Failed Government Policies in the Financial Industry


INTRODUCTION

Bear Sterns, Washington Mutual... Lehman Brothers. These are just a few companies that filed for bankruptcy within the two years. All have reached out to the government for a bail out but only a selected few received it. The laws surrounding these events include failed policies by the government in regards to corporate responsibilities to their respective investors and consumers. The policies set by the government resulted to poor lending judgments that triggered a dramatic rise in mortgage delinquencies and foreclosures in the United States. This research paper will study the financial meltdown within our economy in the past years and the laws surrounding the event. We will first define the causes of the meltdown and then examine policy alternatives and recommend specific courses of action as possible solutions to deal with our current economy.

Scary headlines and scarier statistics tell the story of a financial crisis on a scale not seen in decades--- certainly not within the lifetime of most Americans. Moreover, this is worldwide financial crisis. Financial institutions on both sides of the Atlantic have either collapsed or have been saved from collapse by government bailouts, as a result of buying securities based on American housing values that eroded or evaporated.


BODY

Around 1997, the U.S. Congress did a few things that triggered the financial crisis we are facing today. One was the real estate capital gains tax cut, which eliminated the capital gains tax on primary home real estate held over two years up to $250,000 for a single filer and $500,000 for a married couple. This is one of the biggest tax cut ever and it made the real estate market the most favored investment by all the financial gurus at the time. Real estate prices rose in an unprecedented manner for approximately ten years in a row. Around the same time, the Dot com bubble burst and with the events of 9/11, the Federal Reserve responded by cutting interest rate to 1%, the lowest level ever in their history.

Low Interest rates encouraged a lot of people to buy or invest on a house. Congress pressured the mortgage industry to provide loans to those people who were normally would be denied in the past. It was basically making the mortgage companies lower their standards and in return unlimited funds would be available from private institutions. In addition to easy credit conditions, there is evidence that both the government policies contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises played an important role in the expansion of higher-risk lending. The term subprime refers to the credit quality of some borrowers, who have bad credit histories which means a greater risk of loan default than prime borrowers. At the center of it all were Freddie Mac and Fannie Mae, private companies but sponsored by the government and leadership was politically appointed. Basically, these two institutions were run by politicians from both parties, feeding the mortgage industry with billions of dollars earmarked for loans to those who previously didn't qualify for home ownership. Now you could buy a house for merely 10% down or maybe less in some cases even with a bad credit rating.Only $20,000 was needed to buy a house valued at $200,000 and the mortgage companies would even let applicants borrow that.Mortgage companies actively sold mortgages to people with bad credit and low incomes. The subprime market expanded very quickly. The value of the U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007.

Recognizing the demand for the housing market due to these new policies by the government, savvy investors jumped in the opportunity of buying homes with hopes of flipping it over for a profit. They started making fortunes overnight as they bought properties pre-construction and flipped them for a profit before they were even built. With the money they made, people started buying yet more properties, or larger ones. Home prices went higher and higher, banks and sellers reaped huge profits. With the consistent rise of the housing market, the government persuaded banks to relax its rules for loan approval. Mortgage applicants with bad credit rating or insufficient income were approved with banks simply charging them a higher interest rate after five years. The subprime market was seen as very profitable because of those higher interest rates

Then home prices stalled. They didn't drop, they just stopped ballooning. Many home owners feared they would lose their profit (not their house, just the money they'd "earned" over the last five to ten years). "The Jones's sold for $500,000 last year." Suddenly, thousands of home owners, then hundreds of thousands, put their homes on the market to get out while they still could.The market was flooded with supply and demand dried up while frightened buyers took a breather. Tick, tick, tick....

Home prices plummeted. A panic broke out first on Main Street. "For Sale" signs started cropping up like weeds as home owners tried to sell the roof over their heads before prices hit the basement. This was like a run on the bank. Simultaneously, millions ofadjustable rate mortgages were getting to that five year point when the interest rates would jump. Many people couldn't afford the new rates and they couldn't sell. Tick, tick, tick...

BOOM! Or rather, "bust."

Then came the margin call. Banks said pay up or it's foreclosure time. Millions of people faced the prospect of losing their only home, albeit one they couldn't afford in the first place. A new term was coined: "jingle mail." Many home owners justdropped the keys in the mailbox and walked away.

The bust quickly spread to Wall Street where those derivatives that looked like such a good idea were suddenly worthless. The banks (including Fannie Mae and Freddie Mac on the secondary mortgage market) couldn't sell foreclosed propertiesfor enough money to cover the original inflated loan and the huge home equity lines. Three of the five top investment banks, plus Fannie and Freddie, either failed or were taken over.

Fannie Mae and Freddie Mac were created to supply liquidity to the market. We keep hearing the word, "liquidity." It simply means cash or its electronic equivalent. Banks make mortgage loans to you and me, but then they have to wait up to 30 years to get that money back, so they sell your debt to Fannieor Freddie. That infuses themwithfresh capital, allowing the same bank to make more loans (keeping the market "liquid").

