I don’t have to tell you how severe this recession has become. Jobs have been lost, unemployment is creeping up to 10%, earnings have been cut in half, 401k’s have become 101k’s. Our baby boomers approaching retirement age may have to work for an additional 5-10 years to feel comfortable in their fixed-income environment. This financial collapse has had and will continue to have extreme effects on the future of business and markets. Whether we like it or not, we are a global economy. The United States is not alone in being affected. Markets around the world have been affected by this massive crisis. I have worked in the financial industry for 12 years and September 2008 was one of the scariest times I can remember in the financial industry. Warren Buffet described it as “an economic Pearl Harbor”. Previously successful companies like Bear Sterns and Lehman Brothers were forced to close their doors, Meryl Lynch and Countrywide were forced to sell to Bank of America, Wells Fargo had to buy Wachovia, JP Morgan swallowed Washington Mutual, and the lists go on. . and in. And today the banks continue to fail at an enormous rate. We know what seems to have happened, but what REALLY happened? As an industry insider, I expose the truth behind the recession.
In 1999, President Clinton made the following statement: “For many prospective homebuyers, the lack of cash available to accumulate the required down payment and closing costs is the number one impediment to buying a home. Other households do not have enough income available to make monthly payments on mortgages financed at market interest rates for standard loan terms Financing strategies, fueled by the creativity and resources of the public and private sectors, must address both of these financial barriers to homeownership of housing”. Fannie Mac to create plans that would allow anyone interested in buying a home to achieve their goal. Lenders under the guidance of Freddie Mac and Fannie Mae eased their qualification requirements to buy or refinance a home. 100% financing was available to customers who had less than stellar credit. Stated Income Loans, No Income Verification Loans, and No Asset Verification Loans were created. The worst lenders were incentivized by selling these loans.
A borrower was better priced for jumbo loans (loans greater than $333,700 at the time) if the lender placed them in a no income verification (NIV) loan. For the lender, it was an easy transaction with better rates, less work, and an easy sale to the market through Freddie Mac. This created a rush of purchases that drove up real estate prices, and construction was at an all-time high. It was not unusual for someone to buy a property for a price and three months later sell it for a profit of $100k. This was very common during the years 2003-2006. With all the construction in most major cities booming, many construction companies would hire immigrants to help with the work. Immigration increased with people from Mexico, El Salvador, Panama, and other Central and South American countries. They were the buyers of all the inventory and the houses that were being built. It was a true seller’s market. I remember the frustration of my buyers who couldn’t keep up with the demand for homes. They would call me and tell me that they were losing deals left and right because of the other contracts that were being offered. People were bidding on each other for $30-$40k at a time. Home values were in a massive bubble.
The market was at a point where the “Affordable Housing Program” was not affordable. People were giving up on the market because it was cheaper to rent than to buy. It finally got to a point where people who previously could afford to buy could no longer afford to buy. This caused construction to slow down, workers became unemployed, and immigrants began to return. All of this led to massive inventories being left behind. Defaults began to occur first in the subprime market due to mortgage fraud and providing false documentation to lenders. It was easy for people to walk away from the house they were now upside down in. This started rearing its ugly head on October 9, 2007.
Investment banks that held these mortgages as mortgage-backed securities (MBS) were beginning to see an increase in defaults on their portfolios. This led to these securities now being written down in value, which then led to losses and write-downs. FASB accounting practices also did not help matters with the forced redemptions of these securities to what is called Mark to Market accounting. Before long, the market for these securities was non-existent and the banks had to reduce their portfolio to zero. This caused a mass panic and a rush for capital injections to offset huge balance sheet losses. That’s when people started talking about the government stepping in to save the day.
Federal President Benjamin Bernanke and Treasury Secretary Paulson were in the middle of a firestorm and had to somehow make up for these losses and not cause a financial collapse. On September 16 and 17, 2008, Bear Sterns and Lehman Brothers bank failed. Lehman Brothers were big players in the secondary market (this is where mortgage securities were bought and sold). These investment banks not only had huge portfolios of these instruments, but they were leveraging these investments 30:1. If you or I were leveraged 30:1 we would be broke tomorrow! Rumors were flying on Wall Street about who would be next, credit spreads were at record highs, and LIBOR lending rates were spiraling out of control. The Federal Government came in and as people took their money out of the banks, they guaranteed the money markets and insured these securities. They had to buy a lot of MBS and 10-year Federal Treasury bonds to counteract this crisis. TARP and TALF were created, and now the government owns publicly traded companies like Citigroup and AIG.
Risk tolerance has been neutralized and this has changed the markets forever. Now we see that this great country founded on capitalism becomes socialism. Wall Street has ceded its control to Washington DC. Elected officials have become more powerful than the CEOs of America’s largest corporations. Mortgages are getting harder and harder to get and the “easy” stage that everyone can get has passed. Now we have the pendulum swinging towards very strict regulations. Freddie Mac and Fannie Mae require a 20% down payment for buyers, credit scores over 660, fully documented income for 2 years, a very strict review if you are self-employed, and new laws and regulations are being created every day.
In my opinion, it is too little, too late. The former government blaming capitalism and the free market are the same ones that fueled the massive domestic crisis in the first place. Washington DC needs to stop being a hypocrite, let the free market reign, let failures happen, and let the rewards happen to those who get things right.