First Causes

In all the arguments about the banking collapse and the housing meltdown and all that mess, one point keeps coming up: pretty much everyone agrees that it all went pear-shaped right about the time everyone admitted that a whole bunch of financial instruments, called “mortgage-based securities,” were not worth what they were trading for, but utterly worthless. And a whole lot of institutions who’d been confident they had a whole bunch of money suddenly were forced to admit publicly that they didn’t. Just whose fault it all was is the argument.

 

Yeah, I’m simplifying the hell out of it. That’s the only way I can get my head around it — it’s the sort of thing that my brain doesn’t grasp readily.

 

There was an NPR employee who was fired for participating in an #Occupy rally. She showed up with a big ol’ sign and Tweeted a picture of her holding it up. I don’t bring that up to argue about her firing, but because that sign had a sentiment that got me thinking:

It’s wrong to create a mortgage-backed security filled with loans you know are going to fail so that you can sell it to a client who isn’t aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted upon

At first blush, it’s hard to argue with that sentiment — it does kinda smack of fraud and deceit. And at second blush, it still is. But it got me thinking about the matter from the banks being denounced here — what led up to that?

 

Let’s work it backwards. The “mortgage-backed security” in question is how banks make money quickly off mortgages. They take a bunch of the loans (I’m tired of typing out “mortgages”), bundle them together, and sell them. They get money now, the buyers get the (theoretical) steady income from the mortgage payments. Everyone’s happy.

 

Unless the loans go belly-up, in which case the buyer is screwed. The bank doesn’t care any more. And the law requires the banks to be honest in how they consider the loans in question. Here’s where it gets tricky — they’re required to be honest about their opinion — it’s real hard to make legally-binding predictions of the future. So the federal government set up rules that describe how the banks are to rate these loans.

 

These rules, as I understand it, have about as much relationship to reality as the EPA mileage numbers for cars. They describe how things work under very controlled and artificial conditions; any resemblance to what you might get when you drive the car in the real world is purely coincidental. But they do have some value; while the actual numbers are BS, they do have relative usefulness; when you compare two similar cars, you can be fairly comfortable in knowing the one that has the higher mileage number will most likely get better mileage. Just don’t count on those actual numbers.

 

Anyway, the banks rated the loans the way the feds told them to. But they also rated them by their own rules — rules that were a hell of a lot more realistic. And when they sold off the loans, they provided the “official” assessments, but not their private ones. Illegal? Nope. Unethical? I think so, but arguable.

 

So we have the banks selling off loans that they officially say are worth X, but they’re actually worth X-X (or zero). That’s a crappy thing to do. But let’s keep digging.

 

The banks have, on their books, a number of loans that are pretty much worthless. That means that they fully expect that they will never be paid off. Yeah, the borrowers might make payments for a little while, but eventually they’ll stop and the loan holder will take it in the shorts. Is there any particular reason why the bank shouldn’t find some way to get rid of that financial lit stick of dynamite before it blows? As long as they play by the rules and obey the disclosure rules, why not? Maybe the borrower will keep paying for a few more years. Maybe they’ll pay it off entirely somehow (that’s why we have lotteries). The banks’ business model isn’t built on making all good loans, but on making loans they can then re-sell. As long as they’ve got buyers willing to buy, then it’s on those buyers to make sure they’re buying good loans — or, at least, enough good loans to cover the inevitable bad ones. Caveat emptor, and all that.

 

Let’s keep digging. The banks made loans that are essentially worthless. Did these go bad, or were they bad from the outset? In other words, did the banks have their decisions blow up on them, or did they know from the get-go that these loans were no good?

 

Oh, they knew. They not only knew these loans were bad, but actively sought out and competed to make bad loans. They came up with all kinds of gimmicks to get borrowers in, to make their loans more attractive to bad borrowers than those offered by other banks. They offered “no down payment” loans, “no income verification” loans, and a whole host of other schemes that were designed to appeal to people who could never afford to pay off those mortgages. And it worked like hell.

 

More digging. On the surface, this makes no sense. In the short term, it makes a smidgen of sense — make the loan, resell it, let the buyer take it in the shorts. But once you get past that, it’s really stupid — once you burn enough buyers, you won’t be able to find new ones. And those buyers will not be happy with you, and quite likely inspired to take (legal) revenge. No, the smart thing is to not make any (or, more honestly, not so many) bad loans.