Several proposals from The Bush' White House were regarding a change to this system, but efforts to do so were denied by Congress. Around 2003, both Fannie Mae and Freddie Mac admitted that their financial books couldn't be relied upon but no one really cared. As long as home prices kept rising, these unsound practices didn't bother most people. In fact, the companies who originated the mortgages managed to sell them to Wall Street firms such as Bear Stearns and Lehman Brothers, who were looking to obtain higher yields on their proprietary trading portfolios. Leveraging up over 30:1, this became very profitable for those firms, until the bubble burst. At 30:1 leverage, you are bankrupt at as soon as losses exceed 3%.

Who is to blame? If by blame you mean losing money, obviously everyone who were long real estate after the peak in or around 2005 are to blame. But losing money isn't illegal; it happens in the market every single day � for every buyer, there is a seller, but the market only goes in one direction. Per definition, after the fact, every trade has a winner and a loser. What about doing something illegal? If there is something illegal here, I haven't seen it. Lots of stupidity and the usual bubble mania, but those things aren't illegal.

Certainly Congress is at fault for having created the monster organizations Freddie Mac and Fannie Mae. Neither one should have been created to begin with, because the government has no legitimate role in conducting commerce. It is equivalent to the government starting airline companies for the purpose selling subsidized airline tickets. In addition, the pressures Congress put on the mortgage organizations to make loans to those who didn't deserve them were extremely complicit in this debacle. Some of the investment banks shot themselves in the foot by taking on bad mortgage paper and leveraging up, leading to their demise.

What's the solution now? Sadly, the milk has already been spilled, because some people who didn't deserve mortgages already received them, and others bought homes at prices too high. There is simply no painless solution to this fundamental situation; prices must be allowed to fall. Those who are heavily exposed � indeed leveraged � to overvalued financial instruments, will have to take losses and some may go bankrupt.

One final word of caution and moderation: We had a 10-year real estate boom in which more wealth was created than in any previous boom or bubble. In the last 18 months, we have given back some of those gains, but far from all. Booms and busts do happen, but as with the Internet boom a few years earlier, on balance more wealth was created than destroyed as the bubble burst and some of the gains given back. It's happened before, and it will happen again � just like Summer turns to Fall, Fall turns to Winter... bubbles and business cycles are part of economic � and therefore human � nature.


CONCLUSION:

DRAWN FROM BODY OF PAPER*

RECOMMENDATIONS REFLECT USE OF INFORMATION PROVIDED*


REFERENCES:

CURRENT OR TIMELY*

ALL CITATIONS IN REFERENCE LIST

APA FORMAT

* Proposes bold, yet principled approaches-including financial policy alternatives and specific courses of action-to deal with this unprecedented, systemic financial crisis

* Created by the contributions of various academics from New York University's Stern School of Business

* Provides important perspectives on both the causes of the global financial crisis as well as proposed solutions to ensure it doesn't happen again

* Contains detailed evaluations and analyses covering many spectrums of the marketplace

faculty to make a serious contribution to the repair efforts underway.

Introducing an independent view of the financial crisis, Restoring Financial Stability: How to Repair a Failed System features executive summaries of 18 targeted and definitive White Papers authored by 33 Stern academics that offer financial policy alternatives�and specific courses of action�to restore the global financial system.

1. Why did the financial meltdown happen?

2. Who is to blame for it?

3. What, if anything, can be done to fix it?

I know many of you don't have the patience to read more than the absolute minimum, so I start by giving some of the briefest answers possible:

1. Cause? The price of housing � and therefore mortgages � was too high, which in combination with high leverage (such as >30:1) caused those institutions who bet on the wrong direction of the market to go bankrupt in an accelerated fashion.

2. Blame? Most of the blame is simply in the hands of those who were too optimistic on the housing/mortgage market. Those who shorted those markets made lots of money.

3. Solution? Basically nothing. Asset bubbles happen every few years (remember the Internet boom 1999-2000?) and they will happen again. Prices must simply be allowed to adjust down.

Here is more detail:

Why did the financial meltdown happen? In and around 1997, the US Congress � supported by President Clinton � did two things. One was the real estate capital gains tax cut, which eliminated the capital gains tax on primary home real estate held over two years up to $250,000 for a single filer and $500,000 for a married couple. This may be the biggest tax cut ever, and it made real estate the most favored investment class. Small wonder, then, that real estate prices rose in an unprecedented manner for approximately ten years in a row. At some point, however, as in any bubble rising, it went too far. It became easy to see at some point after year 2000 when in many places it had become cheaper to rent than to own, pointing to over-inflated prices.

Around the same time, Congress was persuaded to pressure the mortgage industry to provide loans to those it claimed it had been unjustly denied loans in the past � the poor, blacks, et.al. The mortgage companies were basically told to make loans with lower standards than in the past...or else. If they played ball, unlimited funds would be available from Freddie Mac (FRE) and Fannie Mae (FNM). If they didn't play ball... well, John Edwards is a great trial lawyer going after those evil big corporations.

