Sharing The Blame

The subprime mortgage problem is rippling through the economy and is leading the country into a possible recession. Homeowners have lost their homes, financial institutions have already lost hundreds of billions of dollars, and there is no end in sight.

As with any problem, the natural reaction is to look for fault. Who can be blamed for this mess? In this case, there are many candidates:


a) Borrower: The homeowner has been at the center of the mortgage mess. It is the homeowner that initially signed a contract with the lender and purchased a mortgage. For a variety of reasons, many homeowners have been unable to make monthly payments on their loans. This has led to defaults, foreclosures and evictions. While most people are sympathetic to the homeowner who loses their home, the fact of the matter is that many of these homeowners should never have been in a position to own their own homes in the first place. Many borrowers recklessly took out mortgages way beyond their ability to make payments.

b) Lender: Homeowners typically purchased their mortgages from mortgage brokers. While most loans were arms-length contracts done in good faith, there have been an increasing number of stories involving predatory lending practices. Boiler room operations were not uncommon. Just in the last week, the cities of Baltimore and Cleveland have begun legal proceedings against banks for their roles in the subprime mess.

c) Appraisers: Historically, appraisers played an important role in keeping the real estate market "honest." Their independence contributed toward a smooth running market. Unfortunately, the system changed with the rise of mortgage brokers. Aggressive mortgage brokers figured out which appraisers would provide inflated appraisals and directed work to them. The system now rewarded appraisers to increase appraised values.

d) Fannie Mae and Freddie Mac: These quasi-government enterprises played a key role as the real estate bubble grew. In their role to make and guarantee loans, they purchased mortgages and securitized them into mortgage-backed security bonds. As Wikipedia says, "this secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures that money continues to be available for new home purchases." Being in the middle of this bubble that they helped create, they probably should have been the first to see the problems as they unfolded. In reality, however, they were probably distracted by a massive accounting scandal involving executive bonuses and the restatement of results on the order of $6 billion.

e) Federal Reserve: Early in this decade, the country was in a recession. This had been caused by a combination of the dot com bubble bursting and the 9/11 terrorist attacks. In response, the Federal Reserve lowered interest rates all the way down to 1% and created a period of very easy money. Many analysts believe that the dot com bubble became the real estate bubble. And as with all bubbles, they eventually burst.

f) Investment Banks: Once created, the mortgage banks would typically sell their mortgages (sub-prime loans included) to investment banks who would package them with other loans, split them into multiple layers of risk, and then resell them to other financial organizations. This would happen over and over. The original loan would no longer be recognized.

g) Rating Agencies: As summarized on 01/11/08 in The Sovereign Society Offshore A Letter: "Sub-prime mortgage-backed securities worth nearly one-trillion-dollars were stamped with investment-grade credit ratings. Moody's, S&P and Fitch gave them their highest possible seal of approval. This gave institutional investors the green-light to pile into these bonds. The investment herd assumed these bonds were as safe and secure as government bonds." And talk about a conflict of interest. These rating agencies collected fees from these same investment banks that they were "helping out."

h) Foreign Investors: As Hillary said on the campaign trail last week, "A lot of pressure is coming from the investors who bought all these loans. It's not our local bank. It's not the fella who sold it to you. It's somebody in Shanghai or Dubai or Berlin or London. And they're saying, 'I'm supposed to get an interest rate return and, if you stop me from doing that, I'm not getting a return on that investment.'"

i) All of the above


It is probably fair to say that all of these organizations share the blame for the subprime problem. There certainly is enough blame to go around.

But noticeably absent from this list is the taxpayer. Unfortunately, it is the taxpayer that will suffer as this problem is cleaned up.

Every day seems to bring a new proposal from the politicians. Fiscal stimulus programs will cost money. Monetary interest rate cuts and liquidity injections will lead to inflation. The mortgage market will change forever as bailout programs are implemented, judges void contracts, bankruptcy laws are rewritten, and regulations are revamped.