President Bush recently called for increased powers for the Federal Reserve.[1] Before we make that leap, perhaps we should evaluate who is really responsible for the current sub-prime mess. Companies from banks to rating agencies to underwriters are being sued or suing others as lawyers try to determine who was ultimately responsible for the disastrous sub-prime collapse. In the meantime, Congress is considering giving the Federal Reserve more power to control and protect the economy. Everyone is missing the real culprit in all of this. The sub-prime mess was caused by the actions of the Federal Reserve and the natural business reactions by all of the parties involved (with some notable exceptions).
What caused the sub-prime mess was cheap money. When money is cheap financial institutions loan as much as they can. That is how they make money. Obtain it at a low rate and loan it out at higher rates. When all the good solid deals are done and money is still available, lenders and all good investors see opportunity. Higher risk deals, referred to as Alt A and Sub prime loans, yield higher interest rates and a greater spread between the cost of money and the income from the loan.
First, a bit of history. Increasing home-ownership has long been the “American Dream,” and therefore a political objective of the administration in power. In the 1960s Fannie Mae’s charter was changed to help banks make more loans. They began the process of buying mortgages from banks so that they had new money to loan. Fannie Mae then bundled these mortgages and with investment bankers, registered them as securities and had them rated by Standard and Poor’s and other trusted securities rating houses. The investment bankers then sold them to investors. These were designed to be long-term investments whose value was based on the underlying collateralized mortgage loans. This process was virtually identical to a similar process used for years to sell municipal bonds, corporate debt and commercial paper. These bundled securities were referred to as collateralized debt obligations (CDOs).
Over twenty years ago, investment bankers began to facilitate auctions where these CDOs could be purchased and sold. Auctions were held more or less monthly. As a result, investors began to purchase Auction-Rated CDO Securities (ARS) as short term high yield and fairly liquid investments for cash that they would need in the near term.
ARS were rated from investment grade, AAA, to “junk” quality. The latter of course came with the highest return on investment possibility and the highest level of risk. Bundled sub-prime loans often found themselves rated as junk or nearly junk in this manner throughout time, even into this decade. Junk bonds, also popular in this era, were rated in the same manner, and also continue to be traded today. ARS were purchased and sold based upon those ratings and have been reliably traded up until the recent crisis.
So, many smart people were investing in securities rated by smart people that were created by smart people and traded by smart people for years. What drove this recent and unprecedented situation?
The answer is simple, the actions of an unbelievably irresponsible Federal Reserve. The Federal Funds Rate is set by the Federal Reservs’s Board of Governors and is the rate at which bank’s borrow money from the Fed. It is the leading driver of interest rates.
On September 17, 2001 the Fed lowered this rate to 3.0%. Historically this was seen as a drastically low rate, one reached only once since 1962. Nonetheless, in an over-reaction to 9/11, the Federal Reserve lowered the Fed Funds rate even further, below 3.0% for the first time in 40 years.
Ø From July 1990 to January 2001, the Fed Funds rate hit a high of 8% (July 13, 1990) and low of 3% (September 4, 1992), but averaged about 5.25% (from the Fed’s website).
Ø On January 3, 2001 the Fed Fund rate was 6.0%.
Ø September 17, 2001 it hit 3.0%.
Ø October 2, 2001 the Fed dropped this rate to 2.5%, below 3.0% for the first time since the early 1960s, nearly 40 years. Then dropped it further.
Ø November 6, 2001: 2.0%
Ø December 11, 2001: 1.75%
Ø November 6, 2002: 1.25%
Ø June 25, 2003: 1.0%.
While all previous forays below 3.0% lasted only briefly, this time the Fed Funds Rate sat at 1.0% for a full year and did not move above 2.0% for over three years. It did not eclipse 3.0% again until May 3, 2005, a period of three years and eight months. This time of incredibly low interest rates is simply unprecedented in U.S. history and led to dire but predictable reactions in the markets.
What lender had any experience in such an environment? Spurred by post-9/11 rhetoric, they did what banks do, they made loans. This had vast consequences that compounded upon one another to create the disaster we are currently experiencing.
Banks felt pressure to make loans. When all of the good loans were made, the only way to invest the cheap cash available was to make more sub-prime loans than usual.
For loans to be made, people who could not afford a home had to decide to buy one using a sub-prime mortgage.
Demand for homes went up.
In 2004, when rates were 1.0% and not coincidentally in the midst of the presidential campaign, home ownership hit all-time highs. Millions achieved a dream they never believed they could reach.
