The Underlying Basis of Finance & Credit
Here is an oddly interesting observation: Over the entire history of human finance, the underlying premise of all credit transactions -- loans, mortgages, and all debt instrument -- has been the borrower's ability to repay.
From 1 million B.C. up until the present, repayment ability was the dominant factor.
This goes as far back as when Og lent the guy in the next cave a few dozen clamshells in order to go and purchase that newfangled wheel. If Og didn't think his neighbor would be able to repay him those clamshells, he never would've entered into what we can describe as the first commercial loan.
Since real estate loans are at the bottom of all of our current credit woes, let's take mortgages as an example. The historical basis for making a loan for a home purchase was several simple factors: Employment history, Income, down payment, credit rating, assets, loan-to-value ratio of the property, and debt servicing ability. But for some crazy reason, those factors went away during the housing boom.
That may sound simple, but it becomes even more stark when viewed over a time line.
>
<-1 million B.C. --------------------------- 2002-07 ---2008->
>
Except for that 5 year period, the entire history of human finance was rather reasonable about the basis for making loans in general, and extending mortgage loans in particular.
Makes you wonder, doesn't it.
~~~
UPDATE: September 26, 2008 5:46am
As mentioned last night, there is a specific reason for this change: During that 5 year period (02-07), the basis for mortgage lending was NOT the borrowers ability to pay -- it was the lender's ability to securitize and repackage a mortgage.
Saturday, September 20, 2008 | 02:44 PM | Permalink
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» An Important Point about the Recent Past from The Left Coaster
Barry Ritholtz has an important point to make about what led up to our current financial crisis which was strangely out of step with the sensible way humans use to consider important in extending credit through out history: Since real estate loans are ... [Read More]
Tracked on Sep 20, 2008 5:26:08 PM
Comments
Must have been the Community Reinvestment Act.
Yeah, that's the ticket -- the CRA!
Posted by: Barry Ritholtz | Sep 20, 2008 2:57:40 PM
What about the concept of usury (charging interest for loaning money). Who came up with that idea?
Trust, once destroyed, is tough to regain. But betrayal of trust is a common theme in the entire history of human endeavors, so we should not be too unnerved by this latest example. It happens. Things get sorted out. We muddle on.
Plus ca change, plus c'est la meme chose.
Posted by: babycondor | Sep 20, 2008 2:58:04 PM
The American people elected an administration whose core of power joined in daily prayer breakfasts of the pentecostal kind. They believed the end was near, a biblical collapse imminent. They believed that they few would be saved while the masses would be wiped out. And so it was. But it didn't work out the way they thought it would.
We in the USA get the democratic government that reflects our integrity as a people. Except, maybe we merely have a figurehead democracy, the way Great Britain has a figurehead monarchy (their's is a better deal for the people). What we increasingly have in place of a functioning democracy is a plutocratic kleptocracy, an ineptocracy, and a dupocracy, government of the dupes.
Save the dupes.
Tim Mooney
Posted by: Tim Mooney | Sep 20, 2008 3:13:47 PM
--------------------------------------------------------------------------------
MONEYNETDAILY
Guess again who's to blame for U.S. mortgage meltdown
Analysts point not to greed, but to social activist politics
--------------------------------------------------------------------------------
Posted: September 19, 2008 6:19 pm Eastern
By Drew Zahn
While many pundits are pointing to corporate greed and a lack of government regulation as the cause for the American mortgage and financial crisis, some analysts are saying it wasn't too little government intervention that cased the mortgage meltdown, but too much, in the form of activists compelling the government to pressure Freddie Mac and Fannie Mae into unsound – though politically correct – lending practices.
"Home mortgages have been a political piñata for many decades," writes Stan J. Liebowitz, economics professor at the University of Texas at Dallas, in a chapter of his forthcoming book, Housing America: Building out of a Crisis.
Liebowitz puts forward an explanation that he admits is "not consistent with the nasty-subprime-lender hypothesis currently considered to be the cause of the mortgage meltdown."
In a nutshell, Liebowitz contends that the federal government over the last 20 years pushed the mortgage industry so hard to get minority homeownership up, that it undermined the country's financial foundation to achieve its goal.
"In an attempt to increase homeownership, particularly by minorities and the less affluent, an attack on underwriting standards was undertaken by virtually every branch of the government since the early 1990s," Liebowitz writes. "The decline in mortgage underwriting standards was universally praised as 'innovation' in mortgage lending by regulators, academic specialists, (government-sponsored enterprises) and housing activists."
He continues, "Although a seemingly noble goal, the tool chosen to achieve this goal was one that endangered the entire mortgage enterprise."
