Financial crisis of 2007-2008

Overview

There are two theories of what caused the Financial crisis. 

  1. Too little government: Big Banks / Wall St. and under-regulation (the removal of Glass-Steagall) allowed banks to inject risk into the system (with fancy derivatives) which created the bubble, and the bail-out sheltered them from any ramifications 
  2. Too much government: The Housing Bubble was over inflated by the CRA, Fannie/Freddie, the risks spread thru MBS’s, and over-regulation (FAS-157) froze the credit markets and magnified the correction

Both of these fit each sides political agendas. Glass-Steagall theory (GST) is simpler, but CRAFFT (CRA, Fannie/Freddie theory) matches the data/facts far better, and explains far more. I’ll cover both. But every one of the claims of GST or “too little government” falls apart with the slightest scrutiny, like regulation increased over that time by over 17%, with thousands of pages of new regulations, or if repealing Glass Steagall caused it, you’d have seen the failure in the new Universal banks, but they’re the ones that bailed out and saved the other banks (not the other way around). 

> NOTE: You can jump to the end and scan the terms section, or just reference them as you go; like read what a Bank does (and differences between investment/commercial/universal), what a GSE like Fannie/freddie does, or what an MBS’s are or Mark-to-market accounting is.

Glass-Steagall Theory (GST)

The idea is: 

  1. Bill Clinton lifted the Glass-Steagall act (under pressure from Republicans) and signed the bipartisan Gramm-Leach-Bliley Act (GLBA)
  2. This allowed banks/investment houses to merge and over-leverage themselves (using Credit-Default Swaps, and MBS’s) and rampant predatory capitalism of evil bankers caused them to oversell loans to people that people couldn’t afford them (subprime mortgages) and get into over-leveraging themselves
  3. The bankers knew they were risking all (and going to crush the economy), thus they were actively defrauding the people by selling/making the loans (criminal activity to get their bonuses), and they should go to prison.
  4. The bubble popped, and everything came down (as expected), but they all got bail-outs / cash from Uncle Sam and consumers paid the bills ($700 billion for TARP AND $831B for ARRA / American Recovery Reinvestment Act / Stimulus), and they walked away scott-free with big bonuses. 

To these folks, it was collusion between the the Fed and Banks that allowed crimes to be committed and not punished, the little guy got screwed and got their homes taken away, and because Big-Government did nothing, thus we need Bigger-Government and wealth-redistribution to fix it and go after these crooks and evil 1%’ers. (This is the Occupy theory).

It’s a great theory to appeal to emotions, but none of it makes sense or fits the facts/evidence, or explains anything. Let’s break it down.

 

Why add/remove Glass-Steagall? 

The New Deal was about increasing waste/bureaucracy and employing more people. Their Keynesian economic theory (long disproven) was that by making things less efficient (requiring more people to do the same job, and injecting bureaucracy), that you employed more people, gave them more money, so more people were better off. This is called the broken-window fallacy in economics (seen benefits matter, hidden costs do not); it is wrong and rebuked in economic circles, but it plays well in the political and media spheres. We also know Glass-Steagall didn’t do anything valuable (which was why it was removed bipartisan support). How do we know? 

  • Transparency inside banks hasn’t been a problem, so inter-bank transfers didn’t help (there wasn’t a problem here).
  • Adding or removing a step, didn’t alter what happens. One way bank (a) talked to bank (b) to do your trades — the other way bank has dept. (a) talk to dept. (b) and does the trades. But nothing changed except overhead.
  • There’s no difference in leverage (either by them or you). They had the same incentives either way, as did you. There’s no advantage to the customer for having an adversarial relationship between banker and securities broker. 
  • Europe and Asia had never had Glass-Steagall! That’s why it was removed. American banks were having to compete with European and Asian banks on an uneven field; they had Unified banks and we didn’t. We had an extra layer, and less services and lower returns than if they had tighter coupling). And none of those banks had a problem in the 66 years between G-S and American repeal of it. If it was protecting us, why hadn’t they had problems? 
  • Most banks didn’t unify (most stayed separate), and if G-S was the problem, then during the collapse it would have been the unified banks that had the biggest problems (over-leveraged/under-capitalized). It wasn’t. The Unified banks outperformed the Commercial banks (Countrywide) and the Investment Banks went out of business (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns). The Unified banks that never had problems; JP Morgan Chase (Unified) bailed out Bear Stearns (Investment), while B of A (Unified) helped by taking over Merrill Lynch (Investment) and Countrtywide (Commercial). This is backwards from what GST says should have happened!
  • This has been widely researched, after a few bad books and articles promoting this brain-dead theory started duping the gullible. Bill Clinton, the CBO, the SEC, and dozens of other economists all concluded the same thing: Glass-Steagall had nothing to do with the crisis, or the credit freeze 
  • Not only that,  studies concluded GS had done nothing to help in the Depression, and research into the debates from the era demonstrate it was passed based on complete bullshit, even for the time. It wasn’t economics but flim-flam. It was always a confidence scam to dupe the public into thinking the politicians had done something to make banking safer. But even back then, the people at the time knew, passing it was bullshit. There’s just some that bought into the lie so hard that they refuse to learn this to this day. 

