How Most People Got into Their Mortgage Mess

Here's an interesting exchange from my post titled How to Postpone Foreclosure. It starts with this comment:

Another way to postpone (or even eliminate) foreclosure...

-make your payments as agreed.

I know it's not a very popular idea, but it works!

One reader (Laura S) took exception to this and said:

What a very insensitive remark. Don't you think most people would make their payments if they could? Of course there are dead beats and people living beyond their means but there are many that face foreclosure due to a series on unfortunate events. Medical expenses, loss of job, divorce, death of bread winner, just to name a few. It could happen to anyone. Although my family is doing well and we've worked hard to prepare for those kinds of emergencies, I never take for granted the life I've been afforded.

Which then led to this insightful comment:

I am a foreclosure attorney and unfortunately Laura S is off the mark. The majority of my foreclosures are people who have either (1) bought too much home for their income, (2) watched too many "Flip this Home" shows and thought that real estate was easy money, or (3) people who had a history of not paying their debt but somehow miraculously was able to buy a home. There are very few who have had an unfortunate event in their life and are facing foreclosure.

Everyone always asks me who do I blame in this mess and I blame everyone. I blame the banks, I blame the government, I blame home buyer, and I even blame those of us who turned a blind eye to the whole mess. Where was the average joe when all of this was going on and knew this was too good to be true?

Very, very interesting...

Comments

[Apex]

I agree with the attorney but don't understand the average joe comment. There were tons of average joe blogs about the housing bubble. They were mostly ridiculed until later in the process. I have been telling everyone for many years that I thought this was a mess waiting to happen and I was early, but I actually told my family in the summer of 20007 that I thought we had to be at a peak in prices and it couldn't run any further. ...... So what. What could I or any of the collection of average joe's do to actually prevent the mess other than keep our selves out of the way of the train wreck.

I guess I don't quite get his point about "blaming" the average joe who knew this was too good to be true. Everyone else he blames could have done their part to stop it from happening, not sure what the average joe who knew the bridge was out could have done to stop the train.

[JimL]

A parallel to this is the stated causes for bankruptcy. Often, we hear that bankruptcy was the result of job loss and/or medical bills.

I was involvded in debt couseling for a number of years and saw the real problem. Most people in trouble ran up huge debts by leaving beyond their means. Car loans (buying new cars too frequently with negative equity), huge school loans, credit card debt (buying the latest fashions, eating out, etc.) and buying a house to the maximum levels. Most of these people were living paycheck to paycheck due to the debt load. Then, when a life event, such as a medical issue or job loss, they did not have an emergency fund to dip into and they could not afford the payments tied to the huge pile of debt. So in the end, the job loss/medical issue just pushed them over the edge of an already problematic situation. The life event really wasn't the cause, it just was the final straw.

[Shaun]

So true. It's easy for us to try to find a single entity to blame, but sometimes it just doesn't work out that way. There have been so many mistakes made by so many people in the past decade or so, this whole crisis was almost unavoidable.

[beastlike]

100% in agreement with Apex.

[Andie]

I can tell you where some of the average joes were:

In 2005, I was sitting around with a bunch of my college friends as we got together from states across the country; we were in our late 20s. A few had scrimped and bought starter homes, most of us hadn't. We looked around and we knew that what we were witnessing wasn't sustainable. Most of us at that get together still don't own anything or own affordable homes. We expected the market to implode on itself because we anticipated the resetting of option ARMs.

We had some idea that things were wacky, but Mr. Foreclosure Atty, what should we have done? What could we have done? When we live in a cultural tide of "your way, right away" which is being propped up by the government and incentivised by the banks, what are half a dozen 20-somethings to do?

A lot of people bear a lot of blame. Maybe responsible people with insight like my friends do as well. But before we accept that responsibility, I'd like to hear what we realistically could have done in 2005. Realistically. Like as people with normal jobs. Not as people who think that advocacy is a possible living.

[Scott Scheurich]

What I don't understand is if 92% (number I heard on NBC Nightly News) of homeowners pay their mortgages on time every month, how can the other 8% unknowingly hold this much power in their hands to cause this many problems? And how could banks allow this 8% to cause this many problems? I guess that 8% is still a lot of money.

I would also agree that lenders waived or disregarded some of the income verification that SHOULD have been performed. I can't speak to whether it was REQUIRED of them or not.

Thanks.

I think both sides have valid points. Our mortgage was for about the same as our yearly combined salary, making out payment about 7% of our monthly income, a very reasonable mortgage most people would agree and not out of our means at all. However 20% of my coworkers have already been laid off, so it's not that unlikely that it would happen to me. If that did happen, our modest mortgage payment would be about 30% of our take home pay. That kind of jump is a big adjustment, and for a single income family, it could be devastating. That may be the sort of thing that Laura is talking about. However, unemployment benefits would allow us to live quite comfortably for 6 months or longer, and we have a sizeable emergency fund which would cover our living expenses for another 6 months. Also, we are saving over 50% of our income now, so the worst thing that would happen if we lost our jobs is that we would just end up saving less, not being forced out of our homes. So I agree that almost all foreclosures are a result of people buying more house than they can afford, but there is always a chance that bad luck could cause a couple.

[wanzman]

The funny thing about mortgage notes (and all other loan docs), is that they say the following:

"You promise to pay x amount for x number of years, or we can foreclose on the collateral." Period, end of story.

They do not say the following:

"You promise to pay x amount for x number of years, or we can foreclose on the collateral. Unless you husband loses his job. Or you get sick. Or you need to pay the iPhone bill one month instead of paying us."

When you sign the documents, you are agreeing to la legal contract, NO MATTER WHAT THE HELL HAPPENS FROM THEN ON OUT. For some reason, people do not understand this. I wonder why?

Do people not read mortgage documents? Sure this cannot be the case, right?

Do we live in a society that cultivates an entitlement mentality? BINGO, I THINK WE HAVE OUR ANSWER.

I understand that sometimes bad things happen to good people. Being good does not remove consequences that should apply universally based upon the contract you signed. Period.

