Mortgages Gone Wild: We've Started to Recover But Have a Way to Go!

February 26, 2010

Two recent articles, one in the Wall Street Journal and the other on, largely explain the credit crisis which threatened to bring down the American economy – indeed, the global economy – last year.

Start Here:

Washington Mutual failure has biggest impact on consumers - Sep. 8, 2009*

This CNN article about Washington Mutual (WaMu) explains problems in the mortgage arena, what I call “Mortgages Gone Wild.” Loans were being made that lenders had every reason to suspect could never be repaid. In many cases, these lenders collected their fees “off the top” and sent the loans to Wall Street to be packaged into “collateralized debt obligations,” which made collection of the loan “someone else’s problem.”

The now-defunct WaMu and Wachiovia were leaders in issuing so-called Option ARM mortgages. In discussing Wachovia’s Option ARMS (called “Pick A Pay” loans), the article says, “Two-thirds of borrowers as of Dec. 31(2008) were using the minimum payment option -- the one that results in their paying less than the full amount of interest due and having the balance added to the loan. Six loans in seven were written without documenting the borrower's income or assets.”  $700 billion of "Option ARMS" were issued by several lenders, but this problem debt was itself "leveraged" by Wall Street in ways that made the problem far greater.

Even more than subprime loans, "Option ARMS" were poison. If not outright banned, these loans should at minimum have been strictly monitored and controlled by regulators. These questionable mortgages, coupled with “collateralized debt obligations” and "credit derivatives" which Wall Street’s “financial engineers” built to multiply their impact, are at the root of the financial crisis that nearly brought the economy to its knees in 2008 and early 2009.

Where are we today? Read this: - Government's Trial and Error Helped Stem Financial Panic*

Many citizens still may not realize how close to the cliff the global economy came last year. This crisis was precipitated by "debt gone wild" in the American economy, especially mortgage debt but also credit card debt and certain commercial real estate lending. The problems caused by America’s debt binge are not behind us by any means, but our economy is in a much better position than a year ago.

The bold actions of Bernanke, Paulson, Geithner and Obama will, in my judgment, be recognized by historians for saving America and the world from a repeat of the Great Depression. President Bush deserves credit also for having supported Paulson and Bernanke in doing what had to be done.

I expect historians to conclude that an excessive zeal for deregulation at the end of the Clinton Administration and throughout most of the Bush Administration encouraged irrational lending by lenders who generally expected to pass on responsibility for collecting these loans to others, after taking their fees off the top. This lending was facilitated by Fannie Mae and Freddie Mac and, to a much greater extent, by Wall Street-created "funny money" (aka, collateralized debt obligations and other credit derivatives, credit default swaps, etc.).

In my judgment, America and the world were fortunate that Bernanke -- a widely recognized expert on the Great Depression -- was in the right place at the right time. We may still be in "a bit of a fix," but without aggressive action by the Federal Reserve and the Treasury, I expect America’s economy and the global economy would be in a far worse fix today.