"As homeownership rates increased there as self-congratulation all around," Liebowitz writes. "The community of regulators, academic specialists, and housing activists all reveled in the increase in homeownership."
>--snip--<
~~~
BR: I've been waiting for someone to show me where the CRA requires lenders to ignore "employment history, income, down payment, credit rating, assets, loan-to-value ratio of the property, and debt servicing ability" as the basis for making a loan.
Without some legislation that says banks must override those factors, CRA arguments are the refuge of liars or idiots . . .
Posted by: Guess again who's to blame | Sep 20, 2008 3:21:51 PM
I'm not sure that lending based on an ability to repay is back yet. I was just talking to someone who bought too much house and will not be able to keep it. She also has a ton of credit card debt. She decided she will need to declare bankruptcy. Lawyer told her she will not be able to get a new car for 5 years. So before she files for bankruptcy she goes and buy 2 Audi's no money down, one for her and one for her daughter. She's stoped paying everything and is filing.
Obviously it is fraud, but this lender would still rather look the other way and make the loan.
Until I have some sense that stuff like this isn't happening I have a hard time getting to enthusiastic about any bailouts.
Posted by: Paul | Sep 20, 2008 3:22:24 PM
Securitization + Ridiculously High Fees and Bonuses = The Reason Things Changed From 2002-2007
Posted by: SINGER | Sep 20, 2008 3:26:45 PM
the Paulson/Bernanke/Cox/Bush responses are so cockamamie on so many levels, I don't even know where to begin to refute them. their actions tell me that we are dancing around a black hole here.
I'm thinking, they'll not only close the banks, they'll shut down the stock markets for a week or more. then they'll have to start printing ration stamps.
Posted by: cloudy | Sep 20, 2008 3:27:24 PM
A year or so ago suggestions here we would see people walk away from home loans, and questions like 'What will they call the new Resolution Trust Corporation' were greeted by faithaholics with skepticism.
Well guess what. Here we are. Believe it now?
Now just imagine that things a year from now could be as much worse than they are now, as they are now from a year ago.
Can't happen right?
Posted by: Bob A | Sep 20, 2008 3:33:44 PM
They could shut the market down for a month and you'd be stuck with everything you currently own. I think about that for every trade I make.
Posted by: dean | Sep 20, 2008 3:40:01 PM
Here's a draft copy of the Treasury's proposed legislation.
http://www.cnbc.com/id/26803766/site/14081545/
Posted by: Kent | Sep 20, 2008 3:44:14 PM
"the Paulson/Bernanke/Cox/Bush responses are so cockamamie on so many levels, I don't even know where to begin to refute them."
I agree!! How can you trust Bush as to the state of our economy when he gave us WMD in Iraq? Fool me once, shame on you. Fool me twice, shame on me. I say no bailouts and let the shit hit the fan. I am going long precious metals because the dollar is about to turn into confetti.
Posted by: Pat G. | Sep 20, 2008 3:49:02 PM
"Since real estate loans are at the bottom of all of our current credit woes"
NOT
root cause is the need of a trade - any trade will do - in this new world of traded off responsibility
THAT
produces a stream of consumption - creating revenue for the crafty
Posted by: Greg0658 | Sep 20, 2008 3:56:48 PM
Sidney Homer's magisterial "History of Interest Rates" showed that the earliest credit was secured lending -- pawnshop loans, if you will. Repayment wasn't a huge concern, because the lender already held an asset of equivalent value in hand. Nevertheless, interest rates were high because money was scarce in primitive, poor societies.
As banking, credit and affluence developed, rates fell. In fact, over the long run, Homer found a "bathtub curve" -- high rates in the early, primitive days; low rates in the high noon of economic development; then high rates again as social decadence and currency depreciation set in.
Guess where the US stands in the bathtub curve ... and where it's headed? Hint: don't borrow at a floating rate now.
Posted by: Jim Haygood | Sep 20, 2008 4:02:26 PM
It's not just individuals but whole countries who borrow with little thought of paying the debt off. With another trillion being added to America's debts to bail out the banks, just exactly how does America plan on paying back the Chinese, Russian, Arab and others who purchase America's treasury notes and bonds?
Inflate them away and stick it to the bondholders.
Posted by: Paul | Sep 20, 2008 4:06:50 PM
But people can repay!
(Granted, when the government takes money from the people who were responsible and gives it to the people who borrowed recklessly. But who looks smart now? Hint: Not those of us who saved and got out of the market.)
Posted by: Dan | Sep 20, 2008 4:07:34 PM
To Mr.Ritholtz,
Mortgages are collateralized loans. In principle, the ability of the borrower to repay is irrelevant as long as the value of collateral is higher than the loan value.
