The Bank Crisis for Dummies

Hi. We had a stock market crash. On October 9, 2007, the Dow Jones industrial average reached a record 14,164. Exactly one year later, October 9, 2008, the Dow closed at 8,579. The United States stock market lost 39.4%. What happened? Why is the economy in such bad condition that the U.S. Congress just voted for and the president signed into law a 700 billion dollar banking bail-out legislation?

You've heard about Republican deregulation, about Freddie and Fannie, and you've heard about failed financial policies. Everything seems so complicated. Our national leaders said we had to have this bail-out or things would become even worse than what they are. What happened and whose fault was it? Did we really need this expensive bill to be passed? Let me explain. Understanding this should impact your vote in this presidential election.

People Put Their Money, Their Savings, Into Banks

Dads and moms have jobs and they make money. They put their money into banks. When they put their money into a savings account, they are able to earn a little bit of interest on their money from the bank. This interest a bank will pay on a savings account is usually around 3%. Banks earn money by investing the money that people deposit in their savings accounts.

Banks Give People Loans to Buy a House---These Loans Are Called Mortgages

Banks can earn money by making home loans. They receive more interest on the home loan than the interest money people receive for their savings account. In order for people to get a home loan, they must qualify to have that loan. Those qualifications once were much more strict. These banks knew they were investing other people's money, so they were very careful who they would loan it to. The old standard for getting a loan was having at least a 700+ credit score, 20% down payment on the loan, five years on a job, two months of payments in the bank, and no bankruptcy in the last eight years. When those standards were enforced, people rarely defaulted on their loan and lost their homes to foreclosure.

Banks make money by the people paying back their loans at a higher interest than they are giving back to customers in savings interest. Banks also loan money to businesses in the form of business loans. The way that many small businesses operate is that they use these loans to buy inventory, paper for billing customers, and for paying their employees. They pay back the loans with the money make from their business. Everything in the United States economy was moving along fine with the kind of arrangement that I've described so far. But then something happened.

The United States Government Changed the Rules for Home Loans

Something did happen and what happened first was President Jimmy Carter in 1977. Banks would not give loans to people in certain neighborhoods---it wasn't very safe banking practice to do so. President Carter changed this by signing the Community Reinvestment Act (CRA). This law made banks give loans to people who lived in those bad loan areas. The idea, of course, was that if more people owned homes in those areas, they would do a better job of taking care of the neighborhood. CRA encouraged home loans through two government sponsored enterprises: one was The Federal National Mortgage Association (Fannie Mae) and the other was The Federal Home Loan Mortgage Corporation (Freddie Mac). With this new law, to go unpunished by the federal government, banks had to find buyers who could qualify for loans under the old, reliable standards. They often could not find any so out of the lack of qualified buyers hatched the concept of the sub-prime mortgage.

CRA also created hundreds of unregulated housing "agencies," who would lobby banks for more money for their agencies. If they couldn't get the money, these agencies would cause great difficulties for banks with nasty lawsuits. The Reverend Al Sharpton was involved with these. One of these agencies, the Association of Community Organizations for Reform Now (ACORN) bragged that because of their influence, over one trillion dollars worth of these CRA sub-prime mortgages were written. Now Senator Barack Obama was a community organizer heavily involved in ACORN.

We're not done yet. In 1980 President Jimmy Carter signed The Deregulation and Monetary Control Act. In 1982 President Ronald Reagan signed The Alternative Mortgage Transactions Parity Act. These two laws created some modern mortage products with which we have now all become familiar: adjustable rate mortgages (ARM), balloon payment mortgages, interest only mortgages, etc. In 1986 the IRS tax code was changed to give a deduction for only the interest on a home loan. Financial advisors started encouraging customers to pay off mortgage debt only and to pay off other forms of debt with the equity in their homes. In 1993 President Bill Clinton made changes to the CRA that made it even more difficult for banks to deny loans to under qualified and gave banks points for giving out the more exotic loans.

Home loans became a major business. Many made incredible amounts of money as loan brokers. Amazing numbers of loans and bad ones, deceptive ones, were given to unqualified buyers. These mortgage brokers were just swimming in the waters created by the deregulation in the industry, that was designed by Democrats for the purpose of social architecture in poor neighborhoods.

Mainly Under Qualified Home Owners Defaulted on Millions of Home Loans

After a certain period of time, the creative loans given to under qualified buyers began to balloon and adjust to a higher rate, pricing the owners out of their own homes. The defaults on loans started as a trickle and built to a giant river of foreclosures. People were not paying back their loans to the banks. The banks were losing money.

Many of the banks were tied up into investment firms and investment organizations were strapped into banks. Many businesses needed banks for loans to operate. Corporations began to suffer the effects and the stock market began to drop. Banks and investment companies folded. Remember those people who had put their money in the bank? They were afraid, so in many cases, they ran to the banks to take out their money. People foreclosed on their houses and stopped making payments to the banks on their mortgages. Then others took their money from the banks. Many banks collapsed. The housing mortgage bubble popped and down came the U. S. economy with it.

Why Didn't Someone Warn Us About This Happening?

1999 was the first wave of sub-prime company busts. We didn't hear much about it in 2000 because that would not reflect well on Vice-President Gore's presidential run. Some warned about it. Several Republicans in the Senate gave warning, including Senator John McCain in 2005. Reforms of the mortgage industry were championed in the Senate by Senator John Sununu, who is presently losing his Senatorial race in New Hampshire to liberal Democrat and former Governor Jeanne Shaheen ironically in part because of the financial crisis. In 2003, Franklin Raines, CEO of Fannie Mae, said that they would not put effort into verifying immigration status of those applying for home loans. Yes, illegal immigrants contributed to the bank and mortgage crisis we're now in. There were many in the Senate who were given giant campaign contributions by Fannie Mae. Some of them were those in charge of government oversight of the home loan organizations. As late as July of this year, Democratic Senator Christopher Dodd, chair of the Senate Banking Committee, called Fannie and Freddie, "fundamentally strong." In 2007, the sub prime mortgages had begun to crumble again, but a number of economic factors would not allow anything to stop the destruction that has taken place.

Why the Bail-Out?

As I understand it, this financial collapse has resulted in a lack of credit available for doing business. Almost everything operates on credit now. If businesses don't have credit, they will lay off employees. The unemployment rate could double. If it doubles, even more people won't pay their mortgages placing more stress on banks. More credit will also allow the big mortgage lenders to sell some of their defaulted mortgages to other institutions. Less foreclosures will mean stabilization of housing prices which will save the equity of homeowners who did not default on their loan. Even if they did pay their mortgage, so many others didn't that their home price has plummeted.

That's my explanation. I won't say that it will work or that it is right.

So Who Is to Blame?

It is easy to see who should be blamed for the bank crisis. You just read how it happened. It isn't Wall Street, although corporations are an easy target in an environment of class warfare like we see in the election season. It isn't even the banks, who faced great pressure to go along with the new regulations. Who is to blame, more than anyone, are our elected representatives. That would make use to blame too, because we elected them. However, a lot of what they do is so that they will be more and more popular in order to win elections.

Our government changed the laws that would protect the mortgage industry and banks. It was almost entirely Democrats who did it in order to curry the favor of their special interests. They were involved for 30 years in forcing banks to give loans to people too poor or untrustworthy to pay them back. Now they're successful at putting the blame on everyone else.

The Bank Crisis for Dummies would like to thank my friend Mike Marshall, a long time banker in Michigan, for sending out an explanation of the bank crisis. It helped greatly with the writing of this post.