In early two parts of this course, we covered the climb of securitized loans and looking after birth of credit non-payment swaps. We left off around the throngs of a flaming bull market being by considering a new era gurus technology companies. With the exception of a few hiccups, Wall Street has prepetuated almost twenty years of wealth creating, bull market returns on the backs of financial leverage, innovation, issue good ol' fashion greed.
The booming 90's stumbled on a screeching halt at the turn of the 1, when the "dot-com bubble" in conclusion burst. Technology stocks, especially anything even remotely interrelated Internet, were trading at substantial valuation levels on original speculation that at someday at some point these dot-com companies would be making no longer that. Once the market realized that "the emperor has not one clothes, " investors bolted in connection with door, yanking the integral capital (money) that non-profit producing set off companies needed to survive. During this time, some companies like Enron, WorldCom, and Tyco were individual for investor fraud and at last went bankrupt. In the middle of all this, the US also dealt with it's first attack for us soil since the bombing that Pearl Harbor in 1941. It was a dire some time to many Americans as us states was slipping into a recession and are worried about another terror attack weighed on people's kisses.
In an attempt right to stimulate the economy, the Federal Reserve Bank (commonly know as "the Fed") systematically reduced the Fed Funds rate all the way down to 1%. To attract some background, banks are required under legal standing to maintain a multiple level of reserves to help with their portfolio of legal contracts. If they fall plantar too the reserve amount, they can borrow utilizing other banks who bunch excess reserves. The nominal Fed Funds minute rates are the target interest rate at which point banks should lend money one to the other and is set through Fed. The effective Fed Funds rate is the actual rate from which banks lend from any other. The Fed tries to create these two rates nearer together through open market activity (e. g. should the effective rate is beyond reach, the Fed injects additional money into the system making it easier to get a offer, so banks have shed their rates to take a seat competitive). A bank makes a profit on the spread is amongst rate at which they borrow as well as rate at which the company lend out. With the price of borrowing at historical lows, banks were able for you to do lend out funds during very attractive rates being successful extremely easy for people to obtain OPM (other people's money).
There was no bigger winner from the Fed's fast and loose monetary policy along with US housing market. With stock exchange trading tanking and the cost of debt at historic levels, money started to pour into real estate markets. Americans started to "up size" their homes and investors began to jump into the market. As the number of buyers started to outpace traders, prices adjusted upward to be able to supply with demand (a lower econ 101). This back once again attracted more money to qualify for the market as people began to flip houses for buck, which added to the importance and further perpetuated the ability housing market's meteoric more. Homeowners became "house-rich" and cash poor, so they turned to home equity loans to tap some from the new found wealth. This money in-turn was dumped back into the economy as Americans continued to feature their spending addiction. These same spending spree stimulated financial mess growth, pulled the US markets due to a recession, and put the bull market back to normal.
Historically, under "normal" buyers conditions, the average home inventor purchases a home worth three to four times their annual your personal income. During the peak regarding this proflict housing boom, the product quality house sold for several times (a 50% increase) household income with some hot markets along the coasts hitting greater levels. Housing prices went up by to unsustainably high stages, which was perpetuated simply by using a both aggressive lending techniques and Congressional posturing.
Back every day, when someone wanted for an unfortunate house they would go to the bank or a thrift for a loan. The lender would then originate the financial lending, keep it on their unique balance sheet, and service it until we found it paid off or defaulted. The beauty of this simple system is that each lender was keenly been aware of the risk they were taking by developing loans to each Man Soon-to-be-Homeowner that walked on the door. But as it was previously addressed, this all changed associated with dawn of the securitized financing market. Under the new world of mortgage lending, loan originators were stand alone entities (Countrywide is an excellent example) who's compensation was a little more aligned to the total loans created rather versus the quality.
In order keep the lending spigot operating at full blast, lien originators created new, charming loans that offered claimed income, teaser rates, interest only, and balloon control features. The details during these exotic terms are all over the scope of this get-together, but all of them tweaked the features of a conventional fixed interest rate amortizing loan. The primary purchasers in just their loans were the securitization companies (mainly Frannie Mae a person Freddie Mac) who swallowed the loans, packed your ex together, and sold the theifs to investors (primarily banks). Packaged loans were thought analyzed by outdated utilities which were not utterly capturing the risks of exotic new products. Marc Gott, an old director of Fannie Mae's amount you borrow servicing department was reported as saying: "We didn't realize what we were buying. This system was designed for plain vanilla loans, and we expected to push chocolate sundaes during the gears. " But that didn't stop the machine available pumping out new securitized products held "chocolate sundaes. " In terms of the rating agencies (who's a lending product interests were also aligned with the total loans they rated) signed off all around methodology and put a greater triple AAA rating on your product, securitization firms could back up for sale with easy and therefore also cared more about the quantity versus the grade of loans they purchased.
Adding to this very massive tailwind was The legislature pushing both Fannie and Freddie to take in more risks and keep breakneck pace going. Whenever anyone counsel that Congress rein the actual conclusion giant pseudo government any lender, lawmakers where hit when using a barrage of angry dialing and letters. One such automated find warned, "Your congressman is attempting to make mortgages more steep. Ask him why he opposes nation dream of home closet. " To make the situation worse, Wall Street in order to jump into the living space as investment banks the capacity Bear Sterns, Lehman Bros, and Goldman Sachs we've been cutting Fannie and Freddie outside the loop by securitizing gives and selling them locally to investors. Suddenly, Fannie and Freddie ran risking potential becoming obsolete and failing or even her Congressional mandate. Another at an earlier time senior executive at Fannie Mae used to be quoted as saying:
Everybody became aware of we were now buying loans we would have previously waived, and that the options were telling us we were charging way a lack of, but our mandate would have been to stay relevant and to go around low-income borrowers. So it is exactly what we did.
With Congressional business, the sub-prime mortgage sell ballooned from $160 billion in 2001 to $540 billion by 2004, a three fold within just four years.
Loose business policy, aggressive lending draws near, speculative real estate shareholders, and financial weapons of those mass destruction had now set happens for biggest finanical manifested inability in US history because Great Depression. We'll explore the wild ride toward 2007 to today next and final installment from the series.
Ciao,
Frugal Franco
All quotes obtained from The New York Time periods article entitled The Reckoning.
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