Catastrophe - Dick Morris [36]
HOW THE CATASTROPHE STARTED
Thirteen Steps to Doom
Step 1 Under the Clinton administration, Congress calls for Fannie Mae and Freddie Mac to encourage more mortgage loans to low and middle income families. In 1996, Secretary of Housing and Urban Development (HUD) Henry Cisneros sets a quota requiring that 42 percent of Freddie or Fannie loan purchases or insurance be for families in the low or middle income bracket. In 2000, his successor, Andrew Cuomo, raises it to 50 percent.
Step 2 Fannie and Freddie step up their program to buy low-income mortgages and encourage lenders to issue them. To meet the Clinton administration quotas, they waive the requirements for down payments and income verification.
Step 3 Hustlers like Countrywide Financial take advantage of the opportunity and issue subprime mortgages they know cannot be repaid. They lend mortgages that cover the entire property value—no down payment needed—as well as some of the early years’ interest payments and the brokers’ and bankers’ and lawyers’ fees. Often this practice leads to a loan that exceeds the value of the property. After three years, typically, these special loans for interest will lapse and the family will have to pay the full mortgage debt. But to many families that seems like a distant, far-off threat—especially when they’re looking at a nice new house.
Step 4 Fannie and Freddie buy these subprime loans, as Congress and HUD want them to do. They and other financial institutions then bundle their good and bad loans together (in a process called “securitization”) and sell Wall Street investors a share of the package.
Step 5 Eager to get in on the mortgage boom, banks, brokerage houses, pension funds, and other investors flock to buy these securitized mortgages.
Step 6 To permit them to lend out more money based on these mortgage assets (called “leverage”), the banks get insurance firms such as AIG to insure the securitized mortgages. With insurance, the bond rating firms give a triple-A rating, which lets the financial institution lend as much as ten times the value of the mortgage assets.
Step 7 Eager to squeeze even more leverage out of these mortgage-backed securities, the financial institutions get other banks around the world to insure them by buying credit default swaps. With this extra backing, the financial institutions holding the mortgage-backed securities can lend many additional multiples of loans based on these assets. Credit default swaps increased from $900 billion in 1999 to $60 trillion in 2007.116
Step 8 With a glut of both new and existing homes on the market, real estate prices stop increasing and begin to level off.
Step 9 After three years, families holding subprime mortgages get hit with big interest rate increases, which they can’t afford, and they start to default on the loans. The creditors consider foreclosing, but with real estate prices stagnant, the loan is often worth more than the house—so even taking the property entirely wouldn’t pay off the debt.
Step 10 With so many homes in default, real estate prices drop and more home owners find that their mortgage outstrips their property’s value. Banks have to count these loans as losses on their balance sheets.
Step 11 As the underlying mortgages go bad, the mortgage-backed securities that are based on them also go into the red. Banks call on insurance companies and holders of credit default swaps to make good on their insurance.
Step 12 The balance sheets of banks all over the world turn negative; insurance companies are unable to pay out on their policies insuring the mortgage-backed securities. These now-toxic assets drive the portfolios of major financial institutions into the red.
Step 13Faced with huge losses and negative balance sheets, banks stop lending. Credit dries up, companies go bankrupt, and layoffs pile up. The recession begins.
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The problem, of course, is how to remove these toxic assets from the banks’ balance sheets. The easiest option would be for home values to increase so they become nontoxic,