No one has ever adequately explained how removing GS could cause a bubble or the credit markets to freeze, or how GS could have stopped the bubble, let alone why investment or commercial bankers would knowingly shoot themselves in the foot, why politicians would let them get away with it (if crimes were committing, prosecuting them would get them fame/votes), and so on. They usually stop at step 1 — which is that leverage helped inflate the bubble and that eventually popped. OK. But Universal banks weren’t the problem, and how did the credit crunch happen? How did loaning them money fix it? And so on — they want to stop here, because everything else proves that their theory is more political than historical. 

There are a few books that preyed on the desire for it to be the fault of Capitalism/Greed/Deregulation by Wall St., and then uses technical mumbo-jumbo, to sounds credible (if you don’t understand what they’re saying). But they are flim-flam. Like this one (http://www.usnews.com/opinion/blogs/economic-intelligence/2012/08/27/repeal-of-glass-steagall-caused-the-financial-crisis)— the whole theory is that GS,

> "prevented the banks from using insured depositories to underwrite private securities and dump them on their own customers. This ability along with financing provided to all the other players was what kept the bubble-machine going for so long”.

So he says, Unified Banks could over-leverage themselves and sell bad instruments to their customers, which will go bad, and cause a credit crunch (in their own company), and thus they’ll need the bail out. Only we know that this didn’t happen in 2008, it was the Investment banks (not Unified banks) that had the problems. More than that, the bubble was inflated in Real Estate Sector (Commercial bank territory), not in Unified or Investment bank areas. So the theory is disproven.

To quote the GAO: 

> "The GAO confirmed that leverage at the CSE Holding Companies had been higher at the end of 1998 than at the end of 2006 just before the financial crisis began.” http://www.gao.gov/new.items/d09739.pdf

 If the problem was over-leverage, we should have had the Housing Financial crisis in 1999, not in 2007.

Not only that, In 1997, there were 23,422 restrictions on the industry (banking/finance), a level that increased to 26,235 (up 17%) by 2008. So there was no deregulation, only increases in regulation. On top of that, the pure number of regulations doesn’t fully quantify how much larger and more complex regulation has gotten over time. Dodd-Frank for example is 22,000 page alone. Those claiming deregulation are ignorant about history and congress (which is continuously writing new laws, and very rarely repealing old bad ones). There might have been mistargeted regulation, but there was no deregulation that allowed this to happen. 

If you have any better explanations that you’ve read, let me know and I’ll look into them and debunk them as appropriate. But all of them have been variants of that hole-riddled self-contradictory theme . So now let’s explain what makes far more sense (and covers far more of what happened). 

## CRA, Fannie/Freddie Theory (CRAFFT)

The idea of this theory is as follows:

Inflating the bubble:

