The Credit Crunch Millstone
Several times in recent weeks I have heard people scoffing at bankers and suggesting that as a profession bankers are now more reviled than estate agents and second-hand car salesmen. Bankers it would seem are to blame for the current credit crisis and the directors of our British banks are not deemed worthy of the bonuses that would accrue to them during the normal discharge of their duties.
Popular belief is that the credit crisis has been caused by reckless lending on the part of bankers everywhere. The term 'sub-prime lending' has been banded about as a generic description of this reckless lending in which bankers are alleged to have loaned money to people who could never have been judged capable of repaying the debts incurred - but what is the truth? What collective insanity overcame the banking world and caused the current crisis?
Sub-Prime Lending In The UK
Firstly, while there has been a loosening of credit restrictions over several decades in the UK and while the total of both national and consumer debt is higher than at any time in our history, there has not yet been a massive wave of loan defaults in this country and certainly nothing has happened on the domestic consumer front that could be blamed for the collapse of Northern Rock and the demise of Bradford & Bingley and HBoS. Yet the British public have been stunned by these events and the subsequent announcements that our banks have desperately low cash reserves, such that their liquidity ratios are so out of kilter that they are terrified of lending to each other and disinclined to lend further to the public either.
We are aware that the so called 'Credit Crunch' emanates from the US, but so far economic pundits and political commentators have been rather hazy when it come to explaining the link and the mechanism by which 'sub-prime lending' in the US is linked to bank failures in the UK and elsewhere.
Sub Prime Lending Per Se
In the UK it has been possible until recently to obtain mortgages where the amount advanced is 100% of the purchase price of a property or more, possibly as much as 125% of the purchase price. Such loans however have usually only been available to first time borrowers in steady employment and with good credit histories. Furthermore, 125% advances have in the main only been made in circumstances where a property has been purchase for substantially less than its normal market value, such as when a council house tenant purchases a house under a right to buy scheme for half its normal value. In such circumstances, while the advance is perhaps 125% of the purchase price, it may still be less than say 90% of the normal market value of the property.
It has also been possible in the UK until recently to obtain self-certified mortgages in which the lender does not require proof of income, but instead takes the applicant's word that they can afford the loan requested. These loans have been popular with the self-employed who have always tended to present a different set of accounts to their bank manager than they would present to HM Revenue and Customs. Self-certified loans however have normally only been available to borrowers where the advance is no more than 75% of the value of the property. Young professionals have also traditionally been able to obtain low-start or deferred interest mortgages in which the repayments have been reduced for an initial period, thus enabling them to afford much larger mortgages with much higher income multiples than would normally be the case. The assumption has been that as they gain professional qualifications their income will increase significantly and in a way that is almost predictable, thereby enabling them to afford the higher repayments that will inevitably apply once the low-start initial period has elapsed. Lastly, there have been sub-prime mortgages proper, the mortgage facilities that a small number of specialist lenders have offered to people with less than perfect credit histories. These loans have traditionally been offered only to people who can substantiate mitigating reasons for their poor credit history and only in circumstances where they are subsequently borrowing on terms that are relatively conservative in all other respects.
All these things have been available in the UK and the credit expansion they represent has contributed to the constant rise in house prices in recent years. However limiting factors have always applied to their application and it has not been possible in the UK for borrowers to obtain all of the features listed above in one loan package. The full-blooded 'Ninja' mortgage, No Income, No Job or Assets, has only really been available to consumers on any significant scale in the US.
Sub-Prime Lending In The US
In the US sub-prime mortgage lending has deep roots that are as much political as they are economic and to understand the way in which matters have unfolded over the years it is necessary to go back several decades.
Freddie Mac & Fannie Mae Are Created
In 1938 the Federal National Mortgage Association or 'Fannie Mae' as it has become known, was formed as a government agency to create liquidity in the mortgage market. That is, to buy mortgages from loan providers, many of which are small town banks that operate on a mutual basis, much as building societies have traditionally done in the UK, and to package the mortgages and sell them on. This practice allowed small banks in rural areas to extend far more credit to the communities they served, thereby extending home ownership.
