There’s been plenty of blame to go around for our current financial predicament: subprime lending, regulatory mandates, unmitigated Wall Street greed. But what has rocked our financial world may have more to do with a variety of elements lining up over the course of many years — even decades — than one single problem, says Marc Simpson, associate professor of finance and department chair at Northern Illinois University’s College of Business.
“Taken alone, none of these events are necessarily bad, but you get a perfect storm when all of the events coincide and then you have a housing bubble that burst,” Simpson says.
Smart Business spoke with Simpson about the current economic situation and what needs to occur in order to calm our turbulent financial waters.
Could you outline the sequence of events that created this ‘perfect storm’?
To understand what has happened, we need to go back to 1938 when Fannie Mae (the Federal National Mortgage Association) was created. Fannie Mae provided money to banks to encourage lenders to invest in home loans. Fannie Mae became a private entity in 1968. Freddie Mac (Federal Home Loan Mortgage Corporation) was set up in 1970. From 1970 to just recently, Fannie Mae and Freddie Mac were publicly traded companies, but there was a widespread belief — which turned out to be correct — that they were implicitly backed by the U.S. government.
Freddie and Fannie do not issue mortgages, but instead purchase mortgages from banks — thereby creating a secondary market for mortgages. This makes the mortgages more liquid, which in turn makes banks more likely to make mortgages. Taken alone, the creation of a secondary market for mortgages was a positive development that has worked well for the past 30-plus years.
The next step was the securitization of mortgages. In this process, mortgages from disparate borrowers are bundled together in a portfolio and interest in payments from this portfolio is sold to other investors.
Again, this bundling process is, in itself, a risk-reducing measure, as the risk is diversified across a number of mortgages. There is, however, a limit to the risk that can be eliminated through diversification.
In the early 1980s subprime mortgages were able to help more people buy homes. But it was not until the mid-1990s that pressure intensified for banks to make these types of mortgages and for Fannie and Freddie to purchase them. The Community Reinvestment Act (CRA) requires banks to make home mortgages available to all segments of the population where they do business. Nothing in the CRA requires a bank to make a bad mortgage, but in practice, this may have been an unintended consequence.
If you take each event alone, it does not have the kind of impact that all of these events together have, resulting in the crisis we are in the midst of today.
Shouldn’t the $700 billion rescue package help stop the bleeding?
There is no reason why it shouldn’t work — except for psychology. The problem is now a crisis of confidence.
What kind of confidence is needed to jump-start the economy?
Consumers could be afraid of spending or borrowing money because they have been watching their 401(k)s and IRAs dwindle. If consumers cut back, companies will be afraid to expand their operations. More importantly, lenders are afraid to make loans because they fear not getting paid back — by both consumers and companies. What most people don’t realize is that the current default rate on mortgages is only about 3 percent; there is a perception that it is much higher than that.
Most homeowners won’t default on their mortgage, and the mortgage-backed securities that the federal government plans to buy will have been purchased at trading values below the estimate of their value, if held to maturity. There is the potential, as with the S&L crisis, for the federal government to make money.
What are the lessons we can learn from this ‘perfect storm’ financial crisis?
For one, government regulation and intervention — such as the push to provide housing to lower income families — however well-intentioned, can cause unanticipated consequences.
Second, subprime mortgages should not be issued without regard to the risks involved. Many loan originators were not exposed to the risk because they could sell the loans to Freddie and Fannie.
Lastly, I hope we have learned about systematic risk. That is, you can eliminate some risk through diversification but not all risk. In other words, you can’t bundle together a bunch of bad loans and then assume you’ve got a good loan. It doesn’t work that way.