  1. Fannie/Freddie (F/F) was created to help the poor get better loans (sell sub-prime loans, using MBS’s).
  2. The CRA (Community Reinvestment Act) started under Carter, magnified under Clinton (and Bush), and was a way for communities to use Community Organizers (ACORN, Obama, etc), to punish banks/bankers who didn’t loan enough to sub-prime customers. (They could harass them in their homes using transparency rules, or businesses, block mergers, and new offices and so on). So it was created to encourage/force banks to take more risk in these high risk (sub-prime) loans in inner-city and under-developed areas. (They’re higher risk because poorer people don’t have the up-front capital, worse credit histories and don’t have the resources/judgement if things go bad).
  3. Think of F/F as the carrot (they buy/bundle/resell these loans into MBS’s), and CRA was the stick (community organizers punish banks that aren’t giving out enough liar loans in their community).
  4. Fannie/Freddie had quotas (forced on them by congress) on who they had to loan to (ratios), and this was continuously getting pushed down by politicians (Democrats especially, since this was more of their base). In 1992 30% had to be loans to those below the median income, and by 2008 that hit 56% of all loans. To get that many loans out there, F/F had to keep dropping the standards on who would qualify for a loan. And banks got to comply as that’s what F/F was buying, and the CRA would punish them. 
  5. Banks didn’t know how much risk was in the system (F/F doesn’t report well on total types of loans, etc), banks only knew what F/F was buying from them (individually). And these unsecured sub-prime mortgages were being snapped up by the government (F/F), so Banks were happy to keep selling them. (It’s their job to sell the loans that others are buying). Banks did hold some of these loans themselves: 24% of all these loans were held by banks directly (it looked like good returns), but 76% were held by Government agencies. So if you weigh who was more culpable banks or government there’s your weighting right there. Government blamed banks, because they weren’t going to own their own mistake.
  6. Banks started following in Fannie/Freddie and bundling their own MBS’s as well (they had always bought/sold/bundled loans too). Still, remember Fannie/Freddie is bigger than all the banks combined, and they set most of the standards. If banks didn’t lower their risk profile to match Fannie/Freddie then they won’t be selling enough loans to keep on CRA’s good graces. When Franklin Raines took over Fannie (Clinton appointee), he said he wanted to use the influence of Fannie and Freddie to induce the private sector to lower credit standards. The banks FOLLOWED Fannie/Freddie.
  7. Politicians/Congress also incentivized the population to take on this debt through tax policies like home interest deduction, and inflationary spending will drive up the costs of everything (meaning you HAVE to put you money in investments like housing, or it will lose it’s value).

This is why politicians didn’t attack investment bankers, getting them on the stand would mean they would explain to the public what happened, and it would all point back to the politicians/government (democrats especially, as they controlled congress/senate). So they would demagogue that it was all their fault, but they wouldn’t give them the microphone of any high publicity trials to defend themselves. And the left-leaning media wasn’t going to let them explain how the business works. 

Peter Wallison wrote a book detailing this, up to this point: Hidden in Plain Sight. He also covers a lot of this in this podcast: http://www.aei.org/publication/banter-173-peter-wallison-2008-financial-crisis/ , and this article: http://spectator.org/articles/42211/true-origins-financial-crisis . There are many flavors of the same explanation for how the bubble got inflated, but they all cover this same material. 

## Then what? 

Now whether you think Glass-Steagall or CRA/Fannie/Freddie caused the bubble, the following happened after the bubble popped. The GST folks don’t want to talk about the rest of it played out, because it also reflects poorly on their “bigger government will fix it” solutions. 

Popping the Bubble: 

  • The problem is with all these sub-prime loans, too many folks had nothing down, poor government oversight to get in, as soon as the market goes down at all, lots of the people can walk away with no risk or accountability. They have no skin in the game. So we had our first down-blip in 20 years, and many people in sub-primed started defaulting on the loans (like many had warned).
  • That put way too much real-estate on the market at the same time, which caused crashing housing values.
  • And that loss of paper equity (for many Americans), convinced people to invest less, or take money out of their stock accounts (causing stock market to go down). Wall St. didn’t cause this, they were a victim of it. 
  • I had personally experienced this same kind of thing, on a smaller scale with my experiences with HUD, you can read about here: http://igeek.com/1161 – Housing and Urban Development (HUD)

 

Freezing the Credit Market: 