[wanzman]

Long story short on my above post:

Buying a house and therefore signing a contract for a large amount of money is not 100% risk free. Take that into consideration. No matter your intentions, there is a slight chance that something could go wrong. Everyone should realize this upfront.

[weston]

It would also be helpful when weighing the opinion of the foreclosure attorney to know whether or not he is a plaintiff attorney (representing banks) or a defense attorney (representing consumers).

A foreclosure attorney representing banks would have little or no idea regarding the borrowers underlying circumstances that led to the foreclosure. A defense attorney would. My experience from handling dozens of foreclosure defense cases (and related bankruptcies) is that the majority of my clients have in fact suffered a serious and material change in their financial circumstances (usually job loss or reduction in wages). Again,in the interest of full disclosure, I represent only consumers and individuals so obviously I view things through the (hardly unbiased) prism that I've developed through my many years of practice.

[Mark B.]

How about:

1. Bought a house
2. House loses 35% of it's value
3. Lose a job
4. Find new job out of state
5. Must sell house
6. Owe more on house than worth
7. Can't make up the difference
8. Buy new house in new city
9. Walk away from old house

This has been the most common theme that I have seen in my area. This sequence of events then brings the values down even further.

However, the person who walked away has a nice new house in a new city, and the only consequence is a trashed credit rating. The consequences of "walking away" need to be more severe, otherwise people will keep doing it. On the flip side, this person took initiative to find a new job, and they had no control over the 35% drop in value or the job loss. So can you blame them for walking away and starting over?

[Nick]

Wazman, I'm not really sure how what you are saying is only relevant to the home owners? Yes, they agreed to pay no matter what the hells happens, or else they'll be foreclosed on. And the banks agreed that if they don't pay the banks can choose to foreclose. That hasn't really changed any, except that it turns out the banks can't actually afford to live up to their end of the bargain and foreclose without being forced to declare bankruptcy themselves (or without begging to the government for help).

So on one side, the people can't live up to their side of the contract without asking for a handout. And on the other side, the banks can't live up to their side of the bargain without asking for a handout as well. It seems like maybe neither side really paid attention to the "NO MATTER WHAT THE HELL HAPPENS FROM THEN ON OUT" thing.

[Apex]

@Scott,

I really wish the media would stop using that 92% number.

So lets examine that number. That number includes lots of people who have had mortgages for anywhere between 10 years and 29.9 years. Almost all of these people have houses that have appreciated greatly from what they borrowed on them and have paid down significant principle. These people have significant equity in their houses and many of them have very little due left on their loans. But as long as they have a mortgage they are in the 92% that are current. So lets just take anyone with a mortgage more than 15 years old and throw them right out of that number. Those people could sell their house even at these low prices and get 3,4,5 times more than what they still owe on their mortgage. They are zero risk to the bank and their lower balances on houses that were purchased at much cheapter prices are much smaller portions of a banks loan portfolio. In addition these loans were taken out when banks had much stricter lending requirements. 12-1 maximum leverage, 10-20% down payments, max 1/3 of income could go to house payments, and income had to be proven (by the way, put those 4 rules back and this problem will never occur again and it never did occur when those rules were in place)

In the current environment banks have loaned money on houses that cost 3-4 times what they did 15 years ago. So the size of the loan portfolio in the last 10 years dwarfs that of the older loans that are in that 92% of loans that are current. In addition, they were not leveraged 12-1 but 30-1. If you are not sure what that means, think of it this way. If you are leveraged 30-1 and 1 in 30 loans fully defaulted, you would be wipped out. If 1 in 15 loans (6%) was worth only 50% of what you borrowed to them you are wiped out.

This is the problem with the banks. These loans that are defaulted, the properties are being forclosed and often the bank ends up with half what they borrowed. At 30-1 leverage that only takes 6% defaults to wipe you out. The number you mentioned has 8% default. And we already know the 92% number is misleading because it includes old loans at much lower values.

What should be really talked about is percent of dollars loan out that are not current. I guarantee you that number is so much higher than 8%. Probably closer to 20%.

20% of dollars loaned out at risk with 30-1 leverage on properties that have lost up to 50% of their value .... that equals a very large insolvency. That is the problem.

Only rampant greed and ignorance could lead us here. This is the collective assessment of the entire banking/housing/real estate industry that all fall into that category to get us here. They cannot be trusted to make wise decisions. They have proven if you take the restraints off of them they will behave more financially irresponsible than the average american consumer which is hard to believe in this environment of so many americans living beyond their means but the housing industry was far far worse.

[rwh]

How do 8% of bad loans crash the market when 92% are still being paid on time? Well, you (the lender) sell the loan to the secondary market where it's added to thousands of other mortgages and becomes a mortgage bond (or mortgage backed security), divided into tranches of multiple levels with the top levels given a credit rating of AAA and the lower tranches given lower credit ratings, with the lowest tranches rated as below market grade (junk status). So big institutions buy these things, and to try and cover the risk, they purchase insurance from bigger institutions like AIG. Only AIG and their cohorts underwrite so many mortgage bonds they can't possibly pay off if the housing market drops and the bonds lose their value. So AIG and their cohorts go bankrupt, get billions from the government to remain in business or both, creating a cascading market crisis that infects other banks, which freezes credit, which forces companies that have nothing to do with the banking, mortgage or mortgage insurance industry into financial crisis because they can't get the credit they need to continue normal operations, and then millions of people start losing jobs, cut back on spending, many try to sell their houses, which further depresses prices, people lose confidence, the stock market drops, then government steps in to try and prevent economic catastrophe and we get trillion dollar deficits as far as the eye can see.

Well, that's how I see it anyway.

And while borrowers are not innocent bystanders, I put more blame on the banks. It's their responsibility to loan money responsibly, by requiring evidence of ability to pay, by functioning as actual banks, not simply as originators of loans, and not lowering the bar to the point where anyone walking through the door could get a loan to buy a house, simply because the bank knew they would sell the loan and kick the risk down the road.

[rwh]

Apex, we must have been posting about the same time. Great minds think alike:)

[Jim]

Hardships are NOT the primary cause for the current high foreclosure rates.

