My argument for the causation of our current economic predicament and why capitalism and free markets are NOT to blame

GREED IS GOOD! This is often the battle cry of those who support the philosophies of free market economics and capitalism, for greed will breed competition which then leads to superior products/services while simultaneously lowering the prices of said products/services. Those who oppose this philosophy say that greed was the very causation of the financial crisis. It is important to note that when I say, “What caused the current economic crisis?” I am referring the United States mortgage crisis that was the root cause for the rest of the turmoil. The reason the mortgage industry went down the tubes was due to the amount of subprime mortgages that were unable to be repaid. When these subprime loans defaulted they essentially zapped the major lenders of their liquidity which in return prevented the market from being able to fix itself (as it had done in the past) when the rest of the market turned for the worse. In other words, the overzealous lending of high risk (subprime) loans which in turn where unable to be repaid by the majority of the borrowers was the root cause of the financial meltdown, crisis, recession… and whatever other name our current situation has been called.

At prima facie my conclusion in the previous paragraph directly contradicts my assertion that capitalism and greed is not to blame for the financial collapse of the American Mortgage system. For it was a bunch of greedy bankers/lenders who were so willing to hand out these subprime loans like they were going out of style (ironically they were.) This seems like a highly reasonable conclusion, for if the lenders never made so many bad loans the market would have been just fine. I myself believed that it was obviously the lenders’ fault, for if not them who? Then one day a thought occurred to me that seemed so obvious that I can’t believe I never considered its significance before, and that thought was that bankers, lenders, real estate agents, and stock brokers have always been greedy, so why now? Why did the post great depression United States financial system decide that now was the time to expose its horrible flaws and send us into an economic freefall? The answer is that it didn’t, the market is not to blame: the government is.

In a proper financial market loans are distributed by the law of supply and demand. Since the demand for obtaining home mortgages is normally high, the supply side is the main determinate for mortgage behavior. The reason for the constant high demand is the majority of people, if given the chance, will take on a mortgage instead of paying rent because home ownership is the most fundamental way to increase one’s net worth. In the case of lending, the supply is based on the amount of liquidity in the lending institution. Liquidity simply means the amount of readily available funds (cash in most cases) a particular business entity has. So this means that as liquidity increases the amount of high risk (subprime) loans increases and when liquidity decreases so do the amount of risky loans. This begs the question why would anyone want to give out risky or subprime loans in the first place? To understand one must first know what a subprime loan is: a subprime loan is a loan given to a borrower with less than desirable standards; a person’s standard is usually determined by one’s credit score along with a few other variables like available collateral. When a lender chooses to give a loan to a borrower with below average credit, the lender the gets to charge a higher interest rate thus offsetting his/her risk (more risk more reward.) So in times of high liquidity it is ok to take on an increased risk, and as a lender’s liquidity begins to decline, which correlates with the amount of loans given out for lending decreases liquidity, the lending standards become tighter (less riskier) as the demand begins to overtake supply. This is a cyclical process that in the past held in check an acceptable level of risk while allowing a steady supply of funds that the average American could attain and then achieve home ownership. It is important to note that this process is quite literally the core fundamental of the American Economy, so if a kink is thrown into the system our entire economy will unravel, which of course is exactly what happened.

In order to understand what went wrong we must first travel back and view this system operating in early 2000. The United States was just winding down one of the greatest economic expansions in American history which was fueled by the creation and subsequent growth of the internet business. This upswing is commonly referred to us the “Dot Com” boom. There was a vast amount of liquidity in the market and with the technological boom starting to taper off people decided it was time to shift their investments into the traditionally most stable and (in the long-term) most profitable market, real-estate. As Mark Twain once said, “Buy land it’s the only thing God’s not making anymore.” With this renewed interest and large amounts of liquidity in the real-estate market, loan availability was at an all-time high. This meant there were plenty of subprime loans being created and that was fine, real-estate was appreciating at a fantastic but natural rate, and the liquidity lasted a little longer than was expected due to the booming industry in trading mortgage backed securities (I’ll explain those in a short while for it was this industry that created the shit storm.) Then something happened that wasn’t supposed to after a few years of enjoying a nice healthy growth in the real-estate the sector, history would suggest that the market would start to steady out, not lose value by any means but one would expect to see the growth rate fall back into a more reasonable realm since the amount of real assets were not being created at nearly the rate they were a few years ago. However, something else happened, the real-estate market continued to increase and not just increase but increase at an exponential rate! People were of course thrilled, why shouldn’t they be? People were getting rich just for owning a house! But there were a few wise men, like Warren Buffet, who had been around long enough to know better. They took a step back from all the profiteering and asked the question everyone should have been asking: how the hell is this happening? Warren Buffet once said, “Be greedy when others are fearful and fearful when others are greedy.” This could not have been anymore true at this time in history. For this continued financial boom was not created by the natural forces of the market, but by two government sponsored enterprises: Fannie Mae and Freddie Mac which by 2008 owned or guaranteed more than half of the U.S.’s 12 trillion dollar mortgage market.

Fannie Mae actually stands for the Federal National Mortgage Association and was created by the U.S. government in 1938 during the great depression as part of Franklin Delano Roosevelt’s New Deal. The purpose of Fannie Mae was to create more liquidity in the mortgage market, since the great depression caused so many to lose their homes it was important that loans be made readily available in order to jump start the economy. Fannie Mae helped increase liquidity by operating as one of the primary purchasers in the secondary mortgage market.