  1. Once the housing costs started dropping, people started defaulting on those bad loans. And that caused the crisis.
  2. Republicans had fought for more transparency and regulation of Fannie/Freddie (from 2001-2006), but Democrats in congress (Barney Frank especially, Chair of the House Finance Committee) was able to block all those efforts. Bush spoke on this a few times during that time, but he was burning his political capital on Iraq, so his pull was limited. Democrats obstructed this because these community organizers and special interests were a powerful lobby that paid handsomely, and their voters were the recipients of all these sub-prime loans, so as long as housing costs were going up, it looked like everything was great. (And if it went down, they could point fingers, and their constituents were gullible enough to buy-in. Win-win!)
  3. MBS’s were complex and opaque (as F/F had been designed: to hide the poison and get everyone to drink a little), but that meant that when the market was correcting, no one was sure how much poison they had (how many of these bad loans and what areas) were going to be impacted and how much exposure you had in your securities. And that was going to take 12-24 months to unravel and figure out.
  4. Banks were regulated by law to keep a certain debt-to-asset ratios — so if their assets (MBS’s) were dropping, they couldn’t loan to people, or to other banks. Thus government regulations required that they seize up the cashflow, and in fact sell some assets (MBS’s) to get their debt-to-equity (cash) balances right.
  5. Democrats (in 2007) had passed something called FAS 157 which said that banks had to use mark-to-market accounting. Before this banks could value their assets based on things like a 3 or 5 year rolling average of asset sales (to slow up/down trends). Mark-to-market said they had to peg all their like assets value, to the last market sale: immediately!
  6. Since Bank-A had to sell MBS’s (because of their debt-to-equity ratio), and no one was buying them (since the bank couldn’t explain how much poison/exposure F/F had stuffed in them), then they were required to sell for whatever the market would bear. Let’s say $.10 on the dollar (10% of prior value, immediately). Boom, every other bank had to mark all their assets to that market sale, and all their like assets dropped 90% in value immediately. Which meant they too had to sell more assets (to get their asset ratios up), and certainly couldn’t loan money. And the markets froze! No one would loan, and thus companies suddenly couldn’t buy the inventory (which they buy on credit) to keep operating/growing/etc. It was going to be ruin that made the 1929 crash look like cakewalk. 

What are the fixes: 

  1. So the banking market froze up because of Government regulations causing a bigger drop than before, and requiring banks to sell their assets to keep liquidity high enough to comply with other regulations (so they couldn’t loan). And they were scared a further drop would squeeze them more, so they didn’t want to take on more liability.
  2. The quick/simple fix would have been repealing FAS 157 (which would have freed up assets) — but that would have been publicized and shown that congress/government was wrong to pass it (and is what caused the problem  in the first place. Since that Democrats wouldn’t let that happen, instead of playing politics and publicly hammering Democrats to repeal FAS 157, while the economy collapsed around us, he pushed for a compromise: TARP.
  3. TARP (Troubled Asset Relief Program) was the Government FORCING banks to take massive LOANS, to give them a HUGE buffer on their debt-to-equity ratios, so they could start loaning again. On top of that, there were only a few banks that were in trouble, but the Fed made ALL the banks take loans, so people didn’t know which banks had the worst problems (and cause a run on those banks). But we know after the fact it mostly the investment banks (not the Unified Banks that G-S theory says should have the problems). 
  4. NOTE: these were just LOANS, not give-aways to the banks. Once things stabilized, and we figured out the floor on the housing market, and the actual value of MBS’s stabilized (because banks weren’t forced to sell them under FAS 157 and other regulations), the liquidity crunch abated, banks paid back the government ALL the loans in TARP. They didn’t keep that money — it was money loaned to banks so they had credit to loan out TO THE PEOPLE! The public benefited, not the rich bankers.
  5. And the banks paid all those loans back. While they authorized more (to have head-room), they only loaned $414B out, and the banks pad back, with interest. Their part was $405B. The other money was to auto-companies, and not the bankers or Wall St.

Which is why no bankers went to prison, because there was no crimes you could convict them of, other than complying with many bad government regulations that nearly destroyed them, and paying back the loans they were forced to take (but most didn’t need), to cover for the few that were most compliant with CRA and Governmental pressure. If Congress/Democrats dug too deeply, all the systemic problems pointed back at them. Some banker was going to explain what happen well enough on TV that the media might start doing its job and explain to the public what had really happened, instead of the Democrat version, and then they’d be in trouble. So politicians might be dumb, but they’re not THAT dumb. 

