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6 The News Ar^us April 14, 2008 Crisis on Wall Street Every day there seems to be more bad economic news — dropping stock prices, collapsed investment banks, increasing foreclosures. But how did we get here? This primer takes a look. Bv Kkvin G. HAi.t., McCi.aichy Nkwspapkks One of Wall Street’s most venerable investment banks has col lapsed, the Federal Reserve has made available more than half a trillion in credit and dropped interest rates like a bad habit. And still, financial markets remain in turmoil, threaten ing the broader U.S. economy. Confused? So are government regulators and economic analysts. Former Fed Chairman Alan Greenspan wrote recently that in the rearview mirror, the current crisis will be seen as the biggest global financial challenge since the end of World War il. He blames the problems on a breakdown in the evaluation of risk. Here’s a suimnary of some of the components that together have combined to cause the cuirent crisis now gripping Wall Street and sucking wealth out of the retirement plans of millions of ordinary Americans. HOUSING The housing sector is the principal cause of turbulence in financial markets. In the aftermath of tlie Sepi. 1] terror aliacks and a ninc-monih recession in 2(K)I. Oreenspan’s t-'cderai Reserve brought the benchmark federal funds rate down to 1 percent and this influenced lending rates acioss the economy. Money was clwaii. and that allowed Americans to buy new homes, or refinance their homes in order to lap the equity they'd built up in their home to add a sun room, purchase a car or add new furniture. The cheap money fueled bolh a boom in home building and a nm up in home prices, most notably in four states that make up the brunt of problem loans today — California. Florida, Arizona and Nevada. Along the way, lending standards deteriorated significantly, particularly for the Joans given to the weakest borrowers, sub-prime loans, which carried a higher interest rate because they implied a higher risk to lenders. Many of these sub-prime loans involved adjustable rates, with a low starter rale that grad ually ticked up and then, after two or three yeare, reset lo monthly mortgage rates as high as 14 pcrccnt. Both loan originators and lenders often did little to verify income and. In some cases, didn't even require proof of income. Although everyone involved knew tho.se rates were Kw high, the working assumption was that the home prices would continue rising and bor rowers couid simply refinance to avoid a reset to higher monthly mortgage rates. Most of these sub-prime loans were oi iginated by mortgage brokers who are regulated on the slate level with spotty enforcement. The loans were underwritten by non-bank lenders like New Century Financial Corp. and Ameriquest Mortgage Co. — both of which fell through the cracks of federal regulation and were wc;ikly reg ulated on the state level. Tliese mega lenders have since gone bust, as have more than another dozen imporiant non-bank lenders. MORTGAGE FINANCE The housing boom ended and the housing cri sis started in late 2(KJ6. The Federal Reserve had steadily raised interest rales from its low of 1 pcrccnt in June 2004 to 5.25 percent in June 2(KXi. That meant that the sub-prime adjustable- rate loans, which exploded in number between 2004 and 2006, would adjust to much higher rates. And home prices stopped rising. A pcrfcct storm was about to be unleashed on Wall Street. In the past, banks underwrote mortgages imd kepi those loans on their books. Bui innovations in mortgage finance meant that once a bank issued a loan, that loan was quickly sold into what's callcd the .secondary mortgage market. There, many home loans were bundled togeth er into a bond called a mortgage-backed security. Some were added together wiih other kinds of loans and sold as collatcralized debt obligations, or CDOs. Investors were offered lionds with dif ferent risk classifications — the riskiest bonds, containing sub-prime loans, earned Ihe biggest yield to investors. This proccss is callcd sccuritization, and it happened largely behind the scenes. Most home owners were completely unaware that it wasn't the bank who ow ned their ln)mc but a company — often an investment bank on Wall Street oi' its subsidiai'y — that sliced and diced loans and sold them to inveslors. Many investors were kirgcly unaware that the underiying collat eral of the loan the home on which a loan had been issued — was often owned by someone who misstated their income or had been put ink) an unaffordable loan by an unscrupulous lender. Investors felt comforlable because bonds have rccci\ed favorable ratings from Wall Street agen cies like Standard & Poor's, Moody's and Fitch. Whai they didn’t know was these agencies had a huge conflict of interest. One part of their operations was actUsitly involved as a consultant, helping package together loans into bonds, which were ihen given favorable ratings by another pari of their operation. COMPLEXITY CONFOUNDS