Many follow the news in the US and don’t understand what is occurring with the financial crisis. How did this happen? Why is it occurring? This article will touch on those subjects and hopefully provide insight and understanding without political rhetoric.
In 1977 there was a little known act signed by the Democratic president called the community reinvestment act (CRA). Its purpose was to spark financial support in what was considered to be high risk areas (bankruptcy, low income etc). The thought was that by offering higher interest the financial industry would offset the high risk losses which would occur. On the flip side it offered some folks a second chance toward home ownership. This did lead toward predatory lending, however, since the financial industry was highly regulated it only represented about 1%.
The financial industry had wanted congress for many years to de-regulate the industry. This de-regulation would allow Banks, Securities Firms, and Insurance Companies to merge into bigger institutions and to sell each others products (including home loans). This selling would show up as portfolios of various products being offered for sale on the market. It would allow even small investors a chance to play in the wall street game.
In November of 1999 then democratic president Clinton signed into law a bill known as the Gramm, Leach, Bliley act. This bill was the sweeping financial reform needed to make America competitive. It repealed some of the financial regulations defined by the 1933 Glass Steagall, and the 1956 Bank Holding Act.
The root cause of the Problem
There was one section of the bill which almost saw its demise. That was section Vi the Community Reinvestment Act Provisions. This section required increased bank examinations to verify the quotas of high risk loans were being met by those participating in the de-regulation activities. The smaller financial intuitions were targeted with higher examinations to verify they did not rise to the next dollar level plateau without maintaining the proper quota for high risk loans.
The quota of high risk loans required by the CRA is what fueled the sub-prime lending market. All types of incentives were used to get the market rolling so quotas could be met. Eventually as prospectus buyers started to evaporate, other incentives were needed to bring in more higher risk buyers. The process continued with ridiculous practices like interest only mortgages, adjustable rate mortgages, balloon mortgages, non income qualifying mortgages (or liar mortgages), and just about any other non qualifying activity that can be considered. The though was that this would generate a market where the house price would increase dramatically over a few months and the home owner could refinance the mortgage with a better credit history, at lower interest, using the equity built up over the past few months.
The housing Boom and Financial instability
This CRA activity resulted in a housing boom in the US, where thousands of homes were constructed, which surpassed the market need. These high risk loans were being included and sold in financial portfolios throughout the financial industry. The buyers would purchase the portfolio and then merge parts of one portfolio with parts of another to create another marketable portfolio, and so on and so on... When the actual interest came to bear on the buyer who was of high financial risk anyway, they could not find credit available to refinance their home and the home failures started. Bankruptcy cases started to be rampant in the US, in 2005 just prior to the 2006 revisions, over 2 million bankruptcies were filled. With the new tougher laws in 2006 many informal (deadbeat) bankruptcies occurred (people just walked away). 2007 saw a greater increase as did 2008. The high risk CRA program instigated by the democrats was falling apart.
This rampant housing market failure resulted in failure within the traded portfolios, which most American financial intuitions were holding. No longer income these failed loans produced negative ratios of cash to debt for most financial institutions. The Texas ratio (as its referred to) for financial intuitions rose above 50% for most with some being well into the hundreds (example Integrity Bank of Alpharetta Ga 372% Texas Ratio). With the failure of the housing market, these banks have no cash to loan, meaning all of their money is tied up in bad debt and partially completed construction.
The bailout still prone to failure
If the congressional package offered as a bail out does not repeal the CRA and end the quotas, then the bail out will be just money thrown at a problem which is not fixed, and we will revisit this very issue until the CRA goes away.
You hear time and time again Senator Obama refer to banking de-regulation as the issue that cause this problem. In some twisted way that statement is true but only because the democrats tied the CRA to the de-regulation legislation in 1999. Then president Clinton threatened to veto the legislation unless the CRA was addressed to the satisfaction of the democrats.
Without the CRA being tied to the banking reform of 1999, there quite possibly would not have been a sub-prime mortgage market, capable of putting the US financial institution in is current chapter 11 state.
Deregulation is needed to make our financial market competitive, however quotas for supporting high risk loans are not needed. It was the very regulation of the industry by the CRA act that caused the banking failure in the first place. Any bail out package that does not repeal the CRA is doomed to failure as the root cause has not been eliminated.