Could the Bailout Have Been Prevented?

By Kimberly Amadeo, About.com GuideOctober 2, 2008

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^{(Credit: David McNew/Getty Images}

Signs of the current mortgage crisis first appeared November 2006, when new home permits dropped 28% from the year before. At that time, most economists thought that, as long as the Federal Reserve dropped the interest rates by summer, the housing decline would reverse itself.

However, what they didn't realize was the sheer magnitude of the subprime mortgage market, which had created a "perfect storm" of bad events.

Banks and unregulated mortgage brokers made loans to people who weren't qualified because they could resell them on the secondary market.
The use of interest-only and negative amortization loans skyrocketed.
Mortgages were repackaged as mortgage-backed securities (MBS) and sold individual investors, pension funds and unregulated hedge funds. This meant that the risk was spread throughout the economy.

By August 2007, the Fed realized that banks were reluctant to lend to each other because they were afraid of getting stuck with bad debt, and took over the lending function until banks could sort it out on their own. By November 2007, the Treasury realized it was a credibility problem and created a Superfund to $75 billion in private sector dollars to purchase bad mortgages. However, panic had gripped the markets and $75 billion was no longer enough.

Two things could have prevented the crisis. The first would be regulation of mortgage brokers, who made the bad loans, and hedge funds, who used too much leverage. The second would be recognition early-on that it was a credibility problem, and that the government would have to buy the bad loans. If it had been done last year, when real estate values were higher, the bill would have been less than $700 billion.

For more signs of the mortgage crisis, read Could the Mortgage Crisis and Bailout Have Been Prevented?

For more about the bailout bill, read

Comments

October 2, 2008 at 9:08 pm (1) Ajay Madwesh :

Kimberly,

I really appreciate the format in which you set up the information. I did not know about the initial $75 billion superfund.

Well said about credibility – the lending freeze amazingly is due to a borrowers lack of confidence in the lender and vice versa that lenders are not sure if they will recoup.

In fact there is evidence (and the good news) that borrowers are looking for money but lenders have set the bar too high for a borrowers to gain decent return on capital.

The cycle will be broken by borrowers not lenders. Those banks that figure out ways to offset their risks and not pass it on to its customers will win out.

October 3, 2008 at 2:30 pm (2) Kimberly Amadeo :

Hi Ajay,

That is a very, very good point. There is probably such a pent up demand for loans right now that, when the banks decide to get back into business, there will probably be an upturn next year that will surprise a lot of people who now think we are entering the next depression.

Thanks for your insightful comment.

Kimberly

October 14, 2008 at 7:20 pm (3) MKS :

I wouldn’t point the finger at brokers for making the bad loans. The secondary market was willing to invest in the subprime borrowers. These bad borrowers chose to live outside their means, leading to defaulted loans. The investors chose to take on the risk of loans secured by properties that didn’t appreciate in value as anticipated. Because the borrowers put little or nothing down, the banks couldn’t recoup so well as they hoped. The banks accommodate the secondary investors who create demand for certain loans and brokers found people to fill the investors demand. It isn’t up to the brokers to protect the secondary market or decide if and when someone is living within their means.

Could the Bailout Have Been Prevented?

For more signs of the mortgage crisis, read Could the Mortgage Crisis and Bailout Have Been Prevented?

For more about the bailout bill, read

Comments

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