The financial crisis: looking back and looking ahead

September 25, 2008

Dr. Robert E. Pritchard
Professor of Finance
Rowan University

The world-wide financial systems are in crisis – a crisis that, if not dealt with quickly, could result in a deep recession or depression. During his first inaugural address made in 1933 during the Great Depression, FDR made his famous statement “… the only thing we have to fear is fear itself.” That was correct then, and I hope it will prove to be correct now. Together, let’s trace a bit of history to see how this crisis came about and then look to the future.

The story starts with the passage of The Federal Community Reinvestment Act in 1977 during the Carter Administration. This law was basically designed to promote minority home ownership. Unfortunately, however, this well-intended act sowed the seeds of the current financial crisis. [For more background and very current (hour by hour) information on the Community Reinvestment Act and its root as the cause of the current financial crisis, Google “Community Reinvestment Act.”]

During President Clinton’s administration, he further advocated enacting programs that encouraged home ownership for those who were less fortunate and could not meet the existing requirements for obtaining mortgages.

Under President Clinton’s leadership, lending to subprime applicants increased dramatically. This resulted in the formation of a market for subprime mortgages – mortgages that did not meet the previously accepted lending norms.

The subprime lending programs were helpful for many people who previously were unable to purchase homes. Many of these new homeowners worked hard, paid their mortgages, took a sense of pride in their homes, improved their communities, and acquired wealth as their homes increased in value and they repaid their mortgages.

To avoid the risk of holding subprime mortgages, many traditional lending institutions became “mortgage packagers” and sold their mortgages rather than holding them. Thus, the traditional connection between the lenders (who traditionally had borne the risk of mortgages defaulting) and the borrowers largely ceased to exist.

Instead, the risk was transferred to investors throughout the world who purchased trillions of dollars of mortgages – sometimes not being fully aware of their quality. “Mortgage packaging” became a very profitable business. Many new mortgage companies were started. These companies packaged mortgages but did not hold them.

“Mortgage packagers” frequently paid their employees a commission for each mortgage that they closed. This encouraged those commission-compensated employees to use creative financing – financing that was not always in the best interest of the borrowers. Low interest rates led to increases in the numbers of subprime applicants who could be approved for mortgages. Some “mortgage packagers” became greedy as the mortgage business became very profitable.

With the markets in place to package and sell subprime (as well as prime) mortgages, mortgages with zero down payments, adjustable rate mortgages, and a variety of other forms of highly leveraged financing became the norm. Easy credit, low (or zero) down payments, and low-interest rates spurred increases in property values and quickly led to speculation. For example, California, Nevada and Florida as well as many New Jersey shore communities experienced skyrocketing property values largely as a consequence of speculation.

Not only the mortgage brokers and those in the financial industry profited, but the entire construction industry, real estate agents and the many people who purchased properties and sold them at a profit prospered as well.

So too did the states and federal governments as tax revenues poured in. As long as property prices increased everyone was making money! As the saying goes, “When everyone is having fun at the party, no one looks at the clock.” Congress, as well as regulators, tended to look the other way.

The use of leverage (lots of borrowing with little equity) became increasingly popular not only in real estate but in other areas, such as commodities. Many well-known investment banking companies became highly leveraged (i.e., had a high ratio of debt to assets), borrowing money to invest in various types of securities.

Then, the bubble burst worldwide. Real estate prices started down and mortgage defaults spiraled. Stock prices tumbled, and commodities gyrated wildly. Many of those who borrowed to purchase stock and commodities were highly leveraged and could not repay their loans. Major investment banks (e.g., Bear Sterns and Lehman Brothers) and finance companies that operated throughout the world, as well as some commercial banks, went under.

There now exists a world-wide credit crunch that, if not corrected in a timely manner, could lead to a deep world-wide depression and (some speculate) to war.

Treasury Secretary Henry Paulson and Federal Reserve Bank Chairman Ben Bernanke, working with governments and banking institutions around the world, have already taken very bold steps to avoid the impending crisis. But, while productive, further action is required.

Where are we now? Secretary Paulson and Chairman Bernanke have proposed legislation that would settle the credit markets and, if passed in a timely manner, likely avoid the looming financial meltdown.

Some argue that the proposed legislation does not deal directly with the issue facing many people: losing their homes to repossession. That perception is incorrect. The legislation would permit the government to purchase mortgages and, as necessary, renegotiate them on terms that would allow homeowners to avoid losing their homes to foreclosure.

This would hasten the stabilization of the real estate markets. Implementation of the proposed legislation would also inject liquidity into the financial system, thereby helping to stabilize it as well. But, this legislation needs to be enacted quickly.

When the dust settles, stronger, better-regulated and more conservative investment and commercial banking systems will emerge. The real estate markets in most of the country (exceptions perhaps in California, Nevada and Florida) are likely to bottom and settle within the next 12 to 18 months. The rate of decline in real estate prices has already moderated.

At present, your money is safe in money market accounts, FDIC-insured accounts, and, of course, in Treasury Securities. If Congress takes rapid action on the legislation proposed by Paulson and Bernanke, then the stock and commodity markets throughout the world also will start to stabilize.

Then, within the next 18 months stock values in the United States markets could well increase by 10 to 15 percent or even more from their current levels. This increase is critically important for the many millions of workers who have 401(k), individual retirement accounts and other retirement plans that include stock.

What about the cost to the taxpayers for the Paulson/Bernanke proposal? Current estimates are that the cost would be around $700 billion. Certainly, that is a lot of taxpayer money but, in my mind, the price is well worth avoiding a possible deep recession or depression. Furthermore, in the longer term, the government might very well come out ahead.

The reason is that the government would be purchasing mortgages at very low discounted prices. As the real estate market stabilizes, the value of these mortgages and the underlying real estate will very likely increase.

I am cautiously optimistic about the future!

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