Tidbits: (More complexities to note)

  • Feeding the bubble: many foreign investors (and others) lost trust in their governments for a variety of good reasons, they still needed a place to put their money/savings and if they didn’t trust their currency/governments, American MBS’s was a great/safe place. They needed to put their money somewhere, and that was safer than in their own countries. And you couldn’t trust currencies because of manipulation (China, U.S., EU). You couldn’t trust the treasury bills because Greenspan was keeping interest rates too low (in order to encourage more leverage/investment and less savings — e.g. creating a bubble). So socialist corruption in Europe, U.S. and abroad helped fed the American (Dollar) and real-estate bubble. 
  • Feeding the bubble: in America municipal bonds weren’t good investments because cities had defaulted (especially in liberal controlled states like California, NY or Michigan), and other states and municipalities looked higher risk because they couldn’t control their debts. (See liberal states like California, Michigan, NY, especially). If you don’t trust city/state bonds, then more goes into stocks and real-estate (the bubbles that popped).  And tax incentives were further inflating the bubble. 
  • Mis-assessing risk:  there’s no doubt that the credit agencies mis-assessed risks. But imagine you’re Moody’s — and there hasn’t been a system wide real-estate drop in 70 years, and the majority of the loans are going through GSE’s (Government), and you have government agents like Barney Frank screaming that everything is good and safe? You’re going to assume these instruments are very low risk too. But black swans hit once in a while. The credit agencies were wrong, for trusting what the government was telling them!
  • The banks sold sub-prime loans and MBS’s too! Yes, a few did. But if you look at scale, they were not most of them (government was), and they were kind of arm-twisted into following by the successes of Fannie/Freddie. So they might be wrong, but they were wrong second — thus if you want to get to the root of the problem, you look at who did it first and bigger. Banks listened to government and credit agencies that said these things were safe, so they FOLLOWED! (They did not LEAD) into bundling their own MBS’s, as well as selling the sub-prime loans that Fannie/Freddie and the CRA was pushing them to. And as long as Government (GSE’s) were buying these loans, there was virtually no risk to signing up as many people as you could: it looked like free money (backed up by the government).
  • After government had chummed the waters, the feeding frenzy started, then investment houses created derivative/instruments to magnify the results (like CDO’s) which magnified leverage. Note derivative and leverage aren’t bad things. The reason lefty-politicians  focus on it, is because they can make it sound complex and distract people from root causes, and their base doesn’t understand that both can LOWER your risk. (In fact, that’s what hedging as in hedge-fund managers does). So the fundamental problem here was that investors (and investment banks) listened to Moody’s and Government’s mis-represented risks, and reacted accordingly. And they paid the price (by being driven out of business). 
  • What about smarmy companies selling bad loans or selling investments they knew were bad? Both are a failure of government: it is their job to stop those criminal activities. If they were widespread (and they really weren’t from a systemic level), then it shows how bad government was at doing its job of stopping abuse. Blaming the industry for a few exceptions is daft. Not blaming government for doing their job and catching, stopping, or punishing it, is dafter.
  •  What about Credit default Swaps (CDO’s)? These are just two companies insuring each other. I agree that if your assets go down, I’ll cover you, as long as you do the same. It’s really low cost insurance — but if BOTH sides go down at once, you’re screwed. But we hadn’t had a case of that in 70+ years, so they thought (wrongly) that it was safe. Thus there was a lot of greed and failure to assess risks, and this cross insurance and complex derivatives chewed up the Investment Banks and Insurance Companies. They thought they were collecting risk free premiums and got raped for that mis-assumption (and increased leverage). But it wasn’t that companies weren’t insured, it was that their cross-insuring each other, caused as much exposure as it covered it. But that wasn’t because of deregulation (government was writing more new regulation than ever in our history with Sarbanes Oxley and so on), it was a failure of government to realize where we needed new regulation targeted, while simultaneously telling them that there was no risk in housing. (These guys were dumb to believe government — so both sides own that mess). 
  • Some companies were betting against themselves or their investors? Yes. This is called hedging (or "insurance" in gambling). It’s a common technique to lower risk — if you’ve made a ton of money on one investment, you normal bet against it (by a short or derivative against it): if it keeps going up, the asset growth will cover the cost of the insurance/hedge, and if the asset goes down, the insurance/hedge will grow in value and cover the cost of the asset drop — you’re not betting against yourself/customers as much as locking in a gain. Some are trying to flim-flam the gullible that hedging is a bad thing — but the alternatives are usually worse. 
  • CountryWide was the worst! You’re correct — they were the most aggressive at selling MBS’s and sub-prime loans. What lead to all that confidence? They owned too many Democrats in congress (and had become a revolving door for congressmen), and they donated heavily, and Barney Frank protected them and so on. 

