What Caused The Subprime Mortgage Disaster – The Problems Began Before the Depression

What Caused The Subprime Mortgage Disaster – The Problems Began Before the Depression

President Bush and Ben Bernanke

(Best Syndication News) Wall Street avoided a crash last week after the Bush Administration announced a bailout plan for companies holding subprime mortgages. The announcement came a little late for Lehman Brothers who declared bankruptcy on Monday. Maybe they could have waited until Thursday when stock prices went right back up. But how did we get into this mess?

The Great Depression and the Federal Reserve

Some of our problems can be traced back to Woodrow Wilson who pledged that he would keep us out of the war in Europe and not to create a central bank. He broke both of those promises and it has cost us dearly.

Advocates for the Federal Reserve say that the banks should have more control over our economy and money system. The banks were given power by the creation of 12 regional Federal Reserve Banks. Besides getting paid a 6 percent dividend each year by the Federal Reserve, the banks get to choose members of the board of directors which rotate into the Federal Open Market Committee (FOMC). This gave the banks a lot of control over the economy.

Although the Fed was created to prevent bubbles and busts, many claimed that their primary function was to help member banks buy up public assets during recessions and depressions. JPMorgan Chase was recently given a line of credit by the Federal Reserve so they could purchase Bear Stearns. Bank of American has been on a buying spree lately purchasing Countrywide and now Merrill Lynch.

A similar thing happened during the Great Depression. Recently Ben Bernanke admitted this to Milton Friedman at his 90th birthday party. You can read what the current Fed Chair said here.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Those are ironic words. The Federal Reserve was created in 1913 and the Great Depression began in 1929 with a stock market crash. The subprime disaster has already caused some banks to fold some major banks could be next.

The History of Fannie Mae and Freddie Mac

During the Great Depression banks faced a similar situation – they didn’t have any money to loan. As part of President Franklin Delano Roosevelt's New Deal, in 1938 the government created the Federal National Mortgage Association (FNMA or Fannie Mae) to buy conforming mortgages from banks. The money they got for the loans freed the banks up to make new loans.

In 1968 the government spun-off Fannie Mae converting it to a private corporation. In an effort to create competition for their new private behemoth, the government created the Federal Home Loan Mortgage Corporation (FHLMC – or Freddie Mac).

Both Freddie Mac and Fannie Mae buy mortgages from the banks and then bundle them together and sell them off as Mortgage Backed Securities (MBS). Since they were both created by the government, they are called Government Sponsored Enterprises (GSE).

Although created with good intentions, both Fannie Mae and Freddie Mac have contributed to our financial crisis. They helped flood the market with more money to make these bad loans. On September 7, 2008 the government took back control of both GSEs.

Commodity Futures Modernization Act and Credit Default Swaps

In 1982 the Shad-Johnson jurisdictional accord banned single stock futures and determined how derivatives would be regulated. This agreement was codified in the Securities Acts Amendments of 1982 and in the Futures Trading Practices Act of 1982.

Since the creation of the Federal Reserve, Congress has been passing laws in an effort to correct problems caused by the flawed monetary system. But that all changed in 1999 when lobbyists wrote the “Commodity Futures Modernization Act” and gave it to lawmakers for consideration.

The bill had little chance of a hearing, but while the Republican Congress was deadlocked with the Democrats in an effort to pass a budget, the Act was slipped into a budget compromise. Sponsored by Rep. Thomas Ewing [R-IL] and cosponsored by Rep. Tom Bliley (R-VA) Rep. Larry Combest (R-TX) Rep. John LaFalce (D-NY) Rep. James Leach (R-IA) the bill went to the Senate without debate.

The budget compromise later went to the Senate and then to President Bill Clinton for his signature. The Commodity Futures Modernization Act of 2000 was signed into law on December 21, 2000. The purpose was to allow new financial products called swaps to be unregulated. Neither the SEC nor he Commodity Futures Trading Commission (CFTC) would be able to regulate them.

A credit default swap (CDS) is a derivative and form of insurance. A CDS is the most widely sold derivative in the market. It is used to insure against the default of collateralized debt obligations. Here is how it works:

1) Let’s say Joe goes to the bank and gets a $100,000 loan to either buy a house or take out a second mortgage. If Joe has poor credit he is considered a subprime borrower.

2) The bank will loan Joe the money and sell the loan to an investment bank like Goldman Sachs. The investment bank will bundle the loans together, including the subprime loans, and sell them as a security.

3) In order to protect themselves the investment bank will purchase a credit default swap. Normally the insurer would be regulated to make sure they had enough money to cover the defaults, but the Commodity Futures Modernization Act of 2000 prevented that.

The insurance companies (or insurer) wouldn’t have any problems unless there were a lot of defaults. But there were a lot of defaults. To add to the problem investors were betting on the risks too. The stock market had become a casino.

There is probably too much money in the stock market, but the problem is much worse. The unregulated derivatives market has been estimated to be $62 trillion, or nearly four times the size of the entire US stock market.

Continued - Gramm-Leach-Bliley Act of 1999

By Dan Wilson
Best Syndication News Writer

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