Misinformation is a proper term for what been disseminated about banks, mortgages, and lending policies. Some have blamed our current economic woes on “greedy” bankers. Other say it is not really the fault of banks or bankers but that the root lies with consumers who bought homes they could not afford. Still others say banks and home buyers share some of the blame but the real culprit is either too much government regulation of financial institutions or too little. There is a kernel of truth in each of these claims.
Banks engaged in two distinct kinds of transactions, each of which had a potential for huge losses. Some banks made loans for home purchases to applicants who would not have qualified under the normal standards. Many banks did not lower their standards but enough of them did to create a fairly large number of what have since become known as “subprime” loans. These are loans that should be assigned a higher level of risk than normal mortgages. Home loans were made to people who did not have sufficient income to be likely to meet the terms for repayment. In many cases, both the applicant and the loan officer knew that in their current financial conditions the borrowers would be unable to make steady payments in the amount required. They were able to justify making these loans because house prices were rising sharply. The assumption was that if the new owners were unable to make their payments at some point, the house could be sold for more than the outstanding loan amount, and the homeowner and the lender would be covered. When housing prices stagnated and then started to fall, the bottom fell out. Borrowers could not sell the house for enough to cover the loan balance and foreclosures started to rise. This spelled big trouble for the banks that had extended these questionable loans but the effects did not stop there.
The banks that extended these questionable loans engaged in some very esoteric transactions to try to cover their risk. They bundled large numbers of mortgages into packages and sold the bundles, usually in pieces, i.e., an investor might purchase one-fortieth of a bundle of mortgages. The subprime loans should have been packaged separately because they obviously carried more risk. Instead, they were included in the same bundles with rock-solid AAA loans. How much risk was an investor in one of these bundles actually assuming? They had no way to know. Banks and investment institutions also engaged in some buying and selling some incredibly complex securities. They traded in such things as credit default swaps, collateralized debt obligations, and mortgage-backed securities. The problem the banks have today is that nobody can agree on how much these instruments are worth.
The credit default swaps are widespread in the banking and insurance industry. They are also completely unregulated, as a result of a policy created by Wendy Gramm (the wife of Phil Gramm) shortly before she left her office with the federal government and joined the board of directors of that honest, open, ethically managed corporation known as Enron. Contrary to what some completely blind people who call themselves conservatives would have us believe, we need more government regulation of large banks, not less. The current economic turmoil is a direct result of allowing big banks and investment institutions to do whatever they think is best.