In 1968 Fannie Mae was converted into a private shareholder-owned corporation to take it off the government's balance sheet, but this move was more cosmetic than substantial as Fannie Mae continues to carry an implicit government guarantee so that if or when it fails, taxpayers will bail it out. A competitor to Fannie Mae was also created 1970, the Federal Home Loan Mortgage Corporation otherwise known as 'Freddie Mac'. 'Freddie' and 'Fannie' now both compete in buying mortgages from loan providers, and in repackaging and selling the mortgages on to investors in the secondary mortgage market.
ACORN is Formed
The Association of Community Organizations for Reform Now (ACORN) was formed in 1970 as a not-for-profit, so called non-partisan social justice organization with national headquarters in New York, New Orleans and Washington, D.C. It has since become the nation's largest grassroots community organization of 'low and moderate income people' with over 400,000 member families organized into more than 1,200 neighbourhood chapters in 110 cities across the USA.
The US is a very racially divided society and the term 'low and moderate income people' has become a euphemism for 'black and minority ethnic' (BME) people, as while ACORN does ostensibly still represent the interests of poor white people too, one only needs to visit their website (www.acorn.org) and observe the graphics used to realise that it is primarily a civil rights group acting almost exclusively in the interests of the BME communities.
ACORN was co-founded by Gary Delgado and Wade Rathke, both ex-organisers of the left-wing National Welfare Rights Organization. Rathke is also an ex-member of SDS (Students for a Democratic Society) a student Marxist group and part of the radical New Left movement that formed in the US during the post war period.
The Community Reinvestment, and Home Mortgage Disclosure Acts The 'Community Reinvestment Act' (CRA) was signed into law by President Jimmy Carter in 1977. The CRA mandates that each banking institution be evaluated to determine if it is meeting the credit needs of its entire community. The purpose of this legislation was to ensure that 'under-served' populations, primarily ethnic minorities, could obtain credit and loans on terms sufficient to boost home ownership rates amongst such groups.
In 1980, ACORN and other community organizations, under the auspices of the CRA began to accuse banks of 'redlining', i.e. of discriminating against minorities in mortgage lending. They argued that home ownership amongst BME communities was significantly lower than amongst the white majority and that this was evidence that banks operated lending policies that were racially discriminatory.
In 1989, Congress dominated by the Democrats, amended the Home Mortgage Disclosure Act in order to force banks to collect racial data on mortgage applicants, with the intention that in so doing, the institutions would provide the likes of ACORN and federal regulators with the statistical ammunition needed to bring about change in banking practices vis-à-vis lending to BME applicants.
Three years later in 1992, under pressure from ACORN and in an effort to appear compliant and in tune with the spirit of legislation in this area, the Federal Reserve Bank of Boston published a study indicating that black and Hispanic mortgage applicants in the Boston metropolitan area were roughly 60 percent more likely to be turned down than whites. ACORN's Marxist political outlook would not accept that BME loan applicants were rejected more frequently for legitimate and prudent banking reasons. While the banks argued that BME applicants on average had lower incomes than white applicants; rarely had a deposit to put down when purchasing a home; had less stable employment histories; and had worse credit histories than white applicants on average, and that for these legitimate reasons presented a greater risk of mortgage default and were less attractive prospective borrowers, ACORN dismissed these factors amid allegations of 'institutional' racism.
Buycks-Robertson vs CitiBank Federal Savings Bank
During this period, Barack Obama was a newly qualified civil rights lawyer involved in community activism with ACORN. He was engaged by ACORN to provide training for their community activists and in 1994 acted as attorney representing one Calvin Robertson in a 'Class Action' lawsuit against Citibank, charging that the bank systematically denied mortgages to African-American applicants and others from minority neighbourhoods. In this case, Obama and four other lawyer associates from his law firm jointly attacked CitiBank and using a premise introduced by the Department of Housing and Urban Development (HUD) under the Clinton administration, that where the application of contractual terms and conditions on average produces differential outcomes for different racial groups, this still constitutes evidence of racial discrimination, even if the terms and conditions have been applied fairly and with no intent to discriminate. 'Disparate impact' as it became known, was regarded as evidence of discrimination.