The real estate prices had been going up for quite a while and it was reasonable to believe they would continue to do so. But not indefinitely, of course.
So it was all about predicting when and how they will crash which it is very difficult. For this reason, booms and bust will continue as long as mankind exists. But reasonable regulations could protect the financial system from total destruction every time it goes bust.
~~~
BR: Even collateralized loans have expensive transaction costs associated with default.
Collateral limits losses -- but does not eliminate them.
Posted by: adeev | Sep 20, 2008 4:11:28 PM
I think Moses (or was it the burning bush?) was the one who told us usury was not OK ...it's actually in the Torah...but we didn't follow the rules...oh well..c'est la vie...
Posted by: lafemmeverte@gmail.com | Sep 20, 2008 4:14:36 PM
Was that period possibly unique in the ability of those who made the loans to make a quick profit and then sell the loans (and their risk) to someone who had no idea that there was any substantial risk associated with the loan.
Posted by: Peter | Sep 20, 2008 4:15:26 PM
What was the primary driver of the crisis?
SINGER @ 3:26:45 PM nailed it:
Securitization + Ridiculously High Fees and Bonuses = The Reason Things Changed From 2002-2007
Same thing is going to happen with securitized credit card and auto loan debt. And somewhere along the way the market for credit default swaps will collapse (who was the genius that came up with that idea)?
We're still in the third inning of a nine-inning game. Before the last out is made, Goldman and Morgan Stanley will no longer exist as independent entities, GM and Ford will be wards of the state (forget about Chrysler and Cerebus -- toast), a couple of thousand banks will have failed (the number stands at 14 today), hundreds of hedge funds will have disappeared, inflation will be over 10 percent and yields on ten-year treasuries will be twice that, and every asset you own will be worth 40 percent less than it is today. (Hey, Giant season ticket holders, you might want to re-think those seat transfer fees.) And you wonder why Bill Gross is dumping his stamp collection? Call it the Schwartzman indicator -- smart guys jumping ship before it goes down.
Posted by: Mitchn | Sep 20, 2008 4:17:28 PM
It is really, really hard for average Joe to accept that his personal decision to offer more for a house than it was worth is at the root of the problem.
From there, it was compounded by mortgage issuers who were really not loaning money at all and by really bright, well paid investment bankers who borrowed 30 to 1 on the the back of it all.
Now Bush has announced - right out in public that the problem goes onto the back of Main Street. In his usual butt-headed manner he made that announcement by saying this would, in fact, protect Main Street. To 'fix' the problems created by ignoring rules that worked for centuries, we will ignore more rules that have worked for centuries.
God help us all. We are just getting into this, not fixing anything.
Posted by: wally | Sep 20, 2008 4:23:29 PM
Barry,
For the vast majority of that time period, borrowers faced drastic CONSEQUENCES for default ranging from death to debtor's prison to indentured servitude. Generally, you only borrowed what you needed because repayment was not an option to be taken lightly.
Today the CONSEQUENCES for not paying are.....fill in the blank.
Posted by: Rich Shinnick | Sep 20, 2008 4:27:24 PM
His daddy should have named him George Herbert Hoover Bush.
Posted by: wally | Sep 20, 2008 4:27:25 PM
Look like we're going to get a f-cking dictator from Wall Street.
It would give Treasury Secretary Henry Paulson sweeping power to hire managers and award contracts to private companies without review by courts or government agencies.
http://bloomberg.com/apps/news?pid=20601087&sid=aDKlO_vRJLmo&refer=home
Hayek thought The Road to Serfdom was going to happen via populist socialism. But it seems to be happening via plutocratic socialism. Disgusting.
(sorry for the multiple post - put it in wrong place initially)
Posted by: ponziq | Sep 20, 2008 4:31:28 PM
Congress should, at the very least, expect the resignation of the current administration as a condition of passing anything that is supposed to 'fix' $700 billion worth of damages.
Posted by: wally | Sep 20, 2008 4:33:29 PM
The answer is really quite simple. AIG, the large broker banks and hedge funds were using Black-Scholes and its analogs to formulate computer rapid fire trading. It was computers that effected the trades. The only people allowed into this lucrative practice were "certified investors" who signed a statement that all their investment was at risk. Yeah, they agreed that they could afford to lose it all. The average person/taxpayer was not allowed to play or profit. Now we are supposed to cover the losses? Now we are told not to think about blame just before an election?
Prison is too good for our politicians (Bernie Sanders and a few others excluded).
Posted by: AGG | Sep 20, 2008 4:41:25 PM