Certainly some foreclosures are caused primarily by personal hardships (death, medical, job loss etc). Hardships couldn't explain the huge increase in the foreclosure rate. THe hardship rate has not gone up 5x in the past couple years.

Normally theres something around 0.5% to 1% of homes in foreclosure. But now about 3% of loans are in foreclosure. That much of an increase is not due to hardships. Job losses will add to the foreclosure rate some but its only one possible cause and shouldn't do anything close to the increase we've seen.

Also consider the fact that subprime mortgages are in foreclosure and default much more than prime mortgages. Foreclosure starts were 0.6% for prime and 4% for subprime. Default rate for prime is around 3% and subprime around 19%. A subprime ARM loan is about 20 times more likely to go into foreclosure than a prime fixed loan.

Its the risky, over extended, subprime mortgages that are the major cause of the current foreclosure problem.

Jim

[Jeff]

RWH, while I agree with your post and that was the straw that broke the camels back. Your underlying point about the bank lending money responsibly went out the window in 1999 with the Clinton adminstration's initiative to relax lending restrictions. These "relaxations" borderlined on putting a gun to banks heads to lend money to obviously unqualified debtors. In an effort to hedge risks related to these junk loans they created MBS, CDO's, etc. In the end, a debtor knows how much they have in income every month, they know their expenses and the rest is what they can spend on a mortgage payment. I blame the debtors getting the mortgage and the Clinton adminst. for believing that everyone has the right to own a home. All that needed to happen was simple arithmetic if your expenses exceed your income you can't afford it. Period.

While unforseen circumstances happen (lost job, medical expenses, death, etc), they are a small portion of this mess, those people still have a responsibility to plan for contingencies whether it be life insurance, savings, whatever. While it's a tough situation and I am sympathetic to their plight I'm don't feel sorry for them losing their home because they didn't have a plan B.

[Jim]

Jeff, blaming it all on Clinton is total fiction. Theres no evidence whatsoever that Clinton administration changes added to the crisis. THe allegations you're echoing are baseless and politically motivated. The law in question was the Community Reinvestment Act. Most of those loans are safe and stable. Most subprime loans (the cause of the problem) are not even regulated by the CRA.

[rwh]

Jeff:

I would have to see real evidence that relaxed lending restrictions forced lenders to make loans to unqualified buyers. My guess is the investment banking industry supported relaxed lending restrictions in order to stimulate the growth of the secondary mortgage market. And local banks and mortgage companies found the risk-free easy money for originating these loans too tempting to resist.

I'm not defending Clinton, as I agreed with Ralph Nader back in 2000 that the repeal of the Glass-Steagall Act under Clinton's watch legalized what was the illegal creation of CitiGroup and blurred the clearly demarcated lines between banking, insurance and Wall Street that had existed since the 1930s. But these things aren't done in a vacuum and it took a GOP congress to pass this type of legislation. And Bush also had a goal of increasing home ownership (remember the "ownership society"?). If he and the GOP congress wanted to reign in irresponsible lending they had 6 years to do it.

That's why I don't blame particular politicians. It's too simplistic and there is way too much blame to go around. In the end the system was broken and it's going to take a lot of pain to fix it.

[plonkee]

In the UK, you can't walk away from your house. I mean you can, but the bank will pursue you - into bankruptcy if necessary - for the difference if it forecloses and sells for less than you owe. I kind of think that's reasonable, as long as bankruptcy settlements are reasonable.

[Recycleholic]

Don't spend more than you have. Second, don't take more than you need.

If everyone adhered to these two simple rules this whole mess might have been avoided.

I fault everyone as well.

Banks - They should have made sure homeowners have the income to cover their loans after they rates jump. Also they should have verified at a minimum income and not taken people's word for it. Common sense to me but it seems to have eluded our banking institutions.

Homeowners - Just because the bank said you are eligible for a certain amount doesn't mean you have to take it. As we are finding out, it's not free money.

Government - These officials are homeowners too. Did not have an inkling of what was going on?

Everyone took a gamble and it didn't pay off. The downside is we all have to pay for someone else's bad bets.

[imarcticblue]

Jeff is right. The program was started in the Carter years and enhanced by the Clintons and the Democrats in charge of the financing committees.

Some people talk about under-regulation being the problem. Fannie Mae and Freddie Mac are the MOST regulated financial entities. This regulation was used to push through a low-income home ownership program. Since Fannie and Freddie make up a large portion of the secondary market, they were the vehicle to force this program onto the banking system in general.

Fannie Mae and Freddie Mac buy loans from originating banks and they both had mandates that 50% of the loans they bought had to be for low income people. This is by Federal mandate. The banks could only sell loans that Fannie and Freddie could by.

The banks created sub-prime, option adjustable and other loan types to be able to qualify people for loans that they really couldn't afford in the first place.

This also greatly increased the demand for housing, thereby pushing up valuations and creating a housing bubble. The bubble collapsed putting us where we are now.

Everyone is being damaged by this collapse, especially those that were supposed to be helped by this low-income financing pushed by liberal democrats. Many of them are facing foreclosure and bankruptcy now and those of us that can afford it are paying for it whether we like it or not.

If you really want to find the source of the housing problem, look to government greed and interference in the markets.

[Apex]

@rwh,

Perhaps we do think alike. I was going to craft something similiar. Clinton, Republican congress, Bush, Barney Frank, excessive deregulation. Plenty of blame in both parties. Everyone had their own idealogical reasons to push for the environment that allowed this to happen.

Rather than exercising sound fiscal judgement they decided that prior restraint was a road block that should be removed rather than guard rails that kept us out of the ditch.

I also agree that its unlikely that these actions were because the banks were forced to make risky loans they didn't want to make. I heard no bank and no politician complain about private finanical entities being forced to risk their own money on clients they considered to be too risky to lend to.

I don't doubt that there was some pressure to lend to higher risk borrowers. Likely the banks got them to drop other restrictions in exchange for increased lending to higher risk borrowers that they mistakenly thought allowed them to make more profit. However the dropping of those other restrictions only led to even higher risk borrowing. For a short time it did seem like it led to higher profits but I emphasize seem. Short term gains achieved through increased risk, are almost always an illusion.

