Financial Crisis

It's been called a market crash, a financial meltdown, fiscal Armageddon and more. It seems the media - and the government officials - can't find strong enough words to describe the financial industry in the western world. A presidential candidate has called it "the worst crisis since the Great Depression." (I wonder how many people alive today are familiar with the Great Depression.) Whatever it is, it is sobering for all of us. It strikes fear in our hearts.

But there are some truths about the current financial markets in the western world (led by the United States). Of course they are not the obvious. Truth is rarely obvious. It gets obscured by the circumstances. But let's be clear ... truth is relevant. That it is often obscure doesn't diminish its relevance. So it would seem that what's true is also what's important. It's sort of like the difference between the urgent and the important. Urgent isn't always true, but it is always demanding. And important isn't always apparent, but it is relevant. So let's take a look at some truths about today's situation.

To begin with, much of what we are seeing in the marketplace is hype. For example, it has been said that as much as $2 trillion worth of wealth has been wiped out in this recent crisis. That is not exactly the truth. Most of us haven't actually lost any real money. If you hold stock in a company, and the market suddenly decides that company isn't as precious today as it was yesterday - you still own the company. You just now own a company that the market doesn't seem to appreciate as much as it used to. But you haven't actually lost any real money. Unless you decided to sell that stock for less than you paid for it, you never actually lose the money. And let's be clear about one more thing: just because the market doesn't think the company is as precious today as it thought it was yesterday doesn't mean that the market is right today - or that the market was right yesterday! You have to look at the fundamentals of the company - it's business, it's market, it's leadership, etc. (And you should have done that before you bought the stock.) Business fundamentals rarely collapse overnight.

Secondly, much of the so-called "market crash" is occurring because people are making decisions in a panic-mode. They are making irrational decisions, and behaving irrationally. Dumping shares and taking losses because you are afraid of the future is irrational! Consider, for example, if your neighbors all told you they were selling at a loss, would that motivate you to suddenly "dump" your house for half its value? Would you suddenly be inspired to agree with the market and take 50% of the appraised value for your house? What if your neighbors brought you a professional looking appraisal, completed by someone perceived to be competent? Would you then dump your house for half its value? Most of us would not. And yet that's exactly what we do when it comes to the stock market.

Finally, let's talk about the mortgage market. It's an interesting subject. Many people are mad about Fannie Mae and Freddie Mac. Many more are angry about the supposed $700 billion bail-out bill that was recently passed. But what is true of this situation? For starters, the government chartered Fannie Mae back in the 1930's to facilitate housing finance. It operated effectively for decades. In the 1970's Fannie Mae was privatized and the government created Freddie Mac to provide competition for Fannie Mae! Again, both functioned effectively and housing finance was available.

In 1977, Solomon Brothers issued the first private mortgage-backed securities. This was the first time any mortgage financing was offered on the national or global markets outside of a government sponsored enterprise (aka "GSE"). It was an important milestone in that it moved us from a housing finance industry to a mortgage banking industry. There is an important distinction between the two. Housing finance facilitates a basic human need (housing). But mortgage banking facilitated basic human greed.

The mortgage banking industry fueled our nation's greed on all levels. The people who made the loans got greedy and pushed mortgages with wild abandon. They were racking up commissions that were unbelievable. For instance, loan officers with Countrywide Mortgage were making as much as $1 million or more - with no college degree, no particular skills, and not facilitating any human need. Wall Street also got greedy. In 2007, Wall Street paid more than $64 billion in commissions to men and women who traded mortgage securities in the global markets. And let's not forget the consumers who took out the mortgages. They financed boats, nose jobs, tummy tucks, cruises, mid-life crises, divorces and many other things besides any basic human need.

In light of this distinction between the housing finance industry and the mortgage banking industry, it would be wise to consider these realities. Perhaps the government intervention can get us back to the basics of housing finance - which functioned effectively for decades - without government bail-outs or subsidies. I'm sorry that shareholders in Fannie Mae or Freddie Mac appear to have been wiped out by the government's intervention (and the jury is still out on whether or not they were). But it if restores a market discipline that makes sense and helps our nation focus on financing fundamental human needs instead of fundamental human greed --- then I'm not so sure this is a bad thing.

There is no question that the chaos in the marketplace is unnerving. But a wise man (or woman) will stop paying so much attention to the urgent - and spend some time looking for and giving strong consideration to the important. After all, important is where the truth usually lives!

Fannie/Freddie

So the government is bailing out financial institutions. Fannie Mae and Freddie Mac were among them. Once chartered as government enterprises, each was sold respectively into the public market and operated as a public stock corporation for years. They fell on hard times and now the government has effectively nationalized each of them, wiping out shareholders and taking control of the stock of both companies.