The Bush Administration pushed through a reducing oversight of the mortgage business. Home demand increased.
Whenever demand increases, however, prices rise and that is precisely what occurred in the housing markets.
Home builders saw this and began building more homes.
Since interest rates were low, builders could borrow money cheaply to build even more homes. Bright experienced builders simply did what they do best.
Lenders also saw that home prices were rising, so well-educated conservative bankers rationalized higher loan to value ratios to put more money to work and get more people into new homes.
Home supply increased to meet the new demand.
The only way to do a sub-prime loan is on an adjustable rate basis, but then rates had been so low for so long, who could have predicted what would come next?
The other shoe dropped. The market certainly predicted that rates could not stay so low, hence the use of ARMs, but everyone assumed that after 3 years and 8 months of unprecedented rates, the extremely bright albeit ivory tower economists at the Fed would raise rates gradually over many years to soften the landing. The system was designed for this. It took over 7 years the last time rates were this low to get to 5%.
Had the rise in rates occurred gradually back to 5.0% over a 4 - 6 year time-span, the sub-prime mess would have been wholly averted. But of course, that is not what happened. The Fed over-reacted yet again.
Greenspan left and Bernanke entered. He and his group began to raise rates, but not gradually. They yanked them up over a short period of time. Beginning on June 30, 2006, it went up and fast.
Ø November 10, 2004: 2.0%
Ø May 3, 2005: 3.0%
Ø June 29, 2006: 5.25%
Rates rose too much, too quickly. In just two years the Fed raised the Fed Fund rate 17 times for a total increase of 4.25 percent. That was one of the steepest and longest climbs in terms of net rate increase in the last twenty years.
No one could react. Houses were being built. Loans were made. Adjustable rate mortgages of all kinds were suddenly untenable. A three-year ARM done in 2004 at 4.0% adjusted to 8.0% or higher. The house of cards fell and banks, investment bankers, investors and borrowers, found themselves on the wrong end of a bad situation. So whose fault was it?
Every player acted economically rationally. Banks loaned money at good rates and helped good people buy a home. Borrowers borrowed what they could afford, and made logical assumptions about future rate adjustment and home values. Builders built homes. The process of creating mortgage-backed securities operated just as it had for all of the years that this vehicle had existed. Rating agencies rated them. Investment bankers, relying on these ratings, sold them. Investors bought them and sold them at monthly auctions.
All players operated rationally, except one. The one everyone else relied upon to know what it was doing: The Federal Reserve.
The Federal Reserve’s blunder raising rates so precipitously created the following predictable Economics 101 results:
ARMs adjusted too much too fast causing great and unrecoverable pain for millions of borrowers. This had to be foreseeable by the Fed.
Good solid middle-class hard-working and excited first-time homeowners, suddenly could not pay their loans and defaulted.
These people were now worse off than before they joined in the American Dream of home ownership.
At the same time, higher interest rates killed the demand for new housing.
Combined with the glut of newly constructed houses, the decline in demand caused housing prices to fall.
Home builders could not sell their home inventories, defaulted and declared bankruptcy.
Individuals with decent credit could not even refinance their homes to get out from under the oppressive increase in their ARM payments.
More homeowners defaulted or became house poor.
Higher mortgage payments decreased available cash to spend.
Consumer spending decreased damaging retailers and sending the economy into a tailspin.
Investors panicked and refused to purchase any kind of ARS at the auctions. Investment banks could not purchase everything and the auctions failed. The only way for investors to sell and get their cash was gone.
Accountants got conservative and relied upon post-auction sale prices to value many remaining and strong non-sub-prime CDOs and corporations were forced to restate financials.
The stock market plummeted.
Lawyers filed lawsuits to figure it all out.
Banks are struggling.
Investment houses are declaring bankruptcy.
The dollar is sliding.
Foreign companies are buying up strong U.S. companies in droves.
U.S. financial markets are falling apart.
And now the Congress is considering giving the Federal Reserve MORE power to screw up the economy? Perhaps they should go back to basic economics and try again.
About the Author:
Ned Lips is a BDM with UHY Advisors FLVS, Inc. and leads its national thought leadership program. He is an attorney, having graduated with High Honors from George Washington University, who practiced in St. Louis for 12 years before becoming an entrepreneur and now business strategist. He also teaches the MBA Capstone Strategy class at St. Louis University as an adjunct professor.
[1] St. Louis Post Dispatch, June 20, 2008, Business Section, Page B2.