[My Life ROI]

rwh: It's just lazy politics. I hate that stuff. When I am discussing economics with someone I just hateeee it when they keep bringing up politics (well democrats said.. republicans said...).

What? We are discussing economics and now all of a sudden you are on a tirade against the pink-o democrats or the fascist repubs? Ugh.

[Apex]

@imarcticblue

you said:

enhanced by the Clintons and the Democrats in charge of the financing committees.

Just to be clear in 1998 and 1998 when these actions were taken under the Clinton administration there were no Democrats in charge of any finance committees in Congrees. Republicans had control of both houses of Congress.

If you think excessive regulation was the problem then I challenge you to address the 4 rules I mentioned previously and how this could possibly occur if they had stayed in place. Those rules are the following:

1. Banks can have maximum of 12-1 leverage.
2. Buyers must put 10% down without using piggy back loans.
3. Buyers cannot get approved for any mortgage that is greater than 1/3 of income.
4. Buyers must document income.

When those rules were in place for decades, we never approached anything like this in housing.

Please demonstrate how you could have those 4 rules in place and still get the situation we have today.

For the record, I am a Repulican (or more correctly a conservative as the current Republican party is entirely empty and without any meaningful ideas or adherence to their own supposed principles), but I am not blind and I see what the banks did and they simply can't be trusted with unrestricted control of the financial system if that means they can take money, loan it out poorly at rediculous rates of leverage and then the taxpayer is forced to bail them out because our whole economy depends on the financial system that they run.

No. They cannot be trusted to run it correctly without guiding principles. For decades we had those principles. They are basically the ones I articulate above. Those were removed. And the banks did what free people left to themselves often do if they have access to other people's money .... do really stupid risky things with it in the hopes of getting rich if it works and walking away if it doesn't.

[C]

@Plonkee: It's the same here. There are a few states that are non-recourse (meaning they can't come after you to get the difference that you owe them), but most states are NOT non-recourse, so the lender can pursue you up to bankruptcy if they desire. Whether they do or not is another story. I'm walking away from my condo (value's dropped 42% in 3.5 years) and our only choice is declare bankruptcy; otherwise the lender has up to 5 years to come after us.

For those of you that talk about the legal contract that you sign when you buy the house: yeah, you sign it, and it spells out what happens to you if you don't live up to your end of the deal. If you choose to walk away, then the other party in the contract can choose to exercise their rights. It's not like you just get to walk away with no consequences. A trashed credit rating is not something to be sniffed at - higher insurance rates, potential issues getting a job, etc. Like everyone says, yeah, there are some deadbeats, but there are some of us who bought what we could afford and then the housing market dropped out from under us, and this is a carefully calculated financial decision. You have no idea what you're talking about.

[Cherry Blossom]

RWH does a good job of explaining this (as well as Apex) but could go into a little more detail on how the MBS( mortgage backed security) is made up.

The problem with the MBS is that as an investor you have no way of knowing which mortgages are going to be bad. As an investor you buy an MBS or CDO (collateralized dept obligation) and expect the mortgages that the security is backed by will give you a constant revenue stream. When lenders default in large numbers the MBS takes a hit to its revenue stream. The problem for the investor that buys the MBS is that there is no way to know which mortgages (because of the way the mortgages are pooled) are going to be bad and which are going to be good.
So this gets back to Scott's question about how 8% could take down the entire system and it basically comes down to the investor not knowing how much of that 8% you are holding in your security. This lack of knowledge and transparency undermines the investor's confidence in the MBS. When investor's lose confidence in a certain type of security no body wants to buy them and the value of that security goes down.

I was sitting in a credit market class in the fall of 2007 when this crisis started to hit. My professor warned us seniors that we would be graduating into a recession and what we were studying would be the root cause of it. I was fairly skeptical at the time. But looking back it amazes me in how right she was.

[Wendell]

I am the person who originally made the "average joe" quip and maybe I should have explained myself better.

We all witnessed the housing boom and most of us knew that something was amiss. However, most of us did nothing about it. The typical reader of this blog is someone who is financially literate and understands that you cannot spend more than you earn or you will face trouble. However, there is a large majority of Americans that have forgotten that basic premise.

There is so much blame to go around on both parties on this issue and the reason I blame the average joe is because we have not been strong enough to vote all of these jerks out of office.

When your government fails you have to stop blaming the other person or the other party and blame yourself because we are still a government of the people.

Yes I represent banks however I deal with borrower attorneys on a daily basis. I also represent creditors in bankruptcy court so I see Chapter 13 plans. I see the people who lived way beyond their means for many years and were not prepared for a hiccup in their lives. If your issue is an issue of an instance of bad luck in your life most banks will work with you to modify your loan. Unfortunately there are very few people who just had one instance of bad luck. It really has been years of bad choices that has led to a series of unfortunate events.

[EasyChange]

@My Life ROI

I totally agree. The lazy politics of this situation is annoying. I want the last 10 minutes of my life back :)

[kitty]

@Frank. Apex, rwh and Cherry have done a good job explaining the crisis. I'd like to add a couple of things.

Some of the supposedly AAA-rated CDOs were "laced" with sub-primer mortgages. The math models that were supposed to justify AAA rating of some of these CDOs were faulty - they only worked when real estate constantly appreciated at about 7% every year. The rating agencies were fast asleep or rather they had conflicts of interest. There were also CDO squared or CDOs based on other CDOs.

Major Wall Street firms were massively over-leveraged to the tune of 40 to 1 so that they could turn more loans into these financial instruments and also to buy more of these instruments.

As Cherry Blossom said: as nobody has a clue what is contained in which CDOs or can trust even AAA ratings, the value of most of them dropped, possibly well below the value of mortgages themselves. Even CDOs not based on mortgages but based on investment grade corporate bonds lost value.

