How Did This Happen? A Plausible Answer

Randall Hoven, an engineer by training, writing at the American Thinker asks a set of questions that are *on the money* (exactly right or accurate): How did this financial mess happen? And why did it apparently happen in Europe first then in the U.S.? And how could a proportionately small decline in the U.S. real estate market first bring about a sudden crash in European investment markets? See here: http://www.americanthinker.com/2009/03/how_did_this_happen.html

Respectfully, the answers that Hoven and his online commenters give are mostly off base and likely confuse symptoms for causes. I would suggest that Hoven and others read Anthony Downs book Niagara of Capital: How Global Capital Has Transformed Housing and Real Estate Markets which was written in 2007. My partial understanding of what happened from reading Downs' book and other sources is as follows:

What brought about our present financial crisis was 9/11. After 9/11 and the rise of terrorism, foreign investors were looking for a safe haven for their money. What could be safer than U.S. real estate?

To avoid a major recession after 9/11, the Federal Reserve cut interest rates and stimulated huge infusions of cash into the economy. Prior to 9/11, U.S. government regulators had pressured banks, insurance companies, and savings and loans to reduce their investment in real estate after massive overbuilding in the 1980’s. Developers and property owners needing capital had little place to go for money but to stock and bond markets.

Soon after 9/11, Wall Street invented collateralized mortgage bonds and securitized stocks which injected trillions of dollars of foreign money into U.S. real estate, thus circumventing the U.S. central bank which conventionally manages the money supply.

Gauged by contributions to the two major U.S. political parties, Wall Street at the time was dominated by investment firms supporting the Democratic Party contrary to the popular notion that Wall Street is “Republican.”

This massive infusion of foreign capital resulted in an oversupply of money, historic low interest rates, the diminishing value of the dollar, a skyrocketing price for oil as a substitute for the exchange rate, and a real estate bubble. The Federal Reserve had to keep interest rates low because the supply of money was so high. This sent a false signal to investors and stock and bond rating houses that risk was low. The gigantic wave of foreign money flooding into real estate collapsed lending and regulatory standards as loan underwriters just handed off the risk to others in the financial food chain as loans were sliced and diced into derivatives.

The idea of derivatives was to spread and reduce risk; for example by selling the cash flow from each year of a home loan to a different investor. But these loan derivatives became unforeclosable when homeowners defaulted on paying their loans because they were spread out over the whole world.

Fannie Mae and Freddie Mac, run by high-profile Democrats, had to be taken over by government due to mega-billions in bad derivatives. Ginnie Mae, run by a Republican, is still sound and has no derivatives

(start) Now let's say you have two people sick with fever, and you are trying to figure out which one spread the virus to the other. I would look for the one who got sicker sooner. In this case, Europe got sicker sooner. Not conclusive, but if you seek merely a keen grasp of the obvious, it sure doesn't look like the global economic decline was due to the US. (end).

The reason that European financial markets were stressed first is apparent: they were the ones holding much of the mortgage-backed investments just as the front wave of baby boomers started to retire and sell their homes and loan defaults on sub-prime loans started to appear.

But Hoven asks how could a 2% to 4.6% decline in housing prices result in a collapse in foreign investment markets? The answer is what is called leverage in home loan lending. When real estate markets are going up, high leverage (99% to 100% loans) creates a postive multiplier of returns (65% to 144% returns, see example at link provided below). However, when markets go down, they create equally negative multiplier losses. Many homeowners were leveraged at $1 invested to $99 loan for every $100 of loan. Banks were allowed to be leveraged at $3.33 invested to $96.67 loan for every $100 invested. For the mechanics of how highly leveraged loans can turn toxic quickly read *Leverage 101: The Real Cause of the Financial Crisis* - link here: http://seekingalpha.com/article/97299-leverage-101-the-real-cause-of-the-financial-crisis

It was our response to 9/11 which apparently triggered our financial crisis. Toxic sub-prime loans, derivatives, the Community Reinvestment Act, the elimination of the Glass-Steagall Act, the artificial setting of low interest rates by the Fed, the politicization of Fannie and Freddie Mae and Indy-Mac all were symptoms or contributors to the problem. I have found this a more plausible answer to why our financial system collapsed. However, since this writer is not all-knowing and there are always multiple layers of meaning of any large social event, there certainly are other explanations and variables not covered here. Surely, other online commenters will fill in missing gaps to the plausible answer provided above. But, apparently, what set in motion the collapse of our financial system was 9/11 (as foretold by even Osama bin Laden).

How’s that Benjamin Franklin rhyme go? (paraphrased) For loss of a nail the shoe was lost. For loss of a shoe the horse was lost. For loss of a horse the rider was lost. For loss of a rider the battle was lost. For loss of a battle the kingdom was lost. And all for the loss of a horseshoe nail.

Just substitute 9/11 for a nail and you have an analogy for our current financial mess. Moral of story: “People, like nails, lose their effectiveness when they lose direction and begin to bend.” Walter Savage Landor

Well, let's move on to the next "expert".

It wasn't 9-11. After our initial setbacks in 2002, the economy roared back. So Hoven needs to go back to the drawing board.

