How did Wall Street get into this mess?

Michael Flynn of Reason.com writes:

Let's be clear: This is a Wall Street crisis, not a national economic crisis. The overall economy, while a bit weak, is still growing. Some politicians are comparing the current environment to the Great Depression. But in 1932, when the federal government last moved to bail out the banking sector, economic output had fallen 45 percent and unemployment was a staggering 24 percent. Today, economic output is actually up and unemployment is a historically modest 6.1 percent.

The overall economy doesn't even face a liquidity crisis in the current turmoil. Consumer, commercial/industrial, and real estate loans are all up over last year. Main Street is doing fine. The liquidity crisis is confined to Wall Street, between and among investment banks, insurance and securities firms, and hedge funds. There is the possibility that the contagion could spread, but in a global capital market, this is hardly certain.

It is the intersection of several underlying trends that have brought us to this point, not a breakdown in any specific part of the financial sector. The fundamental flaw with the bailout approach is that it ignores these trends and simply seeks to shore up the finances of certain Wall Street institutions.

Then there is this:

Fannie Mae and Freddie Mac were going through a crisis. In 2003 and 2004, an accounting scandal was revealed. The two public-private partnerships were cooking the books to show phantom profits. The Bush administration and its allies on the Hill pushed a strong bill to reform how these institutions operated. The measure came very close to passing, but Fannie and Freddie cut a deal. They would refocus on expanding mortgages for low-income borrowers if the feds kept out of their operations. The bargain worked. Virtually all the Democrats and a few Republicans backed the two companies and the reform effort failed.

Fannie and Freddie then went on a subprime bender. They made it clear that they wanted to buy all the subprime or Alt-A mortgages that they could find, eventually acquiring around $1 trillion of the paper. The market responded. In 2003 subprime mortgages made up less than 8 percent of all mortgages. By 2006, they were over 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever increasing amounts of subprime mortgages into the MBSes, they could juice the returns and so earn bigger fees. The rating agencies, thinking they were simply dealing with traditional mortgages, didn't look under the hood.

So really, what have we learned so far.

1. Mortgage Backed Securities are not a sure deal and not a guaranteed return. There never were, mind you, but with the housing bubble, it sure looked that way. The thing is that most of these Wall Street types should have known that they were sitting on a bubble and that all bubbles break. The dot com bubble broke and it seems like everyone forgot that. The housing market was unsustainable and it was obvious to most Americans and should have been a plain as day at Wall Street institutions.

2. Government sponsored entities are not the same as the government. Fannie Mae and Freddie Mac were incentivized and indeed practically explicitly brokered a deal by which they would become the only real subprime backer. Instead of spreading the risk around, Fannie and Freddie backed some 70 or 80 percent of all subprime mortgages. That is too much risk in one place.

3. A subprime mortgage in and of itself is not a bad thing. However, banks and lenders were again not only incentivized, but basically required by such laws as the Community Reinvestment Act and other legislation to ignore common sense risk measurement and basically give loans away. For decades, most first time homebuyers were in subprime mortgages, but banks and mortgage lenders made sure to limit the number of such mortgages and make efforts to minimize the risk as much as possible. Many of these first time homebuyers then go on to become solid credit risks and get into regular mortgages a few years down the road. This process still happens (it happened to my wife and I--with a little help from the VA) and will continue to happen. But it should happen on a far less frequent basis.

4. Too much emphasis has been placed on the financial sector of our economy. Yes, the financial sector is a big part of teh economy, but it is not the end all be all. As Flynn points out, there are other economic indicators that point in a positive direction.

I do thing a recession is likely, but it is not a foregone conclusion. So-called experts and pundits have been claiming we are in a recession and have been doing so for a couple of years, but it hasn't happened. Will it happen now? Maybe...


But then again...Maybe not.