Then, in 2007, SEC decided to apply mark-to-market rule to the CDOs and the fun began. Banks have capital requirements - they can't lend money unless they have a certain amount of capital. The value of CDOs banks hold counts toward this capital. Mark-to-market rule says that the banks have to estimate the value of these CDOs based on their today's market price every quarter and to write down these losses in paper value as actual losses (even if they don't want to sell them). If these losses results in insufficient capital, the banks need to put more money in reserve to compensate. This resulted in more banks' selling CDOs and in further drop in value. This in turn created further losses and further write-downs causing tightening of credit: a) no bank knows what another bank has on its balance sheet so they are all afraid to lend to each other and to others b) the need to put more money in reserve reduces the amount of money available for lending c) as more and more banks failing, even less money are available. Hence the credit crisis at the height of which even McDonald had trouble getting a business loan from BofA. BTW - I am not saying that mark-to-market is responsible for the crisis, but it was just one of the cards, maybe the last one, that caused the whole house to collapse.

Last thing. About Credit Default Swaps - the "insurance" rwh mentioned against various credit instruments like bonds or CDOs. Credit Default Swaps (CDSs) differ from insurance in several major aspects.
a) the insurer selling the CDSs doesn't need to show it has the capital to pay it off in case of default
b) you don't have to own the bond to buy a CDS to protect yourself from its default, nor do you need to actually suffer a loss. As long as the bond or the CDO your CDS references defaults or has some bad event e.g. credit downgrade, you'll collect your money. It's a bit like my buying insurance on your home. This way if something happens to your home, I'll get the money, but I am not the one who lost a home. Even worse, it's like 10 people buying insurance on your home:

c) there is no limit on how many credit default swaps can be bought against the same loans: a CDS just references the credit instrument. Hence, they can be used for speculation. When the value of CDOs goes down, the value of CDSs goes up. So you can resell it without even waiting for a default. Many investors and institutions bought credit default swaps just for speculation, and the number of total credit default swaps on the market exceeded the number of credit instruments they referenced. When CDOs started defaulting, the insurers (like AIG) who sold many Credit Default Swaps simply didn't have enough capital to pay everyone. Oops...

This way a failure in just a few loans can be exponentially magnified through both the loss in CDOs value and the large number of "claims" from every buyer of Credit Default Swaps.

Wish I'd known all of this last year... I knew that real estate was overvalued, but I'd not been diligent enough to learn about all this financial instruments and speculation. So I failed to connect the dots.

[MasterPo]

Owning a house if faaaar more than just a mortgage payment.

There's utilities, property tax, insurance, and repairs/maintence (even with a new house).

I'd be willing to bet people who can't pay their mortgages are also behind in most if not all of these.

Point being that they bought more than they could afford.

[thomas]

I blame the individual. The individual who signed the dotted line. The individual who pushed an unconventional loan. The individual who showed the first individual around homes beyond their means.

Deadbeats, medical problems, etc. are are the results of the individual not taking care of themselves.

[JimL]

The unfortunate part is that the large number of us that have paid our mortgages in full and on time and are suffering from a significant drop in our home values are further penalized has we help to subsidize those who took on risky mortgage products or bought more than they could afford through the latest bailout packages.

[james]

Some excellent comments in this thread. A couple of supplementary thoughts:

1) idologues on the right seem to want to heap the blame on "individual recklessness." Fine. Let Joe Six Pack lose his house, car, boat, etc. But to be fair, let Citigroup and Bank of America -- two of the most reckless individuals during the boom times -- go bankrupt as well. But this will obviously not happen, since Joe Six Pack does not have a well funded lobby, whereas Citigroup, AIG and BOA have the politicians in their back pockets. Cynical? No man, just stating the obvious.

2) to all the Austrian economists who claim fractional reserve banking and Federal Reserve interest rate manipulation are the real culprits, answer me this: does the government first create money, which is then deposited in banks and then loaned out on the fractional reserve model; or do banks expand credit first, only to have the government then print money to meet reserve requirements?

3) do Republicans and pseudo-libertarians -- in short, everyone not named Ron Paul -- have any credibility on issues of fiscal responsibility when they have borrowed trillions upon trillions to persue untenable tax cuts and imperial wars? Is their outrage over Obama's stimulus plan the height of political grandstanding? Have Republican's ever passed a balanced budget in the past 30 years?

4) does Obama really think that clowns like Bernanke and Geithner -- who stood at the center of this financial tsunami while assuring us everything is "under control" -- have the ideas and intellectual muscle to guide us through this mess?

5) is the only true remedy to what ails this economy a more austere and financially literate public, a political class that puts the needs of the country before the needs of the lobbyists, and time?

James,

Your just a shill for the left. Go back and look at Barney Frank and the rest of the crew that pushed for years to provide home loans to low income families. Admit it, the entire Congress sat by while all this was going on.

Despite all that, we must all take personal responsibility for our actions. If people cannot read their loan papers, they have no business to take out a home loan. No one had a gun to their head. It is time for people to "man up" and take responsibility for their own actions and stop expecting someone else to pay for it.

[james]

Right, I'm mister Frank's errand boy; a left wing shill, or whatever.

Please. Your talking to a real fiscal conservative in name and PRACTICE.

Out of respect for the quality and integrity of this excellent site, I refuse to engage in ad hominen attacks.

But feel free to engage me on any of the 5 points I laid out.

If you can.

[kitty]

@Jiml - so true, but this isn't even the most unfortunate part. The most unfortunate part is all the people who've been paying mortgages on time, lived within their means, saved, and who are now losing jobs or are in danger of losing jobs because ALL businesses are suffering now. Companies in industries completely unrelated to mortgages (like Microsoft, Cisco, HP, small businesses that can't get credit to expand, world shipping industry, etc.) are laying off people and the new jobs are difficult to find since most aren't hiring.

@anon at 12:44.
While push to provide homes to poor may have contributed in some small way, it not what caused Wall Street to "invent" more and more exotic derivatives (CDOs, CDOs squared, CDS etc.) and sell them around the world. In fact, if you look at time line, Community Reinvestment Act happened a long time ago, and initially Fanny and Freddy had strict underwriting standards. It's only when the Wall Street took over and banks went into investment business than the real mess started. Sure, eventually Fanny and Freddy started buying up bad mortgages too, but only after the Wall Street investment bank had done it for a time.

Government didn't create all the small lending companies (like Lending Tree) in Florida that gave out mortgages to anybody with a pulse or advertised on TV how everyone can get "free money" by refinancing upwards and taking equity out of their home.

