John Leonard : The Credit Crunch

When Did the Credit Crunch Begin?

There are a million theories as to where this mess all began. I believe it began during the 90’s economic expansion, the dot-com bubble, and subsequent bust, continuing to about 2005/2006 when the real estate market topped-out and interest rates began to rise. In the late 70’s many people had 19% mortgages - unbelievable! This ensured that home prices would be depressed - it would be like putting your house on a Visa card! During this time, and really back through the 80’s, interest rates were on a march downward (with a few hiccups).

During the 80’s mortgage interest rates marched lower and continued to do so, with the exception of the recession of the early 90’s, into the 00’s. During this time of incredible long-term growth and with the levels of wealth being generated by teenagers in the garage with a computer was obscene. It was a fairy tale economy.

Things really began to accelerate in the late ’90’s with the passage of the Community Reinvestment Act (CRA). The CRA had some good sections, but the sections we’re seeing the effects of forced lending institutions to lend money to bad credit risks because of economic status or race.

The Next Step of The Financial Crisis

The growth and success fueled the publics adrenal gland. Because more and more money was available the price tags of big-ticket items followed suit. This was made possible by low interest rates to finance over-priced purchases. I bought my house in ‘98 for $179,000 - I paid $7,000 over the asking price and was sweating bullets. Over the next seven years I watched the house go to about $600,000 in value. I couldn’t help but ask, “who in their right mind would pay $600,000 for this house?” The answer was that, like me when I bought my house, people were qualifying for a payment, not a purchase.

So even though I paid $179,000 with +/-7% down and a 7% 30 year fixed mortgage with a $1,500 payment, people were paying $600,000 with 3% down on a 30 year adjustable rate mortgage (ARM) at 2% with a $1,700 payment seven years later. Then interest rates started inching up and the ARM’s started adjusting up and the $1,700 payment became a $2,500 payment within a few months time. The people who had maxed-out on an ARM to buy their house were now incapable of making their payments.

Banks began to see their delinquencies rise and more homes were going on the market because families couldn’t afford the payments, but all was good (except for the people losing their homes) - most of the loans were made to people with the wherewithal to make the higher payments.

People began to dump their houses because nobody could buy them at their previous values at a higher interest rate and this started driving home values down, but all was good - it was just a market correction from the runaway real estate inflation of the last few years.

The Other Shoe Begins to Drop

As time continued to march on, we began to see the effects of the lowered standards due to the CRA and a rabid frenzy in the real estate market. A few lenders took moderate write downs on their portfolios because of losses due to falling home prices and the need to unload the foreclosures, but everything was OK - they were being above-board with the issues and they took the losses on the chin. Countrywide announced that there was a small slowdown but business was good and profitable and they are staying the course.

Lender losses begin to mount. Countrywide can’t survive and is eaten by Bank of America for a song. More and more lenders are taking writedowns (translate: losses) on their portfolios in the hundreds of millions of dollars. This is now a Wall Street correction. After every announcement, no more major announcements are expected (ostrich?)

Then it comes to light how many seemingly pristine securities are tainted by a sprikling of the bad loans and additional, non-lender, institutions begin to see major losses. IndyMac Bank is seized by the Fed. Bear Stearns can’t maintain themselves after a banner decade of multi-billion dollar profits and are gobbled up by JPMorganChase for pennies on the dollar. Lehman Brothers lose their footing and suffers the same fate.

Surprisingly, at least to me, rumors of liquidity problems at Washington Mutual began to surface and they announced that they were looking for a buyer. They basically had a run on the bank because of the horror stories of people losing their money at IndyMac and it killed their liquidity and they were seized and sold to JPMorganChase in a sweetheart of a deal.

It’s A Wonderful Life

I didn’t really think much about the Countrywide sale, but when the Bear Stearns, Lehman, and WaMu sales happened I realized something. Do you remember in “It’s a Wonderful Life” when there was a run on the bank and on the building & loan and Potter took control of the bank and came within a dollar of eliminating the building & loan as a competitor? James Stewart hit the nail on the head - “Don’t you see? Potter’s not selling, he’s buying!” and he wound up owning the bank because everyone was panicking.

I’m not saying that BofA, JPMChase or Citi are evil, to the contrary - I mention this because it shows us who the strong, stable financial institutions are and, in my opinion, they just became stronger because of their acquisitions.

So what of the other $700 billion that congress is yammering about? It is indeed a crisis that need to be addressed - it is growing.

A Global Problem

I am experiencing the unspoken freeze that is occurring in the world financial markets. Very little is traveling to and from the united states as Congress debates the bail out. The worlds finances are in paralysis.

Most probable outcome? Outlay of $900 billion or so because they underestimated the magnitude of the issue. I expect it to eventually evolve into a situation similar to the Resolution Trust Corp that dealt with the S&L bail out. Eventual net cost? $650 billion.

Worst case scenario? Banks lose liquidity to a magnitude that smothers the Fed’s ability to bail out. Major banks forced to call lines of credit due - UTC, IBM, Boeing, General Motors all having their credit lines called due, are forced to default, are seized and auctioned to the high bidder for pennies. This chain of events could cause millions to be unemployed and usher in times very similar to the 30’s. When I mention this, people disagree and say it won’t happen, but they don’t say it couldn’t happen.

What Are Our Options?

The question is, “what should we do?” What will probably happen is tht the Fed will buy the bad loans, service them, and sell the surviving loans on the secondary market over the next decade, similar to what they did with the Resolution Trust Corp that was created to resolve the S&L crisis. The difference this time is that it’s bigger. This solution will be passed because Congress needs to pass something to be able to say that they addressed it and, therefore, keep their jobs in this election year. The losses will be greater and this solution will probably be followed by a homeowner bail out that will allow families who purchased at absurb prices, to keep their homes. This will add on an additional bill to the taxpayer.

What should we do? I believe that we should encourage what has already been happening. Allow the purveyors of the loans to fail and be acquired by larger, stronger organizations for pennies on the dollar with provisions to write down the loans to market value of the home in exchage for getting the sweetheart of a deal. Continue to publicize the failures, naming names, and block the members of the boards, executives, all the way down to front line managers from working in the banking or mortgage industries. They danced, now it’s time to pay the piper.

We, as a nation, have often gotten away from doing the right thing and allowing failures to fail, so I don’t expect a whole lot from Congress.

Either way we’ll get a bail out. The time to buy is now in my opinion.

John Leonard.