## Conclusion

So what did we learn? 

  1. ALL the banks paid back all the loans within a couple years (with interest), and most didn’t need the money in the first place. In fact, none would have, if it hadn’t of been for FAS-157. They weren’t crunched because they were over-leveraged for real (their leverage rates going into the crisis was lower than they were when Clinton was in office in the 90’s). They only didn’t have the paper assets because of Mark-to-market accounting (FAS-157): fuck-you-very-much.
  2. There was never a “bail out” of the banks — there was a bail out of bad regulations. The term "bail out" implies they were given money. They were forced to take loans to cover up Democrats incompetence. And they paid it all back, with interest. The taxpayer lost money, but that was on Fannie/Freddie and the Auto Loans and other policies by the Democrats. The only bail out was of government malfeasance, not of banks.
  3. The Republicans had been warning about for 5+ years before the collapse about Fannie/Freddie’s problems and trying to fix it. Democrats kept blocking republicans from forcing transparency, because of crony-big-government. Now we can debate whether the Republicans attacking was foresight, or just trying to kick Democrats in a soft-spot, and they weren’t 100% innocent either, Bush had let the CRA and Fannie/Freddie continue to lower standards without taking it to the people. But no one knew when the bubble would pop, and he at least had the excuse of 9/11 or Iraq and F/F was in Congresses purview. 
  4.  There was never any criminal prosecutions because the only thing most were guilty of was compliance with the law (bad regulations), and Democrats in control, they didn’t want that to come out. Which is why they scream so loudly and point fingers at Banks and Wall St. and fund things like Occupy, to distract from their malfeasance. Since the media leans left, they’ve avoided any real journalism or exposés that might make their party look bad — which is why 90% of Americans don’t know/understand what actually happened and why.

The stories about deregulation causing this, and all the other stuff, make no sense on how they could cause anything. Nor do ones about how evil bankers duped the public or the gullible poor into taking loans they couldn’t afford. Yes, I’m sure there’s a few smarmy sales folks out there (even in banking), but that was a symptom of Fannie/Freddy and government requiring so many of these loans and being so willing to buy them up. If the government was buying only 20% of the loans and the private sector was issuing 80%, I’d firmly blame the banks. But as the numbers were the other way until well into the crisis (and the GSE’s had said their intent was to lower standards), the blame lies on them for the bubble, and on the bad regulations like FAS-157 for the crash afterwards. 

## References

## Big Fraud Theory

Let’s call this the BFT, there are a few books or movies like "The Big Short", Liar’s Poker, or William Black who float this. A few complained that this was the most widely spread theory. That massive fraud caused massive leverage, which is what caused everything. The problem is no one credible has really offered this as a "theory", because it’s not economics, it’s politics. And it doesn’t explain anything, if you think it through. 

Now no one is doubting that there were a few unsavory places and events and outliers, or that Countrywide was doing what Fannie/Freddie told them to (and aggressively selling LIAR/NINJA loans) and F&F was buying them up. That hasn’t structurally changed anything, nor could it explain what happened. So I don’t doubt that happened, but it has nothing to do with G-S, which couldn’t have done anything to stop it, and it doesn’t change all the things above that actually caused the crash and credit markets to seize. If F&F weren’t buying these loans, it wouldn’t have been possible: so it’s still a failure of Government Sponsored Entity and thus government. 

But let’s think it through and pretend that fraud is more than a minor contributor to the issue. (And just fodder for 60 minutes and others). 