Obama and his colleagues won the case which was one of a number of similar highly publicised cases against banks and lending institutions instigated by ACORN with the support of HUD during the 1990s, which served as a warning to mortgage providers that their records with the regulators needed to show 'equality of outcomes' and not just 'equality of opportunity'. In short, where BME applicants were found to be less successful than white applicants when lending terms and conditions were applied even handedly, then lenders needed to relax their lending criteria for BME applicants until parity of outcomes was achieved.
(the link's no longer there, sadly).
As a consequence, mortgage banks fell over one another to provide loans to low-income households and especially to minority customers. In the five years from 1994 to 1999, the number of African-American and Latino homeowners increased by two million.
Further Pressure Placed Upon Banks
During the early to mid-90s activists and community organisers from ACORN conducted a campaign of 'direct action' aimed at intimidating banks and more specifically their staff, to increase lending to minority applicants. Organisers led mobs into bank premises and turned up at bank employees' homes in order to physically intimidate bank staff and their families in a campaign that was directly comparable to the kind of low grade 'terrorism' conducted by animal rights activists against the proprietors and employees of Huntingdon Life Sciences during the same period.
In 1995 changes were made to the Community Reinvestment Act to establish a system by which banks were rated according to how much lending they did in low-income neighbourhoods. A good CRA rating was necessary if a bank wanted to get regulators to approve mergers, expansions and even new branch openings. A poor rating could be disastrous for a bank's business plan. It was a different kind of coercion, but just as effective.
Throughout the 1990s and beyond, the Department of Housing and Urban Development (HUD) pressured Fannie Mae and Freddie Mac to increase the percentage of mortgages they purchased from primary lenders that were derived from loans to borrowers earning below the median income for their area. Initially the requirement was set at 42% but it was increased to 50% in 2000 and 52% in 2005.
In April 1998, Andrew Cuomo, President Clinton's Secretary of Housing and Urban Development announced an 'affirmative action' settlement with Accubank, a Texas bank. HUD forced Accubank to provide 2.1 billion dollars in risky mortgages to low-income Americans.
The Involvement Of George Bush
When George W. Bush addressed the White House Conference on Increasing Minority Homeownership at George Washington University on October 15th 2002, he said, "... in America today two-thirds of all Americans own their homes, yet we have a problem here in America because fewer than half of the Hispanics and half the African Americans own their home. That's a homeownership gap. It's a -- it's a gap that we've got to work together to close for the good of our country, for the sake of a more hopeful future."
"We've got to work to knock down the barriers that have created a homeownership gap."
"I set an ambitious goal. It's one that I believe we can achieve. It's a clear goal, that by the end of this decade we'll increase the number of minority homeowners by at least 5.5 million families... And it's going to require a strong commitment from those of you involved in the housing industry ..."
Bush went on to say, "Last June, I issued a challenge to everyone involved in the housing industry to help increase the number of minority families to be home owners. And what I'm talking about, I'm talking about your bankers and your brokers and developers, as well as members of faith-based community and community programs. And the response to the homeowners challenge has been very strong and very gratifying. Twenty-two public and private partners have signed up to help meet our national goal. Partners in the mortgage finance industry are encouraging homeownership by purchasing more loans made by banks to African Americans, Hispanics and other minorities."
"Freddie Mac recently began 25 initiatives around the country to dismantle barriers and create greater opportunities for homeownership. One of the programs is designed to help deserving families who have bad credit histories to qualify for homeownership loans."
Sub-Prime Lending In The US - An Analysis
As we can see from the above, the roots of the sub-prime lending crisis and the subsequent 'Credit Crunch' extend back over more than three decades to the Carter Presidency and the 1977 Community Reinvestment Act.
Successive Democratic and Republican administrations having absorbed the tenets of cultural Marxism wanted to create a situation in which there would be equality of outcomes between the various ethnic and racial groups in their endeavours to buy their own homes, not just equality of opportunity.
