanism against an oversupply of credit. With less money flowing back to the banks, the motivation to put ever more risky mortgages on the books is removed: the riskier any particular mortgage is, the less valuable it is when the bank sells it.

Suddenly, that same customer applying for a mortgage on a home he or she cannot possibly afford is confronted with a banker shaking his head and suggesting a far more modest mortgage, the payments for which the customer can actually afford to service.

How did Freddie and Fannie get into a position of causing such a mess? President Roosevelt, as part of his “New Deal” economic interventionism, created Fannie in 1938 specifically to cause an increase in liquidity for mortgages. That liquidity, exactly 70 years later, led directly to the current crisis.

And where does that leave us today? With the US government proposing a taxpayer financed $1 trillion bailout for the purpose of increasing lending liquidity. And removing, again, financial underwriting decisions from the consequences of those same decisions.

Take a moment to have a chat with your grandchildren: tell them the economic sky is going to fall yet again within the next 70 years. Tell them we’re sorry for causing it, but it seemed like a great idea at the time…

5 Responses

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  1. Democrats created the Fannie Mae and Freddie Mac problems years ago. They stopped ALL eforts at reform until it was too late. Now they are trying to blame Bush, McCain and Republicans, everyone but themselves. That’s the Gods truth and here is the proof:
    http://strategicthought-charles77.blogspot.com/2008/09/democrats-created-fannie-mae-and.html

    Charles

    September 20, 2008 at 3:05 pm

  2. […] the fact artificially increasing the supply of credit (via Fannie and Freddie “guaranteeing” othe…, it seems there is wide-spread agreement among Washington politicians that socializing the US […]

  3. […] taxpayer bailout liability, us government bailout cost to taxpayers Following on from our article on the real source of the “credit crisis”, we’ve had a ton of requests for the methodology behind our assertion that the average cost […]

  4. […] we previously wrote, the government-created surplus of credit, dating back to the 1938 creation of Fannie Mae, caused […]

  5. […] a comment » As we previously wrote, the current crisis in the financial markets could not have happened without Freddie Mac and Fannie […]


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