 

I’ve learned — like a lot of people have — that when nominally smart business people do something really stupid, one of the most common explanations is “the government made us do it.” This is why we have incredibly stupid warning labels on so many products. This is why we have air bags in cars that we can’t legally deactivate, even if we want to put our kids in the front seat or the driver is so short that the air bag is more likely to kill her than save her life. This is why companies in Europe now can’t advertise bottled water as helpful in fighting dehydration.

 

In this case, it goes back to the Clinton administration.

 

A long time ago, banks actually used to think about loans going bad. And they came up with a few observations that helped a lot. The first was, people with very little money tend to have big problems paying off big loans — like for a house. They actually figured out ratios between monthly income and mortgage payments, and went by those rules. They also figured out that people who are bad at saving money also tend to be bad at paying off loans, so they asked for down payments.

 

And they also looked at maps, and noticed that certain areas and neighborhoods tended to have a lot more bad loans in them. So they said “OK, let someone else make those loans; we’re going to not make loans on properties in those areas.”

This was a practice called “red-lining,” and it got a lot of liberals pissed. It turned out that those areas tended to hold a lot of poor people and minorities, and that was obviously discrimination. Never mind that the banks had very neutral facts and figures; the results were bad. So the Clinton administration started leaning on the banks — hard — to liberalize their loaning practices. In fact, they were threatened with legal ramifications if they didn’t crank up the percentage of loans they made in these “disadvantaged” areas, and improved the “diversity” of their borrowers. In brief, they took the “real” out of “realty.”

 

So the banks did what they had to — they made a bunch of loans that they knew, from years and years and years of experience and reams and reams and reams of research, because they figured they’d rather not get pounded by the government and all those “community organizers” who were all howling over the bank’s practices. They figured that they could afford to make a bunch of bad loans for a while, buying time to figure out some way to manage them and not get wiped out by them.

 

And the solution? They had several, but the biggest was “let’s sell them off to someone else.” Make the bad loan, but don’t keep it. Pull the pin on the hand grenade, then hand it off.

 

Two problems there: legal and moral. The moral part was tricky: if they were perfectly honest, then no one in their right mind would buy them. So they had to find some way to make the loans more palatable.

 

Again, the government came to their rescue. Remember how the government had told them to make these loans that broke all the old rules? No problem — the government just made up new rules. They came up with new ways on how to rate the value of these loans, and told the banks “use these.” Under these rules, the loans didn’t look anywhere near as bad.

 

And this was important to the banks. They have to answer to their owners and depositors, and those people would be royally and righteously pissed if they were told “by the way, in the last quarter we made an assload of loans we are absolutely certain are gonna go right down the crapper. And we made those loans with your money. Hope you don’t mind.” Instead, they could say “we made a bunch of loans that, by the official government-approved method of evaluating, are just fine and dandy.” And they could give those assessments — based on the government rules designed to make the loans look like they were worth something.

 

That’s it, in a highly-simplified (and quite possibly incorrect, but I’m no expert) nutshell. The government (in the form of the Clinton administration) told the banks to make a whole lot of bad loans. When the banks said they couldn’t do that without breaking the rules on responsible banking, the government rewrote the rules on “responsible banking.” When banks still balked, the government informed that they WILL make those loans. So the banks did what they had to: they complied with the orders of the federal government, then did what they could to not get stuck holding the dynamite.

 

The dynamite brought in by the federal government, which then lit the fuse and handed it to the banks.Who then did what the government told them to do — they passed it along to the loan buyers. And everyone was all happy, passing the dynamite around, making scads of money in the process.

 

Right up until the dynamite blew up and blew the hell out of the economy.

 

Holy crap, I’m over 1800 words and didn’t even touch on Fannie Mae and Freddie Mac. Let’s just say that they were the main tools used to push all these bad loans.

 

It’s taken the crime scene techs a few years to piece the original bomb, but they’ve managed to pull quite a few fingerprints off it. So far, they’ve matched up to Bill Clinton, Barney Frank, ACORN, community organizers and professional race hustlers, progressives, and a hefty hunk of the political left.

 

This isn’t to let the right off scot-free. A lot of them should have — and did — know better. They had their chances to stop it, and they failed. Sometimes they didn’t try hard enough. Sometimes, they let themselves be bought off. And some just bought into the whole insanity, saying that since it was such a nice idea — “let’s help more people get into homes!” — it couldn’t possibly go wrong.

 

Oh, but it did. And that dynamite done blew up all of us.

 

This is what happens when the government decides it should be in the business of picking winners and losers. And, as P. J. O’Rourke noted, when the government gets into the business of buying and selling, the first thing bought and sold are politicians.

 

You may now commence explaining in detail just all I got wrong. I might even try to understand it.

 

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