To help make sense of the economic crisis that’s dominating the headlines, we asked local CPA Doug Levin of Levin & Hu, LLP to weigh in…
So how did we get into this mess?
On a smaller scale this has been happening periodically for years. The problem this time is that the extent of the bad loans is so much greater. This is primarily due to three almost simultaneous changes in the mortgage industry that started happening around the turn of the millennium. These were the sudden growth of subprime loans and exotic mortgages, as well as the lowering of interest rates by almost 3 points. The first two are now going bad at much higher rates than were predicted, and the third (with help from the first two) created an overpriced real estate market that can no longer be supported.
Let’s step back for a second and discuss each of these. Subprime loans have taken most of the heat in the press, but in reality they’re only one part of the problem. These are loans to people with bad credit and little or no down payment made at a larger than average interest rate to help those making the loans cover the higher risk.
The term exotic loans covers a wide variety of products including mortgages like interest only, adjustable APR and stated or even no documentation loans. Like the subprime loans, a new segment of the population that previously couldn’t buy a house could now qualify for a loan. Finally, the lowering of interest rates gave all buyers much more buying power than they had previously.
These three factors, by tremendously increasing the pool of available buyers as well as their buying power, are what drove that huge run up in home prices that occurred between 2000 and 2006.
Now those same factors have reversed to calamitous results. The subprime and exotic loans went bad at a much, much higher than predicted rate, forcing the almost complete removal of these products from the marketplace. Now with so many people unable to qualify to buy a house, house prices have suffered.
If you’re a bank holding any of these mortgages, you’re getting doubly worked right now. The loans are going bad much more often, and if you foreclose on the loan, the property you get is worth less than the face value of the loan. Thus banks that did a lot of mortgage lending, like Washington Mutual, have collapsed.
How does what’s happening impact the average citizen, as opposed to bankers and Wall Street traders?
Think 1929 all over again. Some historians have argued the entire financial collapse wouldn’t have happened then if the Federal Reserve had stepped in and saved a few banks before the huge bank run started. It’s quite possible we’re facing a similar situation. Back in college the most amazing thing I learned when I took economics was how $1,000 in one bank almost magically becomes $10,000 of capital in the community; and this rule is at the heart of why we must always step in and save banks if there’s a major problem.
Here’s how this works. Banks don’t sit on that money. They are required to hold back a 10 percent reserve, but the other 90 percent is loaned out to the community. The 90 percent then gets paid to someone, who puts it in their bank, which then holds back 10 percent of the $900 deposited and loans $810 out to the community. This occurs again and again until the $1,000 is increased by a factor of ten.
What’s happening now is that banks have pulled back on credit because they’re concerned about their very survival. This is bad because of the way it gains momentum in the economy. Every bank that stops lending has a tenfold effect on the community, which then forces other banks to do the same. This is what the term credit crisis means when you see it in the news. It’s a bad thing.
Should Congress pass a bailout deal?
In my opinion the rejection [earlier this week] was one of worst decisions that could possibly have been made, but fortunately Congress didn’t adjourn to go home (and campaign) as scheduled and have decided to stay in Washington D.C. to fix it.
Here’s why we need this. If you’re a banker and you’re holding questionable mortgages as some of your assets, you’re worried sick about staying solvent. If the value of your portfolio drops any more, you’re going to go out of business. So what do you do? Well, as a protecting measure the first thing you do is pull in and stop issuing credit in your own community simply because you cannot handle any more losses. Instead you invest your free funds in T-bills since these cannot go down. That way you just might be able to survive a further weakening of your mortgage portfolio. When banks stop lending, we all suffer.
The deal that just failed would have provided a means for banks to turn their mortgage portfolios into T-bills, so they would no longer have to be concerned about going out of business. Right now they can’t do that because no one is buying mortgages.
The reason the deal didn’t pass is because the average voter called their Congressional representatives like crazy over the weekend demanding they not bail out Wall Street. I think they did this for two reasons. One, they don’t realize just how important this is; and wo, the press has been misleading when they say it has a $700 billion dollar price tag.
The reality is the U.S. Treasury, if it’s done right, is going to make a fortune off of this. Uncle Sam is going to be trading its own debt and buying mortgages at a steep discount secured by American homes. Remember, most of those mortgages are still good and even if some of the loans are bad, they can foreclose on the house—or better yet offer terms to your average homeowner that just may allow them to stay in their home. It will not cost us, and will most likely actually help feed the Treasury if run right.
Is there any cause for optimism going forward?
Lots actually. Henry Paulsen the Treasury Secretary, Ben Bernanke the Fed Chairman, the FDIC, the SEC and others are catching some hell in the press but are actually doing a stupendous job of keeping this thing from collapsing. They clearly have studied both history and economics and understand the crisis we’re in. Now we just need Congress to catch a clue and get onboard with some stiffer medicine for Wall Street. MTW