Economy: How Washington and Wall Street got into trouble | Timothy Lamer

The current financial crisis gripping Wall Street is head-spinning in its complexity. But economists and analysts have been able to identify several steps along the way that helped lead the country to where it stood last week, on the brink of a massive government program to buy hundreds of billions worth of bad mortgages. Here are some of the steps:

Step 1: Trying to avoid a recession brought on by the bursting of the tech bubble and 9/11, the Federal Reserve under then-Chairman Alan Greenspan began aggressively easing monetary policy. From 2001 to 2003, the Fed Funds rate fell from 6 percent to 1 percent, a 45-year low.

Step 2: With interest rates low and money easy, mortgage lenders started marketing loans to people with questionable credit histories. These “subprime” loans often required no down payments, had adjustable interest rates, and featured exotic elements like “negative amortization” (in which “homeowners” would initially pay less than the interest owed each month, causing the loan’s principal to grow with each “payment”). With these loans fueling demand, housing prices rose, prompting speculators to enter the market and “flip” houses (buying them with debt and then selling them quickly at higher prices). A speculative bubble began to inflate.

Step 3: Mortgage lenders sold their suspect loans to others, especially Fannie Mae and Freddie Mac. Congress had over the years allowed the two government-sponsored enterprises to grow very large and become major players in the mortgage market, and in the name of increasing home ownership the two behemoths encouraged subprime lending. Fannie and Freddie packaged these loans into mortgage-backed securities and sold them to investors. The pair “fueled Wall Street’s efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime–mortgage pools,” writes economist Kevin Hassett for the Bloomberg news service. “In addition, they held an enormous portfolio of mortgages themselves. . . . Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.”

Step 4: With investment banks using these subprime assets to take on high levels of debt, the financial health of Wall Street became linked to the ability of people with poor (or no) credit histories to make monthly house payments.

Step 5: Interest rates couldn’t remain at historic lows forever. As interest rates began to rise, housing demand fell and the bubble deflated. Subprime borrowers found interest rates on their mortgages adjusting upward at the same time as the value of their houses either fell or flattened. Unable to make payments, many defaulted. Investment banks on Wall Street were left holding the bag—the bag being debt backed by assets with falling values.

Step 6: Fearing a full-scale collapse and severe recession, the Bush administration began engineering bailouts of some of these firms and, finally, proposed a $700 billion macro-bailout. Under the proposal, the Treasury secretary will buy the bad assets from the banks and then sell them. (How much the government makes selling them will determine how much of the $700 billion the government will recoup.) “This staves off judgment day,” Anthony Sabino, professor of law and business at St. John’s University, told the Associated Press. “This is a detox for banks, and will help cleanse themselves of the bad mortgage securities, loans and everything else that has hurt them.”

The plan gives the Treasury secretary (currently Henry Paulson, most likely someone else in January) enormous power, which prompted a debate last week in Washington about how much oversight he or she should come under and how much time he or she should have to get the government out of the real estate business.

The fundamental dynamic is this: Washington and Wall Street helped people buy houses they could not afford on such a massive scale that simply letting the lenders and debtors take their lumps would arguably do grave harm to the economy. They will take some lumps (Wall Street isn’t exactly a hot job market right now), but most of the losses will be “socialized,” or spread out among everyone who pays taxes. This includes those who exercised restraint during the bubble. That’s how it is.