Yes government contributed, but IMHO SEC's removing all safeguards that were put in place in the 30s to protect us from the repeat of 1929 had a lot more to do with this then Community Reinvestment Act.

@Thomas - yes it is about individuals. But I'd include not only the individuals who took loans they can't afford and individuals who pushed these loans, but also the individuals who created the CDOs and Credit Default Swaps; individuals in government's credit rating agencies that assigned AAA value to these CDOs knowing full well that the models only worked if the real estate appreciated by 7% every year forever; SEC that allowed 5 major investment firms to be leveraged 40 to 1 and that decided that the Wall Street can police itself. These are all individuals.

@James - you make some good points, but I'd like to comment on this one:
" But this will obviously not happen, since Joe Six Pack does not have a well funded lobby, whereas Citigroup, AIG and BOA have the politicians in their back pockets. "

1. Citygroup, AIG, BOA aren't individuals. There are many Joe Six Packs working for these companies in various capacities that had no relation to this mess - IT, tellers, HR, secretaries, even financial advisers that were selling stocks. AIG has many businesses, and only one of them was selling Credit Default Swaps. All these people will end up unemployed, and since unemployed people don't pay taxes or buy things, both the government's bottom line and the economy will suffer. There are also average Joe Six Packs that own bonds or stocks that would be wiped out as well.

Additionally, the fallout of these companies going under would lead to the failure of many other organizations. Take for example AIG. AIG sold a lot of Credit Default Swaps, so now it has to pay the holders but can't afford to. If it fails, all the holders will be wiped out as well. Which would lead to further tightening of credit, more unemployment and an even worse economy.

Citigroup, BOA and other financial firms are all getting bailed out because of what happened after Lehman. The fact that they were allowed to go belly up, put fear into the market that there would be nothing to back up other financial firms. This fear totally locked up any hopes of liquidity in the banking market.

[james]

kitty, I agree that corporations are not "individuals" by any common sense definition, but the reality is they are individuals according to the law.

I want to know why is it that attempts to help the average working man and woman are greeted with scorn by so called "fiscal conservatives" as treacherous hand-outs to reckless borrowers, yet when it comes to bailing out failed institutions to the tune of TRILLIONS of dollars -- either through direct capital injections, or by the government backing the debt of these failed institutions -- our government represents these bailouts, which are in essense corporate welfare checks, as somehow being absolutely necessary to forestall economic collapse? It's a viscous double standard that can only be explained by the immense political clout these failed companies have over our elected leaders.

I agree that the interconnectedness of our financial universe -- especially in the form of financial derivatives of which CDS's represent a huge and nebulous subset -- makes a simple "bankruptcy" of AIG, Citi, and BOA a dangerous proposition. But the alternative which we are now persuing in various forms -- the proping up insolvent firms, creating in effect "zombie banks" -- represents and even more dangerous proposition, ala Japan's "lost decade."

My sense is that a massive economic dislocation is already unfolding, and that we should take our medicine now -- i.e., take out the insolvent firms -- in order to create the conditions for real growth 5 years down the road. The pain will be immense, many will suffer, but the road to recovery will arrive sooner than later.

Now, according to the anonymous poster:

"Citigroup, BOA and other financial firms are all getting bailed out because of what happened after Lehman. The fact that they were allowed to go belly up, put fear into the market that there would be nothing to back up other financial firms. This fear totally locked up any hopes of liquidity in the banking market."

The problem is not "liquidity," it's a question of "solvency." These firms are not "scared" to lend; they lack the minimal capital requirement to lend. How does a bank grant credit when its vaults are empty due to the devaluation of credit instruments on their balance sheets?

Hence the impotence of recent government measures to return credit markets back to normalcy vis a vis interest rate reductions and capital infusions.

Your putting the psychological cart before the capital horse.

James,

Read what Warren Buffet had to say this past week. Without the bank bailouts, we would have seen the financial systems collapse.

Also, you missed the point on the Citigroup/BOA point. The fear in the market has caused even the solvent and adequately funded banks to hold back on lending. For those getting lending, take a look at the unbelievable rates they are having to pay. Average companies are getting quotes similar to junk bond rates, which make it next to impossible for borrowing.

[james]

I stand by my comments. C and BOA are insolvent. They can't lend because their coffers are empty.

The fact that solvent banks -- and there are many such banks -- are charging higher rates of interest reflects the tightening of credit standards which is a natural off-shoot of the credit bubble implosion.

I can march right down to my local bank and get a 30 year mortgage at aroun 5%; car loan? not a problem. Credit worthy borrowers have no problems accessing the debt markets at reasonable rates of interest.

Firms which are heavily indebted AND which rely on bank financing for their operations are certainly paying through the nose for capital.

Bottom line: those who can afford credit are shunning it, and those who desperately need it can't get it, or get it only by many paying hundreds of basis points above treasury yeilds.

So no, I don't think I "missed" your point.

Finally, Buffet himself has made huge bets on the market using derivatives, i.e., Berkshire sold billions in puts several months ago which are now deeply underwater. The man who told us derivatives are "weapons of mass destruction" is himself being crushed by his use of derivatives. Berkshire stock has been cut in half; his stakes in WFC and AXP have been devastated. His insurance companies are being taken apart. Buffet is not infallible (but he's still an investment genius).

On the bright side, the futures are down again this Monday morning. How is this bright? Because I think the markets are finally entering the real "give-up" phase which is precursor to what I think will be a huge, multi-month rally.

At around 650 S&P I will start to deploy a percentage of my retirement funds back into the markets. If we crack below 600, I will become even more aggressive.

As Buffet said, be greedy when others are fearful.

James,

I think you need to go talk to some business owners. For our business, we still have the same credit rating (which is very strong). We have almost $1 Billion in annual revenues with an EBITDA of about 30%. When looking to borrow for expansion, we are quoted rates in the 12-15%. Why? It is a tight credit market. Many with the cash are not lending, which then keeps the rates high with the few that are.

Take a look at even the strong blue chip businesses. Did you see what Caterpillar had to pay for their last round of bank financing? Did you see what Pfizer had to agree to in order to finance the Wyeth deal? It took 5 banks to syndicate the deal and the rate only goes one year. Notice that corporations are going to bonds now instead of bank debt.

