As most people know, the current financial crisis had to do with real estate and mortgages. But who’s to blame? Politicians have told the world that Wall Street is to blame. This is an outright LIE! As people may know, what happened is easy to explain. People bought houses way outside of their means, borrowed too much money and drove up the price of real estate to unsustainable levels. Then when the real estate bubble burst and variable rate mortgages made payments unmanageable for borrowers, it launched an economic recession the likes of which this country hasn’t seen since the Great Depression of the 1930s. So, who’s to blame for this economic catastrophe, if it isn’t Wall Street? First of all, why isn’t Wall Street? For one thing, how many people that bought a house met a Wall Street investment banker, mortgage banker, mortgage bond trader or mortgage bond structurer? The only person that home buyers came in contact with from a financial point of view are probably their mortgage lender. So, it can be established that no one on Wall Street talked to home owners. So, if that’s true then Wall Street couldn’t have convinced home owners to over buy, over borrow and over stretch their budgets. Nor could Wall Street have convinced home buyers to get into variable rate mortgages. So how did these bad things happen? If people can’t accept the answer that no one is to blame but themselves and their greedy machinations then the only other scape goats are the real estate brokers and mortgage lenders. The funny thing is that the vast majority of real estate brokers and mortgage lenders are middle-class, middle-income people. How ironic is that that these middle-class people got hurt too. A lot of real estate brokers and mortgage lenders had to be laid off when the real estate markets crashed.
Some have blamed Wall Street in another spurious manner: The mortgage bonds and derivative products that they issued. The long and the short of it is that, yes, sloppy due diligence was at fault, but it wasn’t people on Wall Street that did the sloppy due diligence. Again, it was the mortgage lenders at the local bank, whose boss was putting pressure on them and the boss’ boss the head of the mortgage lending group and above him/her is the CEO, who’s under pressure from politicians to abide by the Fair Lending act of 1994 (yes, under Bill Clinton’s administration). The Fair Lending act forced banks to lend more money for home ownership, particularly to minorities and the government started buying more and more mortgages through Fanny Mae and Freddie Mac. For banks to lend more money to minorities, they needed to lower credit standards. However, they couldn’t do it selectively as this would be deemed prejudiced. So they had to do it for everyone. Combine this with people seeing real estate prices rise and millionaires being created from house flipping, greed takes over and off to the races we go. As an aside, the Fair Lending act is yet another well intentioned legislation that had some brutal unintended consequences. Anyway, as demand for more and more mortgages accelerated, banks needed a way to fund the demand for more and more mortgages, and this is where Wall Street comes in. Wall Street figured out a way to give banks and borrowers a cheap way to fund the ever increasing demand for mortgages: They created mortgaged backed securities (MBS). MBS are designed to make more and more money available at the lowest interest rates possible and spread the risk of owning mortgages to as many people as possible. The mechanism of how this is done isn’t for this post, but suffice it to say that it was very successful in achieving its goals. However, there were some weaknesses in the business model: 1) It relied on credit rating agencies (particularly Moody’s and S&P) ability to correctly identify risk, and 2) the ratings assigned to MBS were based on the assumption that relatively normal economic environments would prevail. What this means is that as long as the economic environment in the US was relatively normal (including moderate economic fluctuations) the bond ratings would be fairly robust. The problem was that the ratings agencies could not and did not predict the meltdown of the real estate market. This meant that when the real estate market collapsed, the MBS ratings became meaningless, could not correctly predict the default risk and precipitated the collapse of the MBS markets. This in turn triggered insurance provisions, which called for insurance companies to make up for the loss, which caused the bankruptcy of insurance companies. Not only did insurance companies go down hill, banks couldn’t collect mortgage payments, which caused defaults on the MBS and investors started losing tons of money, so they started dumping any and all MBS and other assets to raise cash to protect their clients principal. These events then caused all assets to decline in prices, everyone started pulling back spending, which then snowballs into the worst recession since the Great Depression. Throughout all this, Wall Street’s role was to try its best to fulfill America’s need for more and more mortgage funding at the cheapest rates possible. That’s all. They could not have precipitated the Great Recession because they did not have a role in convincing buyers to buy the underlying real estate let alone stretching the limits of their financial abilities. So, why don’t the politicians tell the truth? Which one of them would get re-elected, if they said that the reason for the financial pain that their constituents are going through is due to the constituents’ own bad behavior? Yet, it is easy to blame Wall Street because they are a small group when it comes to the number of votes, they have money so the politicians can get them all fired and the impact would be relatively the smallest, it sounds good to blame “greedy” Wall Street people, which plays into the suspicion, envy and jealousy that average Americans feel towards people working on Wall Street and politicians can use the blame game to raise more money from the wealthy segment of society, many of whom are a product of Wall Street in one way or another.
The bottom-line is that the Great Recession would not have happened if the real estate markets did not collapse, and the real estate markets would not have collapsed unless there was a bubble, the bubble would not have existed, if people didn’t bid-up prices of real estate at a frenzied level, people would not have bid up the price of real estate to frenzied levels unless they were blinded by greed and they wouldn’t have been blinded by greed unless they had corrupt morals and values. And, where do bad morals and values come from. That’s a subject of another post.
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