Friday 3 October 2008

It’s not just about Wall Street

Any discussion of the Emergency Economic Support Act and the failure of the real estate market these days is replete with references to greedy and incompetent bankers and the bail-out of Wall Street. This is a vast over-simplification of the issue, and detracts from our understanding of the root causes of the issue, and what to do next.

EESA is primarily concerned with buying non-performing mortgage-backed securities. These are non-performing because the mortgage holders have either defaulted on their loan payments, and the bank has foreclosed, or because they are late with their loan payments, so the security is a non-performing asset. However, signing for a mortgage is the responsibility not solely of the bank, but of the signatory who has committed to the loan.

In evaluating a housing purchase, you need to understand the total cost of the mortgage at current interest rates and decide whether this is affordable. You need to evaluate your current financial situation, but also at what may happen if you lose your job or if interest rates rise. You need to ask the same questions before refinancing your mortgage and cashing out the balance to buy plasma TVs, your third car, or an expensive vacation.

There have definitely been instances of deceptive marketing and possible contractual moves to the detriment of the policy-holder, and the advantage of the bank. However, I also read of blue-collar workers who have taken mortgages on houses which were clearly beyond their ability to pay. I'm not condemning them: the dream of home ownership is a valid and powerful one. But they responded by taking on two or even three jobs, sometimes at minimum wage. With the slightest disruption - such as a 3-month recovery period due to ill-health, or a rise in interest rates - their careful payment plan became impossible to maintain. These things happen, and regrettably they happen more frequently in a country with a low minimum wage and without an effective public healthcare system.

But let's leave this aside for the moment: EESA is purchasing the mortgages of people who can no longer afford to pay for them. How it will manage these mortgages involves a number of decisions, but the government has already established two mechanisms to deal with foreclosures and mortgages, and I believe they will be able to muddle it out.

This is therefore not a bail-out only of Wall Street: it's a bail-out of a vast number of families and individuals who have purchased real estate which they could not afford. We have to be very clear on that if we are to understand why this situation has arisen, and what is to be done in the future.

We also need to be clear about the problems related to the broader credit crisis. This is the real problem, for two reasons:

(1) Banks cannot lend without a risk-assessed capital:loan ratio of 8%. Equally speaking, they cannot borrow to meet short-term obligations.

(2) The failure of banks and traders has led to significant market disruption, which in turn is causing incredible havoc in the derivatives market. This is where the real danger lies. Although the estimated value of outstanding derivatives has fallen from $ 62 to $ 53 trillion, the scope for a catastrophic loss provoked by a highly-leveraged firm or contract is immense.

It is this failure to regulate the contracting and trade of derivatives which is more serious than the current housing crisis. This is why EESA must be passed, and why the Fed needs to keep injecting liquidity into the market through opening its discount window for bank and financial services borrowing.

This is not a new problem - neither is the real estate devaluation, nor is the extremely low saving rate and high debt level of most American citizens. Yet to blame Wall Street exclusively for this problem is ignore other players with shared responsibility of this complex issue: the Federal Government, which has not updated its regulation to keep pace with the financial industry; the pension system, which is increasingly invested in equities; and aspirations of millions of people, and perhaps the society in which they live, which idealise the belief of easy money and immediate self-gratification.

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