As I said, speak to a number of those that run a business and then you will see that you not only missed the point, but missed the mark.

[james]

What am I missing exactly?

Your fundamental claim is that we are in the midst of a "liquidity" crisis.

A real liquidity crisis can be overcome through aggressive Fed action -- see the Long Term Capital crisis of 1998.

Well, here we are today, with the Fed rate at effectively 0%, yet credit markets keep tightening. Why is that?

First, because many of our esteemed financial institutions are in effect "insolvent." They are insolvent because their balance sheets contain trillions in toxic debt instruments that are worth much less than what these banks claim they are worth. This is a direct result of "mark to market" accounting principles which the government forced banks to adopt over a year ago. These firms have no money to lend.

Second, banks with capital to lend are tightening their credit standards due to the precarious state of the economy. Since capital is precious and elusive to obtain -- many traditional outlets for capital raising, like preferred deals or investment from soverign wealth funds have been effectively shut down for many fims -- they are reluctant to lend lest they lose that precious capital, or they will only lend to firms that really need the capital at extremely high rates. Why? Because in a deteriorating economic enviroment, the risk to lenders increases exponentially, and they want to be adequately compensated for that risk, lest they join the ranks of the insolvent.

You state:

"For our business, we still have the same credit rating (which is very strong). We have almost $1 Billion in annual revenues with an EBITDA of about 30%. When looking to borrow for expansion, we are quoted rates in the 12-15%. Why? It is a tight credit market. Many with the cash are not lending, which then keeps the rates high with the few that are."

GE debt has a AAA rating. Yet its CDSs are just blowing out, and I mean off the charts. Why is the debt market punishing this esteemed corporation with an impeccable rating? Because the past year has taught us that credit ratings are worthless. By the time the credit downgrades arrive, it will already be too late.

The fact that your company has 1 billion in revenues, 30% EBITA, and a very strong credit rating means nothing in this enviroment. Do you have any earnings? What is the current debt level of your company? Using traditional metrics (pre 2007) to determine creditworthiness is no longer a usefull tool.

Like I said above, if your firm REALLY needs the capital, i.e., you lack the cash in the bank to expand, retool, revamp, whatever, then expect to pay through the nose.

Have I adequately explained the difference between a fear induced liquidity crisis, and a fear induced solvency crisis? The former is a temproary hiccup, whereas the later is nothing less than the ultimate battle for survival.

James,

Nice job dancing around the points made. Tell me, why do you think Pfizer had to go with 5 banks? Why do they have the 1 year limit on the current financing. Certainly, you are not saying they have a credit rating set for a major downfall. Why did Caterpillar have problems with bank debt? Why is Roche going the route of bonds to acquire Genentech versus taking on bank debt? You state that banks are afraid they will be insolvent. You can't be serious. Tell me how you think anyone would assume that these businesses are really that shakey.

Companies, such as ours, have cash. If we have the ability to borrow, we can expand even more. Yes, we are profitable. By borrowing, we can expand faster and do more of what we have been doing already (more product introductions, etc.) just like what other firms can do. However, as the banks are holding tight, alternatives are few.

Like I said, go out and talk to business owners. Likewise, develop some relationships within the banking industry.

[Todd]

James, I'll address each of your points:

James:

1) idologues on the right seem to want to heap the blame on "individual recklessness." Fine. Let Joe Six Pack lose his house, car, boat, etc. But to be fair, let Citigroup and Bank of America -- two of the most reckless individuals during the boom times -- go bankrupt as well. But this will obviously not happen, since Joe Six Pack does not have a well funded lobby, whereas Citigroup, AIG and BOA have the politicians in their back pockets. Cynical? No man, just stating the obvious.

Todd:

I have no problem with letting Citigroup and Bank of America go bankrupt, but obviously the FDIC would incur significant expense if they did because of its insurance obligations for a large number of those companies' depositors.

In addition, as an aside I don't know that BOA behaved that irresponsibly in "boom times." It seems to me that BOA has recently been in trouble because of obligations associated with its purchases of Merrill Lynch and Countrywide. At the time, those purchases were seen as positives.

James:

2) to all the Austrian economists who claim fractional reserve banking and Federal Reserve interest rate manipulation are the real culprits, answer me this: does the government first create money, which is then deposited in banks and then loaned out on the fractional reserve model; or do banks expand credit first, only to have the government then print money to meet reserve requirements?

Todd:

Ah, the old chicken or the egg question. I'll go with A.

James:

3) do Republicans and pseudo-libertarians -- in short, everyone not named Ron Paul -- have any credibility on issues of fiscal responsibility when they have borrowed trillions upon trillions to persue untenable tax cuts and imperial wars? Is their outrage over Obama's stimulus plan the height of political grandstanding? Have Republican's ever passed a balanced budget in the past 30 years?

Todd:

I'll handle the second question first. Yes, Republicans passed balanced budgets in 1998, 1999, 2000 and 2001. No Democratic Congress has passed a balanced budget in the last 40 years. At the rate the present Democratic Congress is going, it will be 400 years before another is passed.

With regard to spending during the Bush Administration, although there was some unfortunate spending, particularly with the Medicare drug benefit, overall spending excluding the military was up just a (relatively speaking)small amount. In 2000, for example, non-military outlays represented 15.4% of gross domestic product. In 2007, the last year for which firm data are available, non-military outlays represented 16.0% of GDP.

Military outlays did increase by 33%, from 3.0% of GDP to 4.0% of GDP. Obviously, most of this was related to prosecuting the war on terror, something that President Clinton and, unfortunately, Republicans in Congress failed to do in the 1990s as military expenditures fell from 5.2% in 1990 to 3.0% at the end of the decade. Nevertheless, 4.0% of GDP for military expenditures is historically rather modest. Indeed, from 1949 through 1993 military spending was never lower than 4.4% of GDP. Under President Carter, hardly an advocate of military spending, it was never lower than 4.7% of GDP.