  1. as the article points out above, the leverage was lower in the 2007 than it was in 1998 — and leverage doesn’t cause crashes or markets seizing (it can magnify what’s going on, or mitigate / hedge against it (depending on what the leverage was being used against)
  2. for a bubble to be big, that means that housing values and stock values would have had to have been all/mostly based on fraud (fiction) to cause a major correction. Which means that they could NOT have recovered within a few years. The banks couldn’t have paid the money back (which they did), because there was no underlying value to the assets (it was all/mostly fraud). Either Fraud was the cause, and there was no underlying value to the assets being written against, and the market couldn’t recover something that didn’t exist (the correction would have to have been permanent). Or fraud was a very minor part of the issue, and once the bigger issues were worked out, the market/housing would rebound (as happened). Thus the fact that the market bounced back (real estate and stocks), says that there was value there, and any fraud was a very small part of it — and BFT theory is wrong. Pick one.
  3. This theory doesn’t explain is why the credit markets seized. Why do people stop loaning, and why does TARP fix it if it was fraud? So it’s saying that fraud helped with the bubble, slightly – but everything else in CRAFFT theory was still at play. So it’s more a slight modifier to CRAFFT than a new theory. 
  4.  Why didn’t government go after them? To believe the BFT, you have to also believe in a huge conspiracy between Government and Wall Street, that bankers and investors have colluded with Congress to deceive the public and that’s why no one went to prison in massive investigations of widespread abuse. Or the far easier explanation is that while this might have happened in small scale (that TV shows and or sensationalist authors exaggerated for self promotion), that it wasn’t that widespread, and they were complying with Fannie & Freddies standards (as demonstrated by F&F trafficking in 60-80% of these loans) — which is how those loans got in the system. Yes, that injected some risk in the system, but the only reason it could have, is because F&F and regulations allowed it. That’s not fraud, that’s complying with really badly written rules/regulations by a government sponsored entity. Slimy, but legal. (E.g. not Fraud).  

So the real theories posited in the article are the economic explanations. This BFT is just a political agenda masquerading as an explanation for what happened: but doesn’t really explain anything. To me, the fraud theory is the chewbacca defense: it could have happened, it could not have happened, but it’s an unsavory side note to what caused the majority of the bubble, or the credit markets to seize afterwards (FAS-157), and what TARP and the other loans did to get credit moving again. 

Terms

I’ll keep from getting too nerdy, so these are just some basic terms you should understand before reading the article. 

Banking is you putting money in an institution to invest for you. Basically, they loan it to others (for interest), and split the profits (interest) with you, and take a transaction fee for lining up buyers/sellers. Due to government regulation, there are three kinds of banks; commercial and investment, universal (both).

  • Commercial banks loan money to businesses in the form of cash (and give you interest in cash), and you can take out your cash at any time. Most investments are low risk (floating lines of credit, property/asset backed investments, etc.). But the overhead and low-risk investments means you get lower-returns. (This is what most people think of as banks). 
  • Investment banks are more about stocks (equity). They help companies and individuals buy/sell stock/bonds/derivatives with each other (stock offerings, bond sales, Mergers & Acquisition, stock accounts and so on). So customers hold these things (paper/securities) that can be turned into cash through trades, but aren’t cash themselves (thus there’s more volatility/risk). Because customers are accepting more risk (the paper is more volatile than cash), they get much higher returns than traditional banking.  (This is what most people think of as Wall St. or eTrade)
  • Universal are banks that can do both — they’re definitely less risky that Investment houses, but arguably safer than either since they’re more diversified. 

Combined, they provide the economy the "credit market". The idea that you can borrow cash (in some form) as long as you pay it back with interest. And that interest rate will be based on many factors — but basically how risky that investment is, just the risk-reward ratio I was talking about. I must balance. 

> NOTE: You can read more at: https://mises.org/library/separation-commercial-and-investment-banking-morgans-vs-rockefellers

Glass-Steagall (G-S) was the 1930’s new deal regulation that said Commercial and Investment had to be separated. There would be no universal banks

  • The theory was that consumers were easily confused by the differences and so didn’t understand the risks they were taking, and this would prevent banks from deceiving the public — since they’d know the difference between walking into one kind of bank or the other. 
  •  There’s an added layer of abstraction where by requiring Commercial Banks to transact with Investment banks to do certain things, there was more transparency (governments could audit those two companies transaction). 
  • Because of those transactions (between the two types of banks), there’s more waste (two companies get a piece of the transaction instead of one in universal banks), but there’s theoretically less conflict of interest (investment is looking out for equity, and commercial is looking out for cashflow, and somehow this helps consumers). So in their theory, there’s less returns (more waste), and thus less risks. (In truth, there’s just more inefficiency and the same risk). 
  • https://en.wikipedia.org/wiki/Glass–Steagall_Legislation

