There’s been plenty of blame to go
around for our current financial
predicament: subprime lending, regulatory mandates, unmitigated Wall Street
greed. But what has rocked our financial
world may have more to do with a variety
of elements lining up over the course of
many years — even decades — than one
single problem, says Marc Simpson, associate professor of finance and department
chair at Northern Illinois University’s
College of Business.
“Taken alone, none of these events are
necessarily bad, but you get a perfect storm
when all of the events coincide and then
you have a housing bubble that burst,”
Simpson says.
Smart Business spoke with Simpson
about the current economic situation and
what needs to occur in order to calm our
turbulent financial waters.
Could you outline the sequence of events that
created this ‘perfect storm’?
To understand what has happened, we
need to go back to 1938 when Fannie Mae
(the Federal National Mortgage Association) was created. Fannie Mae provided
money to banks to encourage lenders to
invest in home loans. Fannie Mae became a
private entity in 1968. Freddie Mac (Federal
Home Loan Mortgage Corporation) was set
up in 1970. From 1970 to just recently,
Fannie Mae and Freddie Mac were publicly
traded companies, but there was a widespread belief — which turned out to be correct — that they were implicitly backed by
the U.S. government.
Freddie and Fannie do not issue mortgages, but instead purchase mortgages
from banks — thereby creating a secondary market for mortgages. This makes the
mortgages more liquid, which in turn
makes banks more likely to make mortgages. Taken alone, the creation of a secondary market for mortgages was a positive development that has worked well for
the past 30-plus years.
The next step was the securitization of
mortgages. In this process, mortgages from
disparate borrowers are bundled together
in a portfolio and interest in payments from
this portfolio is sold to other investors.
Again, this bundling process is, in itself, a
risk-reducing measure, as the risk is diversified across a number of mortgages. There
is, however, a limit to the risk that can be
eliminated through diversification.
In the early 1980s subprime mortgages
were able to help more people buy homes.
But it was not until the mid-1990s that pressure intensified for banks to make these
types of mortgages and for Fannie and
Freddie to purchase them. The Community
Reinvestment Act (CRA) requires banks to
make home mortgages available to all segments of the population where they do
business. Nothing in the CRA requires a
bank to make a bad mortgage, but in practice, this may have been an unintended
consequence.
If you take each event alone, it does not
have the kind of impact that all of these
events together have, resulting in the crisis
we are in the midst of today.
Shouldn’t the $700 billion rescue package
help stop the bleeding?
There is no reason why it shouldn’t work
— except for psychology. The problem is
now a crisis of confidence.
What kind of confidence is needed to jump-start the economy?
Consumers could be afraid of spending or
borrowing money because they have been
watching their 401(k)s and IRAs dwindle. If
consumers cut back, companies will be
afraid to expand their operations. More
importantly, lenders are afraid to make
loans because they fear not getting paid
back — by both consumers and companies.
What most people don’t realize is that the
current default rate on mortgages is only
about 3 percent; there is a perception that it
is much higher than that.
Most homeowners won’t default on their
mortgage, and the mortgage-backed securities that the federal government plans to
buy will have been purchased at trading values below the estimate of their value, if held
to maturity. There is the potential, as with
the S&L crisis, for the federal government
to make money.
What are the lessons we can learn from this
‘perfect storm’ financial crisis?
For one, government regulation and intervention — such as the push to provide
housing to lower income families — however well-intentioned, can cause unanticipated consequences.
Second, subprime mortgages should not
be issued without regard to the risks
involved. Many loan originators were not
exposed to the risk because they could sell
the loans to Freddie and Fannie.
Lastly, I hope we have learned about systematic risk. That is, you can eliminate
some risk through diversification but not all
risk. In other words, you can’t bundle
together a bunch of bad loans and then
assume you’ve got a good loan. It doesn’t
work that way.
MARC SIMPSON is the chair and associate professor of finance at NIU College of Business, www.niu.edu. Reach him at (815) 753-6394 or [email protected].