I'll also add that your contention that the United States has been fighting "imperial wars" is unsupported by the evidence. Neither Iraq nor Afghanistan is a colony, and the United States does not appear to have imperial designs on either country. Iraq is also a modest supplier of crude oil to the United States, providing about 5.5% of crude oil imports in December 2008. Canada, the United States' #1 supplier, provides four times that much.

James:

4) does Obama really think that clowns like Bernanke and Geithner -- who stood at the center of this financial tsunami while assuring us everything is "under control" -- have the ideas and intellectual muscle to guide us through this mess?

Todd:

The more important question is whether President Obama, who more and more appears to be bereft of ideas and, in fact, little more than an affirmative action moron, has the ideas and intellectual muscle to guide us through this mess.

James:

5) is the only true remedy to what ails this economy a more austere and financially literate public, a political class that puts the needs of the country before the needs of the lobbyists, and time?

Todd:

There is no true remedy. The majority is uneducable.

[james]

Anonymous, it is clear you lack any sophistication in analyzing the current financial crisis. Conversation over.

Todd:

1) my first point is to claim that the insolvent money center banks and insurance companies are being kept on life support because they wield tremendous power over politicians. Do you dispute that?

As far as the cost to the government is concerned, look at just TODAY's headlines: there goes another 30 billion in cash to AIG, and another 300 billion to backstop its CDS liabilities. The question is, do we deploy our tax dollars to proping up these financial black holes, or should we be looking at alternatives?

2) Google Steve Keen's "Roving Cavaliers of Credit" for a very interesting look at the relation between credit expansion, money supply, and bank reserves. No definitive answers, but a fascinating read nonetheless.

3) An unfair dig at the Republicans as far as balanced budgets go, you're right. But in regards to your second point: "With regard to spending during the Bush Administration, although there was some unfortunate spending, particularly with the Medicare drug benefit, overall spending excluding the military was up just a (relatively speaking)small amount."

Excluding the military? That's like saying the Lions had an average season -- if you exlude the 16 games they lost. Not to mention the financial planners in Washington seemed to have borrowed a page righ out of Wall Street's playbook, with their off the books accounting of the wars in Iraq and Afghanistan. Add in TARP I, and your claim regarding marginal increases in spending under Bush seems, well, very wrong.

Again, I'm with Ron Paul as far as these wars go: they are a huge waste of lives and money. But I don't want to get into this political question because it is obvious each of us views what's going on from diametrically opposed positions.

4) Obama, sadly, is bereft of ideas. Nominating Geithner to Treasury and keeping Bernanke in power demonstrates as much. Your little affirmative action dig, however, is just silly and undermines your argument.

5) I don't share your contempt for the masses and their ability to grasp complex financial concepts. I believe financial literacy is not only possible; it's inevitable.

James,

I know you fashion yourself as a financial pundit. As I said before, try talking to those that actually run a business. I work it in every day. I have discussions on a weekly basis with the bankers at most major institutions and also interface with my counterparts at other major U.S. businesses. We actually deal in reality.

As I said before, go talk to business owners and you will get an education.

[Todd]

Hello, James.

As to your responses . . .

James:

1) my first point is to claim that the insolvent money center banks and insurance companies are being kept on life support because they wield tremendous power over politicians. Do you dispute that?

Todd:

Nope.

James:

As far as the cost to the government is concerned, look at just TODAY's headlines: there goes another 30 billion in cash to AIG, and another 300 billion to backstop its CDS liabilities. The question is, do we deploy our tax dollars to proping up these financial black holes, or should we be looking at alternatives?

Todd:

Alternatives.

James:

2) Google Steve Keen's "Roving Cavaliers of Credit" for a very interesting look at the relation between credit expansion, money supply, and bank reserves. No definitive answers, but a fascinating read nonetheless.

Todd:

I will check it out if I get the chance. (So many things to do, so little time.) I'm not too concerned about whether the chicken or the egg came first, however. My main concern is that the unbridled expansion of the money supply (whether via the fed through the printing of money or through the expansion of credit) is going to lead to serious inflation. As I'm planning to retire within the next decade, that's my enemy.

James:

3) An unfair dig at the Republicans as far as balanced budgets go, you're right. But in regards to your second point: "With regard to spending during the Bush Administration, although there was some unfortunate spending, particularly with the Medicare drug benefit, overall spending excluding the military was up just a (relatively speaking)small amount."

Excluding the military? That's like saying the Lions had an average season -- if you exlude the 16 games they lost. Not to mention the financial planners in Washington seemed to have borrowed a page righ out of Wall Street's playbook, with their off the books accounting of the wars in Iraq and Afghanistan. Add in TARP I, and your claim regarding marginal increases in spending under Bush seems, well, very wrong.

Again, I'm with Ron Paul as far as these wars go: they are a huge waste of lives and money. But I don't want to get into this political question because it is obvious each of us views what's going on from diametrically opposed positions.

Todd:

First of all, I view the war in Iraq as a mistake, but one we have to live with. (I view the war in Afghanistan as a political and military necessity.)

That being said, your original claim was about irresponsible spending, and Bush's spending on the military is far from irresponsible in historical terms. Indeed, it is quite modest compared to, inter alia, the defense buildup under President Reagan.

As far as TARP goes, I again agree this was money that should not have been spent in this matter, particularly encouraging stable banks like JP Morgan to take such funds.

James:

4) Obama, sadly, is bereft of ideas. Nominating Geithner to Treasury and keeping Bernanke in power demonstrates as much. Your little affirmative action dig, however, is just silly and undermines your argument.

Todd:

My "affirmative action argument" is actually central to my point. When you elect an intellectual cipher with no demonstrable achievements or leadership abilities as President, you shouldn't be surprised when he finds himself overmatched and led around by the nose by the leaders of his party. As well as bereft of any ideas other than spending the country into oblivion.

James:

5) I don't share your contempt for the masses and their ability to grasp complex financial concepts. I believe financial literacy is not only possible; it's inevitable.

Todd:

The "masses" are utterly incapble of caring for themselves. That's why we have this government Leviathan in the first place. The salient political problem domestically is now, and has been for some time, how to deal with all the idiots who get themselves in trouble through their own choices. In fact, that's what this post was originally about.