He does make this accurate statement: ". . . Toxic sub-prime loans, derivatives, the Community Reinvestment Act, the elimination of the Glass-Steagall Act, the artificial setting of low interest rates by the Fed, the politicization of Fannie and Freddie Mae and Indy-Mac all were symptoms or contributors to the problem."

It was the sudden housing needs of 20 and probably 40 million illegal aliens exponentialing increasing from 2002 onward because of the open borders policies of the Democrats and Bush/Rove. The highly leverage mortgage game of CDOs and bonds needed a large mortgage base to feed the Ponzi pyramid scheme, and that base was provided by the illegal alien hordes looking for housing and finding the subprime mortgages being feverishly marketed to them.

The subprimess issuances peaked in the 2005-6 period, with escalation rates and ARMs coming due in 2007-2008. Anyone with 10 fingers to add with could see that these subprimes were guaranteed to fail.

And they did. And contrary to the myth that it was blacks and house flippers and McMansions and yuppies taking out their inflated equity that were the recipients of subprimes, the actual numbers show that it was subprimes issued to illegal aliens that were responsible for the foreclosures now roiling the markets. There is a direct overlay and correlation of subprimes in foreclosure and illegal alien concentrations, right down to the nine-digit ZIP code.

It wasn't 9-11. After our initial setbacks in 2002, the economy roared back.

Not what the author said. The author said the response to 9/11 (low interest rates). The economy roared back on speculation in real estate. It's nice to have one convenient villain, but all the loans to illegals, plus all the liars loans, plus all the resetting ARMs could have been paid off with a few hundred billion. Currently we are up to almost 10 trillion in infusions and guarantees.

There are obviously many factors involved. The bottom end of the market in Northern VA was illegals and legal immigrants and that part of the market is down the most (from about $450,000 per townhouse to less than 200k and dropping). The collapse of the world's financial system was simply from too much leverage and is playing out next in Eastern Europe. The biggest culprit was Japan before Greenspan.

Sorry, wrong.

The subprime loans to illegals are the core of the problem. While they were not the sole component to the financial collapse, they were the critical mass that started the whole breakdown. These subprimes were so highly leveraged into CDOs and bonds that when the bottom of the Ponzi pyramid collapsed, everything above it came down. All that derivative paper was passed on to the overseas markets as well.

Formerly safe mortgages soon also became vulnerable because the subprime foreclosure brought the other inflated house values down with them, putting formerly “good” mortgages underwater.

Your own Northern Virginia area is proof of the statement. The foreclosures are concentrated in a few neighborhoods - Manassas, Sterling, Herndon, Annandale, Woodbridge - exactly where all the illegals settled down and got their subprime mortgages from Countrywide, Wachovia, and Bank of America. Almost exempt from the housing collapse are the wealthy areas of McLean, Clifton, Great Falls, and Arlington (which cleverly kept out the illegals by gentrification schemes in its run down areas.)

You are falling for the Wall Street/media/politicos smokescreen that tries to explain all this away with obtuse financial gobbledygook. They don’t want you to know less their open borders agenda for cheap labor and Democrat voters be threatened.

Sorry, it’s the 40 million illegals (and that’s the actual number, not the 11.6 they are trying to spread to keep the people asleep for when they bring up amnesty this summer.)

While they were not the sole component to the financial collapse, they were the critical mass that started the whole breakdown. These subprimes were so highly leveraged into CDOs and bonds that when the bottom of the Ponzi pyramid collapsed, everything above it came down.

Your assumption is that it would still be standing had it not had the hollow core of illegals at the bottom, ready to jump the second it was in their interest is false. The latter part of that assumption is quite true, contracts like mortgages mean nothing if you are illegal.

Manassas, Sterling, Herndon, Annandale, Woodbridge

True, high concentration of illegals versus

McLean, Clifton, Great Falls, and Arlington

Ok, except for Arlington. You must only have looked at North Arlington. The rest is as bad as Herndon, yet their YoY price decline has only been 4% due to their convenient location. Where your thesis collapses is Loudoun County. The vast majority of underwater and now foreclosed properties are lily white morons who paid 600k to 1m for tract mansions worth about 250-300. That includes everything from Leesburg to Ashburn to that joke South Riding. The exception is Sterling with the worst performance of all and an illegal core.

Your approach to analyzing the crisis has lots of merit, but fails to take into account the crucial fact that no such edifice of debt like we had (over 30T in private, public and corporate debt) can be paid from income (13T in GDP) under any circumstances. We kept the party going by taking out new debt to pay off the old. I've been posting about this for years and there are plenty of people who are denial about it. You have lots of company. The Pollyannas assume we could have kept adding debt at the rate of $5 to $6 in debt for every new $1 in GDP right to infinity.

When the crisis was obvious in 2007, out of the 30T in collective debt, we could have easily paid off the few hundred billion in bad mortgages completely, or bought them down for a lot less. The fact that we have spent or guaranteed almost 10T so far instead makes it obvious that bad mortgages were not the essential problem.

Mises, as I've said many times here, pointed out a long time ago that it doesn't work. Either you end up with a painful contraction (in our case very painful) or you destroy the currency trying to prevent the defaults (our current approach).

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.