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The blame for this credit crisis can be laid squarely at the feet of former Federal Reserve Chairman Greenspan who encouraged potential homeowners to obtain ARM and exotic mortgages just as he was about to embark on one of the longest rate raising cycles in history. But current Chairman Bernanke must share some of the blame. When he took over in 2006 he watched as the exotic mortgage bubble spiraled out of control. At no time did he make an attempt to curtail the lending practices at banks and non-banks. I am sure they were monitored but the key is putting a stop to the practices before they get out of hand. As an example, China outlawed ARM’s and exotic mortgages just as they were becoming popular because they realized the potential dangers. We ignored the warnings. Busboys making $30,000 were able to afford $500,000 houses and retired old ladies were able to purchase 5 houses. Who cared how much income you earned last year. For the first time that I can remember, you didn’t need to have an income to afford a home. Therein lay the problem. The most important part of the mortgage equation was thrown out the window. Historically, your income determined the size of the mortgage you can afford and ultimately the value of your future home. I remember back in the early 90’s when my friends were buying houses and one of the most difficult processes was having a lawyer review all of the closing documentation. In the last 5 years, that has gone out the window as people were more interested in flipping the homes rather than actually living in them. In the early part of this decade I was told by a friend who was a mortgage broker that the first thing you did when you went to purchase a house was pre-qualify for a 30 year mortgage so that you knew the areas you could afford. After that, the process was simple. You negotiated with the seller and as long as the price was below what you were pre-qualified the sale was easy. Buyers loved dealing with people who were pre-approved as it eliminated the risk of the buyer not being able to obtain a mortgage. In the last three years this was all thrown out the window and now we have to get back to where we started. The Federal Reserve could have required the documentation of income on mortgages or they could have tightened restrictions or issued guidelines on exotic mortgages. But they stood by and watched as the bubble inflated and eventually popped. This reminds me of one of my first jobs out of college back in the early 90’s. I used to work on the commercial lending side doing documentation and accounting work for a large bank in New Jersey. One day, we were told by the FDIC that we would be taking over a failing bank in northern New Jersey. My lenders were not happy about the takeover as they were afraid that the new loans from the failed bank would tarnish their reputation. When we went to go over the books we discovered that the old employees at the failed bank destroyed about 90% of the collateral files prior to their being laid off. This made for a difficult situation. We were holding loans for which, in some circumstances, the entire collateral file was missing. No copy of the guarantee, lien, etc. Only a copy of the note, if that. We realized that going back to the borrower and asking for copies of the documentation would be useless. After all, if your bank told you they lost the mortgage note and collateral what would you do? You can bet they would claim they never signed the note and let the bank find the original. So in the end, the decision was made to return all of the failed banks loans from my region back to the RTC rather than attempt to rebuild the collateral files. We may have lost some good, solid customers from the failed back but in the end the potential problems outweighed any potential gains. There is a point here and that is that once you have no documentation it is very difficult to obtain the documentation in question. In fact, you are better off just writing off the mortgage as bad and walking away rather than trying to obtain the proper information. The Federal Reserve failed in key areas by allowing a potential problem to escalate over a period of years. They may not have known the ramifications caused by a bursting real estate bubble and the long-term implications but they had a general idea and that alone should have been enough to take action. The Federal Reserve’s call to action should have been the moment safe lending practices went out the window. Back in the 90’s the bank bore the brunt of the risk and now it is bondholders worldwide. Countries around the world were caught flat footed when they should have known better. In fact, investment bankers were touting 20% annual returns from the bottom level of a CDO just last year. The question now is not which hedge fund blows up next but how much of CDO paper is held by foreign banks and governments around the world. Just last night the DBS Group and Bank of China reported $13 billion of exposure to the subprime market. Foreign governments have already seen currency losses from their US Dollar holdings. What happens if they are now subjected to a total loss on their holdings? Will they demand a greater risk premium in the future? This will affect our ability to sell debt obligations going forward.
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