The Sixth Day
Tuesday, September 16, 2008
  Financial Chaos! – What it means to You.
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Much has occurred in the last two weeks. The U.S. Treasury assumed the debts of Fannie Mae and Freddie Mac; 158 Year-old investment banking firm Lehman Brothers filed for bankruptcy protection; broker Merrill Lynch sold itself to Bank of America; and global insurer AIG teeters on the brink of failure with reports as I write this that it has been extended an $85 Billion-dollar lifeline by the Federal Reserve to keep it from falling.


Why has this happened and what does it mean to you? I will give you a brief rundown and hopefully answer those questions about each of these events in my next few posts.


The Federal National Mortgage Association (nicknamed Fannie Mae, most likely by Wall Street traders who give nicknames to all the major firms whose securities they trade), was a creation of the Great Depression. Unlike most corporations which are chartered by the various states, it was chartered by Congress and thus given a unique status among corporations as having the backing of the U.S. Government for the bonds that it issued. It was created because bank failures during the Depression meant there was almost no money to lend for housing. Fannie Mae borrowed money by selling bonds and used that money to purchase mortgages from local banks. The banks could then use that money to lend to other home buyers. It was a way of bootstrapping the lending markets to get the housing industry going again in the midst of the financial crises.


While Fannie Mae began as part of the government, its stock ownership was privatized in 1968 to get its obligations off the Vietnam-wartime strained budget of the U.S. Its bonds were explicitly not to be guaranteed by the U.S. Government, but in practice they were treated as though they were in the marketplace which meant that Fannie (and the Federal Home Loan Mortgage Corporation – Freddie Mac, created later to compete with Fannie Mae) could borrow money at nearly the same rate as the U.S. Treasury.


The long and short of it is this. Because of the implied guarantee of the U.S. Government, commercial banks, like the one where you have your checking account, loaded up on the bonds issued by Fannie and Freddie. If Fannie and Freddie had been forced into bankruptcy, hundreds of banks would have become insolvent overnight. The Federal government had to act to prevent that from happening.


Most banks are already experiencing some distress because of falling home prices and difficulties among real estate developers. Fannie and Freddie bankruptcies would have pushed them over the brink. The FDIC (Federal Deposit Insurance Corporation) can only handle a few bank failures at a time. It generally tries to sell failing banks to stronger banks but there simply would not be enough strong banks to buy all the failing banks if Fannie Mae and Freddie Mac had gone into bankruptcy.


WHAT WENT WRONG


The senior executives of Fannie and Freddie are essentially political appointees rather than being elected by shareholders. They were expected to make housing “affordable” to more and more people. They did this all too well by buying loans that never should have been made. Those loans allowed housing prices to rise to levels far beyond the levels that would have prevailed if loans had been underwritten to normal standards. When reality began to hit sub-prime borrowers and adjustable rates ratcheted up on other borrowers, defaults rose and housing prices began to fall. Fannie and Freddie fueled the housing boom with their excesses.


Because of their ability to borrow money at low rates, Fannie and Freddie were hugely profitable. Those profits fueled fat salaries, bonuses, and rich stock options for executives. But, most importantly of all, it allowed Fannie and Freddie to buy exemption from meaningful oversight by spreading campaign contributions liberally around Capitol Hill to anyone who could make sure they did not have to follow the rules that would apply to normal financial corporations. This is the crux of the problem. If you want to know who is to blame, it is Congress!


The two biggest recipients of campaign contributions were Sen. Christopher Dodd, Chairman of the Senate Finance Committee that should have reigned in the excesses, and Sen. Barak Obamma. This is not meant to be partisan and there is plenty of blame to share on both sided of the isle and in both the House and the Senate but they were the biggest recipients. This is important for two reasons. One is that you should find out what, if anything, your senators and representatives did good or bad leading up to this crises and do not vote for anyone who shares the blame. And, you should be very skeptical of presidential candidate Obama’s claim that this is the fault and failure of the Bush Administration.

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Comments:
Gary, very good article. I appreciate the historic background and current perspective on "really" caused the problem.

In terms of AIG, keep in mind that as these 'risky loans' became more commonplace, the stong banks that were purchasing these loans regquired "loan insurnace" as their collateral. That loan insurance was made available via AIG. As more and more loans incurred non-payment and ultimate foreclosure, AIG has to insure the coverage. Ultimately, their credit rankings were lowered (AA+ to B), causing their ability to obtain borrowed money more difficult...which they needed to pay off these failed mortages they were insuring....thus putting the local banks at risk, thus returning us to a day of the great depression, where no loans would be given out, even to secure interests. Our whole economy is intertwined, and if people can't get money for cars, homes, school, etc, they stop spending, and the USA shuts down. If the USA shuts down, the world shuts down, and we go into a global depresion. Thus the feds have to bail out these firms to keep us afloat. The sad part, is it all equates to congress now doing its job of proper oversight and protection, and these quasi-government back firms, which are private, being greedy, and not having to play by the rules. Well, this is my thoughs....do I have the right perspective?
 
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Commentary about all things human; life, the Christian religion, ethics, politics, economics, sociology, art, anything to do with twenty-first century American culture. Perhaps I will inform, perhaps I will anger and frustrate, but I hope always to make you think!

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I grew up in Kansas in the 1950's - 60's. I attended Kansas State (B.S. in Soc. Science) and Washburn Law School (J.D.). My wife and I have been married for over thirty years and are the parents of three grown sons.

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