In the mortgage industry there are two markets, the primary which is the original loan made between the lender and the borrower and the secondary market which is the transfer of the loans in form of security sales. In the secondary market the immediate debt assumed by the bank when they made the loan can be “packaged” into a security and then sold on the open market. By this I mean the purchaser of said security pays the original lender the present value of the total amount the original lender is expecting to receive on the original borrower’s completion of the mortgage. In return the purchaser of the security gets to assume the debt of the borrower and is entitled to receive all payments the borrower makes in regards to reconciling the mortgage loan. Once a mortgage is packaged into a security it essentially operates just as a stock or a bond would on the open market, which means they can be traded freely. By converting an original loan to a security and selling it, the lender allows him/her to free up more capital which leads to an increase in liquidity which then leads to more loans being made.

During the time period 1938 – 1968 Fannie Mae used its government backing to purchase securities from the private sector. It would then either guarantee the securities it had bought or repackage them and sell to other investors. This allowed for liquidity to increase and after World War II ended the American economy began improve once again. Once the United States government thought the economy was solid once again it decided it was time to stop directly financing Fannie Mae. Now this was a bit of a problem for the vast majority of Fannie Mae’s assets were none liquid, since the company dealt solely in financial futures, this meant the government could not simply abolish Fannie Mae for to do that they would have to liquidate the assets which in return would cause the government to absorb a significant financial loss. The solution: sell the company on the market by creating stocks. However, since the Fannie Mae had such an incredible amount of long-term debt on its balance sheet, the market was skeptical that Fannie Mae could collect on the majority of those debts without the financial backing of the U.S. government was, up until then, providing which allowed Fannie Mae to stay solvent while it was waiting for the maturation of its futures. Unwilling to accept the low market value Fannie Mae would have on the open market without their financial backing, the U.S. government decided to list Fannie Mae on the market as a government sponsored enterprise or GSE for short. When investing or lending to a GSE, the people involved are willing to pay a higher price for a stock or provide a lower interest than average on the assumption that if the company, in this case Fannie Mae, was ever going into default (bankruptcy) the U.S. government would step in and bail the company out. So, in 1968 Fannie Mae was turned over to private ownership but still retained access to low interest rates and stocks selling at premiums compared with other companies in the market. It was this assumption that, four decades later, would cause what should have been a small and expected downturn in the mortgage market to transform into one of the greatest financial binges in our countries history, along with a hangover to match. For the U.S. government never provided express written documentation that it would financial back the now privately owned Fannie Mae.

Two years later Freddie Mac (Federal Home Loan Mortgage Corporation) was created by the government under same premises. This gave Fannie and Freddie unrivaled power over the mortgage sector that no other corporation in the market could match, and this was due to the competitive advantages gained on a simple assumption, and capitalism will always falter if a company posses advantages in a market that our unobtainable by its competitors and were unfairly gained to begin with.

Over the next couple of decades (1970-2000) Fannie and Freddie did, unsurprisingly, very well and slowly began to consume a larger and larger portion of the mortgage market. Then in the early 2000’s Fannie and Freddie decided to capitalize on the booming real-estate market, and with their practically limitless sources of capital their access to low interest loans allotted them, they did just that and as they say the rest is history.

Under the guidance of some very near-sighted financial leaders the two companies proceeded to take control of over half the mortgage market’s debt. At the time this seemed to be a brilliant move for as long as real-estate continued to appreciate, the two over-leveraged firms would continue to see astronomical profits. But eventually the market fell through and when it was all said and done Fannie and Freddie had taken on more debt than that which would be repaid to them and their stocks crashed by 90%, taking their share-holders and the 12 trillion dollar mortgage market down with it. This realized the U.S. government’s worst fear, their bluff was called and in 2008 Uncle Sam had to resume control of the two mortgage giants under the assertion that they “were too valuable to fail.” The overleveraging of Fannie and Freddie along with their inevitable collapse caused a chain reaction in our new globalized economy and now we are staring a world-wide depression in the face. To give a quick example of how this affected everyone: Iceland’s central bank was heavily invested in Fannie and Freddie securities and now there’s a good chance the bank will go bankrupt, destroying the currency and forcing them to have the central bank of Europe (the Euro) come in and bail them out.

Were the greedy near-sighted private sector’s CEOs the triggerman for this fiasco? Absolutely, but there never had to be bullets in the gun to begin with. If the U.S. government would have came right out and said Fannie and Freddie were now completely private with no government sponsorship, the private sector would have never had the capital and liquidity needed to crash the economy. It is the equivalent of trusting a gambling junkie with investing your life savings for you. If the government would have acted prudently back in 1968 we would be just finishing up the end of a financial “hiccup,” instead we are headed into a long recession that will be difficult not to turn into a depression. Capitalism was chosen in the first place because, regardless of your opinion of it, it is predictable. We chose the devil we knew, and then, by fault of our own, forgot about him.

Lauren Dow review and grade http://sustainableidentities.pbwiki.com/Lauren-Dow-Review-and-Grade-for-Patrick-Carew