The Wall Street Financial Crisis

The past couple of weeks have been the climax of a longstanding recipe for disaster which boasted such ingredients as reckless greed, deregulation, toxic sub-prime loans, and a housing bubble.

The outcome?

A series of monumental bank and investment firm failures precipitated by a massive increase in foreclosures, panic in the global financial markets, and a staggering $700 billion bailout proposal that was still being fine-tuned over the weekend in Washington.

How we arrived at what is being called the worst economic crisis since the Great Depression is a complicated matter, involving such things as adjustable rate mortgages, securitization, yield spread premiums and collateralized debt obligation. That's enough to bewilder anyone without a sound knowledge of economics.

It may also explain why polls have registered confusion on the part of the American public in regards to the proposed financial bailout package to buy $700 billion worth of toxic mortgages from financial companies in an effort to stabilize the markets and the general economy. In an Associated Press-Knowledge Networks poll conducted last Thursday, only 30 percent of those surveyed supported the deal, 45 percent were opposed, and a surprising 25 percent were undecided.

The collapse of so many financial companies is the culmination of the subprime crisis, which came to light in 2006 and 2007 but was in reality brewing for quite some time. Up through the late 1970's, home mortgages were heavily regulated.

The Truth in Lending Act of 1968 and the Real Estate Settlement Procedures Act of 1974, for example, spelled out strict disclosure terms for lenders. This changed in the 80's when a series of deregulatory laws were passed by Congress to alleviate the troubles of the banking industry and real estate market generated by high interest rates generated by a rise in inflation.

These deregulations superceded state law, and paved the way for sub-prime lending. Around that time, securitization was created. A complex process which bundles, sells and repackages loans into bonds to be sold to investors allowed lenders to spread the risk and frees them from reliance on deposits and capital reserves, securitization was key to sub-prime lending because it diffused the potential of risks and default for lenders and removed rational incentives for prudent lending.

Investment banks also played a huge role n the process. Companies such as Lehman Brothers, Bear Stearns, Merrill Lynch, J.P. Morgan, Morgan Stanley, Citigroup, and Goldman Sachs (any of those ring a bell?) underwrote most of these sub-prime securitizations.

In a nutshell, sub-prime lending is the practice of loaning money for mortgages for consumers who are considered high risk due to factors such as low credit scores, income level and employment status. These loans often come with high adjustable interest rates. However, Dr. Engel explained, many consumers who signed on for sub-prime loans actually qualified for prime loans with preferable interest rates, but this information was not disclosed to them.

The lenders and brokers targeted people with low credit scores, obviously, but also those with little financial know-how. As a result, these loans were often made to the elderly, the lower-income, and those without college degrees, as well as minority groups such as Hispanics and blacks. For example, according to the NAACP, African Americans hold more than half of the subprime mortgage loans at risk of foreclosure. Lack of transparency and disclosure, as well as deceptive advertising which described the loans in complicated and misleading terms, were rampant.

"If you buy a used I-Pod, for example, you know what to expect in terms of the whole 'buyer-beware' concept. These mortgages, in contrast, were so complex that people couldn't parse what they were getting into," CSU Professor Dr. Engel explained.

Not all homeowners were innocent. Many misrepresented information on their mortgage applications, and people often made bad bets in hoping that they would be able to refinance on appreciated property value in a few years. However, the responsibility to conduct background checks and reject applicants ultimately lay with the lenders.

The government has also been unable to escape unscathed in the blame game. Government backed Fannie Mae and Freddie Mac dominated the mortgage underwriting. A tangled web of profit was described by former Dallas Federal Reserve Vice President Gerald P. O'Driscoll as such: "The politicians created the mortgage giants, which then returned some of the profits to the politicians - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."

On April 18, 2006, home loan giant Freddie Mac was fined $3.8 million, by far the largest amount ever assessed by the Federal Election Commission, as a result of illegal campaign contributions. Much of the illegal fund raising benefited members of the U.S. House Committee on Financial Services, a panel now front and center in the $700 billion bailout package negotiations.

In 2006 and 2007, home prices began to decline as the housing bubble went bust, and refinancing a sub-prime loan became much more difficult. Defaults and foreclosures skyrocketed. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. The sub-prime lending crisis, as it became known, heavily affected global financial markets, and during the summer the U.S. stock market entered bear territory.

The events of the past few weeks seem inevitable in retrospect, but the extent of the damage to the financial sector, and the rapid fashion in which these events occurred, has many shocked. Many are proclaiming the end of an era of unfettered capitalism and deregulation glorified by Milton Friedman, the economist hailed as the godfather of staunch free market ideology.