At the center of what turned into a highly unsound feeding frenzy were Freddie Mac and Fannie Mae, ostensibly private companies but ones where the leadership were politically appointed. Basically, these two institutions were run by political hacks from both parties, feeding the mortgage industry with billions of dollars earmarked for loans to those who previously didn't qualify for home ownership.

Around 2003, Fannie/Freddie admitted that their financial statement couldn't be relied upon, and it's not clear that they ever put them in order since. There were several proposals from The White House in recent years to change this system drastically, but efforts to do so were rebuffed by Congress and in particular Chris Dodd and Barney Frank. As long as home prices kept rising, these highly unsound practices didn't bother most people. In fact, the companies who originated the mortgages managed to sell them to Wall Street firms such as Bear Stearns and Lehman Brothers (LEH), who were looking to obtain higher yields on their proprietary trading portfolios. Leveraging up over 30:1, this became very profitable for those firms, until the bubble burst. Remember, at 30:1 leverage, you are bankrupt at as soon as losses exceed 3%.

Who is to blame? If by blame you mean losing money, obviously everyone who were long real estate after the peak in or around 2005 are to blame. But losing money isn't illegal; it happens in the market every single day � for every buyer, there is a seller, but the market only goes in one direction. Per definition, after the fact, every trade has a winner and a loser. What about doing something illegal? If there is something illegal here, I haven't seen it. Lots of stupidity and the usual bubble mania, but those things aren't illegal.

Certainly Congress is at fault for having created the monster organizations Freddie Mac and Fannie Mae. Neither one should have been created to begin with, because the government has no legitimate role in conducting commerce. It is equivalent to the government starting airline companies for the purpose selling subsidized airline tickets. In addition, the pressures Congress put on the mortgage organizations to make loans to those who didn't deserve them were extremely complicit in this debacle. Some of the investment banks shot themselves in the foot by taking on bad mortgage paper and leveraging up, leading to their demise.

What's the solution now? Sadly, the milk has already been spilled, because some people who didn't deserve mortgages already received them, and others bought homes at prices too high. There is simply no painless solution to this fundamental situation; prices must be allowed to fall. Those who are heavily exposed � indeed leveraged � to overvalued financial instruments, will have to take losses and some may go bankrupt.

One final word of caution and moderation: We had a 10-year real estate boom in which more wealth was created than in any previous boom or bubble. In the last 18 months, we have given back some of those gains, but far from all. Booms and busts do happen, but as with the Internet boom a few years earlier, on balance more wealth was created than destroyed as the bubble burst and some of the gains given back. It's happened before, and it will happen again � just like Summer turns to Fall, Fall turns to Winter... bubbles and business cycles are part of economic � and therefore human � nature.

How Did We Get Here?

There's a lot of talk about the word "greed" right now. Taxpayers talk about the greed of Wall Street investment bankers. Bankers talk about the greed of home owners who bought more house than they could afford. And now, after a decade and a half of record profits, the financial sector has gone hat-in-hand to the government looking for a $700 billion handout.

But how did we really get to this point?

The answer, of course, is complex. So complex in fact that there are scores of analysts and economists trying to untangle the mess. But the meltdown of the financial markets can be simplified by taking a long view of history.

In 1929, the roaring twenties came to a screeching halt with the crash of the stock market and a run on the banks. The depression affected the vast majority of Americans and had lasting economic consequences through World War II. Most Americans today know well the story of the "Great Depression" as told by our grandparents. But most don't know the back story and the lessons learned then that can be applied now.

The roaring twenties were fueled by an unprecedented number of Americans gambling on Wall Street -- not bankers and traders, but everyday Americans. The lubricant of this financial machine was something called "margin."Basicallyyou could buy stock on credit, purchasing a thousand dollars worth of shares with just a hundred dollars down. Once the stock went up -- and it always did in the years leading up to 1929 -- you could sell it at a huge profit and pay off the loan and keep the rest. So long as the market kept going up, everyone made a lot of money.

But then stocks started going down. There was a mass "margin call" -- time to pay up for the stock you bought for 10% down. But who had that kind of money, especially sincethey'd have to sell the stock at a huge loss? Not enough had the money, and the margin call accelerated the collapse of the market and the banks that funded all that buying. As the banks started to buckle under the weight of all that unpaid debt, depositors ran to get their money out. That hastened the fall of the banks and left millions of Americans broke. The FDIC was born of that crisis, insuring individual deposits up to $100,000 in all commercial banks.

What does this ancient history have to do with the problems gripping our economy today?We all started treating ourhouses as investments rather than places to live -- and we bought them on margin.

The credit crunch became a true crisis last week when there was zero liquidity in the market. Fannie and Freddie weren't buying mortgages and banks weren't making loans to each other or anyone else. Those transactions are the engine of the entire economy. The credit cycle had ground to a halt -- the financial equivalent of going to the mall and finding all the stores either closed or refusing to sell.

The home was once the very symbol of the American dream. But now it might as well have the Enron "E" in the front yard. We gambled with the one thing we couldn't afford to lose. And now we're all going to pay for it, one way or the other.

Copyright 2008 The E.W. Scripps Co. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/failed-government-policies-in-financial-industry.php


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