Who are these companies? Were they really "too big to fail?" Arguably, the answer is yes. Between these two companies, they provided more than half of all the mortgage money being used in the United States for single family or multifamily housing. Essentially banks and mortgage companies make the mortgages and then sell them immediately to Fannie Mae or Freddie Mac - to recoup their capital and be able to make the next loans with it. If Fannie Mae or Freddie Mac were to shut down, the availability of home mortgages would disappear overnight. Talk about the real estate market taking a nosedive --- that would be catastrophic beyond imagination!

So it would seem that nationalizing these companies again and giving them government bailouts was probably a prudent measure. However, there is another organization that has a role to play in this mess, and they are noticeably quiet and absent. They are called the Office of Federal House Enterprise Oversight (OFHEO). OFHEO was chartered after the thrift industry went bust in the 1980's. Its purpose was to oversee Fannie Mae and Freddie Mac. That's it. It had no other purpose. It's exclusive reason for existing was to ensure that Fannie Mae and Freddie Mac operated safely and didn't get into any trouble that would cost the government money.

OFHEO hired about 300 people, and they spent their time "watching" Fannie Mae and Freddie Mac. Apparently they watched those companies wade into risky investments and get caught with their proverbial pants down in the market meltdown. Both companies became insolvent on OFHEO's watch - costing the government more money than anyone could have ever imagined.

So what I'm wondering is who from OFHEO will go to jail for this crime of negligence? Who from OFHEO will be held accountable for their poor performance? The American taxpayer is taking it on the chin for this. Will someone at OFHEO be called to answer for this? So far, not so much. We haven't heard anyone blame OFHEO, point fingers at OFHEO, launch an inquisition of OFHEO or anything else. In this election year, Mr. Obama and Mr. McCain, perhaps the two of you could ask some pointed questions about our illustrious OFHEO. The people want to know!

Source of Value

Well gosh, you can't hardly look at a newspaper or business magazine these days without being inundated with bad news about the global financial markets. The mortgage sub prime mess, the meltdown in banking, credit crisis and other buzzwords seem to have taken over our vernacular as of late.

Of course, Congress is looking for someone to blame. Inquisitions, hearings, and other initiatives are being undertaken to try and "find the source of this mess." People are asking, "What's the cause?" Others are wondering, "How can we prevent it from ever happening again?" To be sure, legislation is being passed at the federal and state levels to try and deal with both questions.

I've been involved in financial services since 1978. It's long been my primary livelihood. So I've got a view, based on how I understand the global financial services industries to function. And I think I have a pretty clear answer. Unfortunately, it's not an answer that anyone would want to hear. Even worse, it's probably not an answer that could be legislated. That notwithstanding, I'm pretty sure that it's the right answer.

Why are we in this financial mess? It's really simple, you see. Our mortgage industry, which consumes the bulk of the financial services industry in terms of dollars and employment, had a fundamental problem. Back at the end of the World Wars, the U.S. government created securitization - by creating organizations like Fannie Mae, Freddie Mac and Ginnie Mae. There was a shortage of housing in our country and a shortage of capital with which to build houses. Securitization provided it then - and the houses got built.

This mortgage banking industry cruised along for several decades, until America became fully housed. By that I mean that we had adequate housing supply for our population. Unfortunately, we had an industry that had to keep churning out loans. It had been built and structured around creating loans - versus financing houses. I believe there is a difference. And I think that difference makes the difference. Let me explain.

When housing is needed and housing finance facilitates it, a true human need is met. But when housing stock is sufficient and housing is not needed, then the loans we make are funding something else. What else? How about greed? Or folly? Luxuries that we can't afford? And those are the good scenarios! The worse ones are predatory lending, taking advantage of people who are too ignorant to know it.

This is what happened, we constrained our housing finance system so that it could only operate in the U.S. (Fannie Mae and Freddie Mac, for example, are not allowed to fund loans secured by homes in other countries). So when the model matured and the needs had been met, the machine had no where to go and started devouring itself.

There's an old fable about a farmer who wanted his field cut. He brought in a few sheep and noticed that they ate the grass and kept the field cut and looking nice. So he kept adding sheep (capacity), thinking that more would be better. Unfortunately, when he continued to grow beyond the ability of the field to feed the sheep, the sheep turned on each other. The result was not pretty!

If we're going to have a healthy, sustainable housing finance system in this country, it is going to have to limit itself to doing what's really needed ... what really creates value for Americans. To the extent that it is unwilling to do that, then this financial Armageddon is what we'll have.