Mark-to-Market accounting

  • FAS-157 passed in 2007 by Democrats said that instead of valuing an asset on a low-volatility manner (pegging a value to a 3-5 year rolling average), all assets of a like kind must be pegged to the last market sale. (Mark that value to the market).
  • To those who don’t understand economics, this sounds good: it’s transparent, and instantaneous — no one can hide what’s happening. This was to try to compensate for Enron and other tricks of accounting — but when it was passed, it was fought as being dangerous and injecting volatility into the market. Democrats don’t listen. 
  • What this means is when the one bank is struggling and required to sell an asset that no one wants for $.10 on the $1.00, then every other bank must peg all their assets as having an immediate 90% drop in value too. This injects/magnified volatility into the market, since your value is swinging much faster (and stronger) than the dampening effect that a rolling average has. 
  • https://en.wikipedia.org/wiki/Mark-to-market_accounting

Mortgages, Fannie/Freddie and GSE’s

  • Remember how loans work: you get a loan (mortgage) from your bank, which is giving you that loan based on someone else’s underwriting standards (who they sell the loan too).
  • Banks don’t hold most of the loans they write, and they don’t write the standards they must follow — both of those are by who is buying (and reselling) those loans. 
  • The largest buyer/reseller of these loans (handing 70-80% of all private mortgages) is Fannie/Freddie(they set 80% of the standards for the nation)
  • Fannie Mae and Freddy Mac are GSE’s (Government Sponsored Entities), which means a financial services corporation created/owned by the United States Congress
  • Fannie/Freddy don’t hold most of those loans either once they buy them. They bundle a bunch of these loans together into an MBS (mortgage backed security), and sell that to investors all over the world (including back to the banks), which frees up that money to rinse and repeat. 
  • The whole point of Fannie/Freddy was as a Depression era New Deal program to create these MBS’s in order to lower the standards for getting loans, so more poor and middle class people into debt (and homes), in order to shift people from leveraging themselves (borrowing) to buy/invest in stocks, and to get them to do the same but for hard assets (homes). 
  • https://en.wikipedia.org/wiki/Fannie_Mae
  • https://en.wikipedia.org/wiki/Freddie_Mac
  • https://en.wikipedia.org/wiki/Government-sponsored_enterprise

Mortgage backed security

  • An MBS is where a company (Fannie/Freddy) buy a bunch of loans, package them up in sort of a stock (security), and then sell them like they’re on the stock market. 
  • The idea is that if you’re a local bank, and you make a bunch of loans in your area, you’re not very diversified geographically. If the local market tanks, all your assets tank.
  • The idea of an MBS is that you mix in lots of loans (from all over the nation) to geographically diversify the risk — you’re not buying in just one market (and riding the ups and downs), you’re doing it nationally. This creates a national market for real-estate, instead of problems with local supply and demand. And the whole nation’s real-estate market would have to tank at once, before your assets tanked (and that hadn’t happened since the 1930’s so was unlikely). So it reduced risk (and thus the cost of money — as the risk/reward ratio says). 
  • It also bundles different types of property (demographically diversified), instead of buying just McMansions and Middle Class homes with great credit ratings (prime), you also got some poorer homes, lower credit ratings and higher risk (sub-prime) . MBS’s (and Fannie/Freddy) were created to get investors to all take on this risk of poorer / higher risk loans as part of their portfolio. Otherwise, the costs of capital (interest rates) would be too high for many poor people to get into homes. 
  • You can see what percent of MBS’s were issued by Fannie/Freddie 
  • https://en.wikipedia.org/wiki/Mortgage-backed_security

Risk-Reward ratio

  • The more risk you take, the more reward you need to get to be worth the risk. An analogy is, you put in $1, and I’ll flip a coin. Heads I keep it, tails you get $2. Regardless of whether you’re a gambler, that’s fair. But if I said, we’ll roll a dice (die), and a 1 and you get $2, otherwise I keep the $1, and you’d know it is unfair. There’s only a 1:6 chance you’ll win, and a 1:1 payout, you’d need a $6 payout to make it fair. Why? Because there’s more risk of a loss, so the reward has to balance the risk. 
  • http://www.investopedia.com/terms/r/riskrewardratio.asp