How Did It All Happen

By Jon Hainer

In the financial industry, the word “bank” is generally used to refer to a “commercial bank,” a financial institution chartered by state or federal government that accepts deposits and makes a lot of different kinds of loans to consumers and businesses. Savings and loans, now called savings banks, accept deposits but focus primarily on making residential loans. Both kinds of “banks” are subject to stringent regulatory supervision by federal agencies; their examiners visit, audit and rate these banks on a regular basis. However, the media often uses the word “bank” to refer to financial entities that don’t accept deposits and are subject to very little government regulation or oversight. These include mortgages companies and brokers that make home loans and finance companies, as well as Wall Street’s investment banks which are primarily in the business of buying and selling stocks and bonds. Wall Street banks created and “mortgage-backed-securities” (MBS) that were backed by sub-prime home loans; they were snapped up worldwide by small investors and corporate investors including banks, mutual funds, retirement funds, etc. Defaults on sub-prime mortgages and a growing flood of foreclosures, followed by a sharp decline in home prices, caused huge losses slashed the value of MBS supported by sub-prime mortgages. Losses suffered by investors and banks around the globe triggered the current worldwide financial crisis.
The problem arose when unregulated mortgage lenders made home loans to people with questionable credit at unfavorable terms meant to offset the added “risk” to the lender. Often, the loans were for more than the sub-prime borrowers could afford and the terms were “predatory” in that the amount of periodic “resets” to a interest rate resulted in an unexpected and excessive increase in monthly payments Unregulated mortgage lenders sometimes made huge profits for making risky loans which were immediately sold to banks that frequently failed to analyze the credit quality of the loans, which were immediately resold to greedy unregulated Wall Street investment banks. Wall Street created securities which were backed by “pools” of sub-prime mortgages on residential real estate - which was going up in value. The securities were sold to domestic and foreign consumers and investors.
When the value of residential real estate plummeted, the value of the mortgage-backed securities sold by Wall Street tanked. Big investors and ordinary people suffered enormous losses and stopped buying mortgage-backed securities, and Wall Street stopped buying loans from commercial banks. Commercial and savings banks lost one of their primary sources of income (used to make new loans) and had to limit the funds they lend. Naturally, they also stopped buying loans from mortgage lenders. At the same time, but to varying degrees, commercial banks suffered deepening losses from defaulting sub-prime loans, often forcing a foreclosure which usually caused banks to lose about 40% of their investment in the loan (asset). As the value of residential properties have fallen below the amount that homeowners owe on their mortgages, increasing numbers are returning house keys to lenders and “walking away.” More than a few are consumers who bought property to re-sell it at a profit but received terms less profitable to the bank by fraudulently claiming that they would be resident owners of the property. Developers, also, have walked away from unfinished projects. Consequently, the requirements for approval of both commercial and consumer loans are more rigorous and loans to residential real estate developers are scarce.
While the implementation processes relative to the current $700 billion “bailout” bill passed by Congress have yet to be clarified, it is clear that the government is funding Wall Street by buying their mortgage-backed securities at more than their current value on the theory that they will be re-sold at a profit at some future time to pay taxpayers back. Something further may have to be done to increase the liquidity of cash-poor commercial banks that are limited in the number of community-based loans they can make to consumers and small businesses.