The outcome of all the pressure placed upon American banks and mortgage-lending institutions is that progressively they relaxed previously prudent lending standards in order to accommodate the political aims of the federal government and left-wing minority advocacy groups:
- Gradually reducing the requirement for borrowers to place a deposit as a down payment when buying a home until eventually 100% advances were commonplace
- By making low-start and deferred interest payment mortgages available to low income non-professional applicants who had no prospect of a significant increase in income in the foreseeable future
- By not taking up employer's references and by allowing low-income applicants to self-certify that they are employed and that they have the income necessary to afford the loans applied for and
- By not taking up credit references, so that even low-income applicants with horrendous histories of previous loan defaults could still obtain loans.
American Banks found that they could make the full blooded 'Ninja' loans to poor BME applicants almost with impunity as they were able, through the actions of Freddie Mac and Fannie Mae, to relieve themselves of the financial liability that would come from the inevitable 'Tsunami' of loan defaults and repossessions that would follow.
The banks were able to package up the sub-prime mortgages and sell them on, together with the subsequent liabilities to Fannie and Freddie. In turn, Fannie and Freddie were able, in conjunction with Bear Stearns, which was one of the largest investment banks in the US, to re-package the sub-prime mortgages into debt-based securities and sell them on as 'low-risk' SDIs (Structured Debt Investments) to unsuspecting banks around the world.
The Market Goes Pear Shaped
All was well for a while as property prices continued to rise in the US during the late 1990s and early 2000s. As borrowers began to default on their mortgage repayments however, the incomes that the debt-based securities should have generated did not fully materialise and alarm bells started to sound. Happily, when repossessions took place, the proceeds from the re-sale of the properties involved were sufficient to recover all of the income arrears as well as the capital loaned.
In 2006 however, the property boom in the US came to an end and property values started to fall. Re-sale proceeds were suddenly no longer sufficient to cover the financial losses derived from loan defaults and the purchasers of the debt-based securities that Fannie and Freddie had sold them via Bear Stearns found that instead of low risk, AAA rated securities, they had been effectively sold 'junk' bonds that were far lower in value than had previously been imagined.
The Liquidity Crisis
Throughout most of the world, banks operate on a system known as 'fractional reserve' banking. This means that banks are able to lend far more money than they actually have deposited with them and M3 the total value of all bank notes and coins and bank deposits is massively greater than M0, the total of all of the money that physically exists in the form of notes and coins.
Banks have tended to hold as their reserves not just cash, but also 'near money', i.e., Commercial Paper, Treasury Bills, Government Stocks and other debt-based, fixed-interest securities and banks around the world had purchased the SDIs (Structured Debt Investments) sold by Fannie and Freddie via Bear Stearns and were holding these amongst their reserves. Suddenly their reserves were no longer worth anything like the values that had previously been placed upon them and banks all around the world suddenly realised that they had lent massively more than they should have done based upon prudent liquidity ratios and the new lower values of their reserves.
The consequence of this realisation was two threefold;
- Firstly, the banks needed to halt further lending and call in as many loans as possible in an attempt to re-establish healthy liquidity ratios
- Secondly, no-one wanted to purchase further debt-based 'near money' from other financial institutions for fear of making matters worse by buying more concealed junk bonds; and
- Thirdly, investors began to realise that many banks had inadvertently become technically insolvent and were in danger of financial collapse. Investors therefore began selling shares in banking institutions and investment companies like AIG who were known to have acquired large quantities of potentially 'toxic' SDIs.
Bank Failures, Rescue Packages & The 'Bail-Out'
Bear Stearns, Freddie Mac and Fannie Mae were widely recognised as being the source of the 'toxic debt' that was at the heart of the financial crisis and as other institutions shunned them and investors began selling their stock, Bear Stearns collapsed and Fannie and Freddie had to be rescued by the federal government.
