Understanding the Financial Crisis

Speaking as a former real estate regulator and college real estate instructor, the credit crisis comes as no surprise and is something that quite a few of us have predicted for a long time. When the government made it possible for – and even encourages – non-creditworthy individuals to become borrowers the financial snowball began rolling down the hill. One of the better summations I have seen on this subject is by Jack Schultz, a premier authority in economic development research on rural America and author of Boomtown USA: The 7 ½ Keys to Big Success in Small Towns. I’ve reprinted it below with permission. For more info about Jack and his work, go to the Boomtown USA Web site.


Credit Crisis 2008

Even though virtually everyone in Washington, D. C. and on Wall Street talks about the massive $800 billion bailout bill as help for Main Street, I’m still not buying it. I can’t find any evidence that Main Street was a major player in the paralysis of credit markets. Here is the chronology of events that I’ve found that led to the bailout of Wall Street.

December 5, 1996-Alan Greenspan utters words “Irrational Exuberance” for the first time. Congress comes down hard on him, not wanting an end to the .com elevation in stock prices and jobs created from those high flying stocks. Greenspan doesn’t increase margin requirements for stock trading….bubble grows in .com stocks….bubble bursts in early 2000.

1998-Credit Default Obligations (CDO) begin to be used to offer insurance against credit losses. AIG makes the biggest bets, most on the premise that housing values can only move upward, reaping huge premiums and inflating its earnings. Massively wrong bet. CDO market explodes to $60,000,000,000,000 ($60 trillion) by 2008. Buffet calls derivatives like CDOs “Weapons of Mass Destruction.”

1999-Congress repeals Glass-Steagall Act from Great Depression which separated commercial banks from investment banks. Big commercial banks enter investment banking with a vengeance.

2000-When .com bubble bursts, Fed floods markets with cash. Fed Funds rate drops from 6.25% in 2000 to 1.00% in 2003. Cash begins flowing into real estate, especially in CA, NV, AZ and FL. “Flipping” no longer refers to hamburgers but to houses.

2002-Mortgage lending standards are reduced by Freddie and Fannie. The key requirement is no longer whether a borrower can repay their loan but can the loan be sold by Wall Street to unsuspecting buyers worldwide. Reverse amortization, ARMs and other derivations from traditional mortgage lending become widespread. By 2006, 17% of home loans are made with nothing down.

2004-Leverage requirements are loosened. Large commercial banks go from 10:1 debt-to-equity ratio to 20:1. Investment banks and hedge funds go from 20:1 to 40:1 and higher. At 40:1 ratio, you can only make a 2.5% mistake or your capital is wiped out. That means that a hedge fund that buys a $100 stock can only afford to have it fall to $97.50. Hubris rules the hedge fund and investment world. The “rocket scientists” with their black boxes supposed to dominate risk management learn of “black swan” events when $100 stock falls in half.

2006-Housing values hit their peak and start to fall. Even though housing only accounts for 3% of USA GDP, the house of cards built around ever increasing housing values begins to topple.

2008-Credit markets seize up. Banks don’t trust each other. LIBOR interest rates soar. Treasury puts together $700 billion bailout plan. Congress loads up with another $100+ billion of earmarks for wooden arrow manufacturing, Hollywood film producer tax breaks, new NASCAR race tracks, etc. etc. etc.

2008-Treasury panics and increases money supply from normal growth/contraction of +/-10%, to over 250% growth in November, 2008. Bubble in housing that started in 2000 will reemerge in another sector because of the huge amounts of cash sloshing around. Inflation begins to skyrocket in 2010 as a result of the unprecedented growth in M1 money supply, after deleveraging which begins in 2008 comes to an end.

That’s our take on it. Problems lie on Wall Street and Capital Hill. I hope that the hard work of Main Street can help to eventually fix these problems that they’ve brought us.

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