F,ventually. inflated national home prices and W'all Street’s willful look past vvhai now seem like obvious risks combined lo create today’s downward spiral. As home prices fdl, the collateral that backed the mortgage-backed securities and other com plex financial in.straments became worth less. Most of these complex bonds were ilKquid. meaning ihey weren’t nicanfto be bought and sold quickly but instead held ft)r long perisxls of time to generate consistent rettirns. Bui the homes on which these bonds were built increasingly became worth less, and big institutional investors like hedge funds — which pool capital from ihe very rich and college endowments lo make huge inveslinenls — began tiying to get rid of their mortgage-backed securi ties, Increasingly there weren’t willing buyers, and many of the issuers of these securilies had clauses in their contracts to take them back. As they did so, investment banks and other issuers of these complex securities had difficulty even putting a price tag sn the,sc liabilities as they tried to bring them back on their balance sheets. To date, tliese financial institutions have written off more than $100 billion in tied-to- mortgage bonds and related financial instru ments, but that figure could go as high as $500 billion if bond insurers and other players are forccd to take steep losses in months ahead. But no one's quite sure who is still exposed to these toxic bonds, or how much. Thai’s led banks and other financial players lo distrust each olhcr. ORDINARY LENDING FREEZES UP As a crisis in confidence deepened, banks became very reluctant to lend and do so only to the best customers and at a premium. C'oqwrations who finance their day-to-day operations through short-term bonds could find few buyers and had to offer higher interest rales, eating into their operational costs. ONLINE Q&A McClatchy correspondents Ke\ in G. Hall and Tony Pugh are avail able 10 answer your questions aboui the shaky' economy at home and abroad, and what's in store for ordinary Americans in the face of gather ing economic storm clouds. Check out their Q&A, as well as breaking economic news, at http://www.mcclatchydc.com/economics/ Some of Ihe biggest hanks in the world, like Citigroup, looked overseas to foreign investors, offering Ihem a slake in ihc company in exchange for a cash infu sion that puntped up the bank ’s balance sheei. .And rather than lend, banks are raising their reserve levels to look as healthy as possible amid ibis crisis in confi dence. Addling to an already bad situation, high eneirgy and food prices have meant higher inflation than in decades. That made mortgage financing even more compli cated. Few buyers are interested in adjustable- raie mortgages, and fi.x.ed-raie mortgages take their cue from long-tonn debt instruments like the 10-year Trea.sury bond. Inflation pashes up the yield on longer-term bonds, and, thus, fi.xed mortgage rates have either liscn or not fallen despite aggressive attempts by the Fed to cut interest rates and spark the economy. MUSCULAR FED ACTION Becausc lowering short-lcrm inleiest lates has done little to calm financial markets, the Fed has taken bold steps to ensure that, at nunimum. banks continue lentling. fl has created several new lending facilities, offering at least $5(K) bil lion in short-term loans so that banks can keep lending. And il’s offered these loans to invest ment banks and .securities dealers, for periods of 90 days instead of the conventional ,^() days. The Fed even assumed liabilities up lo .$30 billion in helping broker the March 16 sale of invesimcnt bank Bear Stearns to .IP Morgan Chase for a fire- sale price of just S2 a share. It prevented the bankruptcy of a Wall Street liian, which would have, potentially sucked down othei' investment banks. Only time will tel! whether all the Fed’s efforts will work. Democrats in C^ongress meantime are offering legislation that would involve .some government intervention lo lake in prt>b!cm loans, modify them and offer insurance to lenders in the event that there is still a default by borrowers after loan modification. Some proposals even involve the creation t>f a mechanism by which the government auctions off these modifying loans, not unlike how the Resolution Trusl Corp. was crcaicd lt> auction off real estate following the savings & loan crisis of Ihe late 1980s, “I think from here on in, ihc situation is one which really required the federal government to step up and try to resolve some of the problems of the mortgage market." said Lyle Gramley. a fonncr Fed governor with more than 30 years in financial markets. This much is certain: the housing crisis didn't comc about overnight, ;uid it is unlikely to be solved in short order either. It’s likely lo mean economic chop well into next year befoie the U.S. economy enjoys fair winds again. ECONOMY MCCLATCHY-TRIBUNE LAV.SFRrO ALVARtZ/rKe OAI.LAS MORNING NEEWS
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April 14, 2008, edition 1
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