Here in the UK, Northern Rock was well known as a bank that catered for the sub-prime end of the market and unfortunately for Northern Rock, although they had not indulged in sub-prime lending with anything like the recklessness of the American banks, they were tarred with the same brush and institutional investors suddenly stopped buying their packaged mortgage investments. This meant that Northern Rock had no way of raising new money to lend and as their business model relied upon a constant turnover of money generating new fee income, they ran into immediate serious financial difficulties and had to be rescued by nationalisation. The story at Bradford & Bingley was very similar.
Realising that the financial standing of almost all banks had been seriously damaged and that share prices in the banking sector were going to fall come what may, hedge funds began short selling bank stocks, targeting those banks that they viewed as the weakest and whose stock was likely to fall the fastest thereby presenting the greatest opportunity to profit from this misery. Thus Lehman Brothers were driven into liquidation and HBoS was weakened sufficiently to require rescue by Lloyds TSB.
Something had to be done to correct the liquidity crisis, to provide bank with additional collateral so that their liquidity ratios would return to normal and rectify their technical insolvency. Governments on both sides of the Atlantic felt the need to use public money to prop up our failing financial institutions, but Treasury coffers were bare and so a dilemma was created. Governments needed to borrow enough money to bail out the banks, but the banks had no money to lend to governments because they were the one's in trouble and needing help as a result of the liquidity crisis.
Financial Sleight Of Hand & The National Debt
As stated earlier, our banking system operates on the principle of fractional reserve banking under which and within certain limits imposed by liquidity ratios, commercial banks are able to create money out of nothing.
Less well understood is that when governments wish to increase the money supply, instead of instructing the Mint to print more bank notes, governments 'borrow' the new money into existence. Therefore while our banks were unable to cure their liquidity crisis on their own because their reserves were no longer sufficient, with the help of the government they could conduct a feat of near magic, creating more money by financial sleight of hand.
When governments 'borrow' money into existence, they issue Treasury Bills to the value of the amount by which they wish to increase the money supply. These Treasury Bills are a promissory note issued by the government stating that in return for a capital sum of say £500billion, the government promises to pay interest on that sum for a term of years and to repay the capital amount at the end of that term. The Treasury Bills are given to the banks and in exchange, the government's current account with their central bank is credited with £500billion. This is money that has been conjured out of nothing and created by making a simple electronic data entry in the central bank's computer. Following such a transaction, the government then has £500billion to spend and this is £500billion of the same type of 'electronic money' that constitutes the difference between the M0 and M3 money supplies, vast billions of pounds of which already exists and 'circulates' happily within our economy just so long as vital liquidity ratios are maintained.
George Bush followed by Gordon Brown and Alistair Darling, or rather their Treasury advisers decided that the way out of the financial crisis was to 'borrow' hundreds of billions of Dollars and Pounds Sterling by issuing Treasury Bills. They have used the 'money' created to buy shares in our banks and the hundreds of billions of Dollars and Pounds worth of Treasury Bills have been used by the banks to supplement their depleted reserves and so re-establish equilibrium in the world of finance.
All is well that ends well one might say? Except of course that the taxpayer is now left to pay interest on the vast sums borrowed into existence and which have further inflated the national debt. It is we the taxpayers who have had a giant 'millstone' placed around our necks and who will ultimately be required to repay to the banks the vast amounts of capital 'borrowed' into existence through the mere making of an electronic data entry.
It would appear from a thorough analysis of the situation that the 'Credit Crunch' has not been directly caused by the lending policies of British bankers and while American bankers have been complicit in the reckless lending that saw 'Ninja' mortgages become widely available in the US, it would appear that their involvement was not without duress and certainly not so with respect to bankers of the 'common' or 'garden' variety that manage our high street banks.
Merchant banks of the kind that underwrite the activities of our central banks will have profited mightily by their co-operation in effecting the 'bail-out' plans and through their acquisition of billions of Pounds and Dollars worth of Treasury Bills in return for making simple data entries and while many may speculate regarding conspiracy theories, there is no doubt that at the root of the 'Credit Crunch' has been the over zealous pursuit of economic equality and the folly of affirmative action.
This article originally appeared in the January 2009 issue of Economania, newsletter for the British Mensa Special Interest Group on economics, trade and finance.
Members can discuss this and other articles on the economics forum at International Mensa.