Wednesday, October 01, 2008

Teaching the Crisis

I’m responsible to teach economics and current events to eighth graders - woven into a 20th century US History course - and this sub-prime mortgage crisis is the biggest story of the year. It’s complicated, charged with politics during election season, and nobody seems to understand the big picture. I plowed ahead anyway and started by asking my students how many of them had money in the bank. Nearly all did. “Do you know what banks do with the money you put in there?” I asked. Most realized that banks lend that money so people can buy houses, cars, businesses, and so forth. We discussed how banks make money by charging people more interest on loans than they pay to depositors like them.

Then I told them of the three houses my wife and I purchased or built, how much of a down payment we put on each, how much we borrowed for them - how we fixed up the first two, sold them, and used profits to pay for much of building our present house. I told them about our employment history, our credit rating, and the factors that made our mortgage contracts examples of “prime mortgages” because we never borrowed more than we could afford to pay back and never missed a payment. Then I explained that the economic crisis was caused by “sub-prime mortgages” - banks (encouraged by government) lend money to people who can’t or won’t pay it back, either because they borrowed too much, because they were unreliable, because they fell on hard times, or because they didn’t put any of their own money down and can walk away from their payment without losing anything.

Then I wrote on the board and explained that what sound like names for people are actually crude attempts to phonetically pronounce the acronyms for FNMA - the Federal National Mortgage Association, and FHLMC - the Federal Home Loan Mortgage Corporation, respectively. I explained that local banks negotiate mortgage contracts such as mine but have limited money to lend, so Fannie Mae and Freddie Mac buy those contracts. Mine was for $95,000 at 6% for fifteen years with monthly payments of $801.66 and my house was worth way more than that. My contract can be sold - and has been twice, to Bank America and again to Wells Fargo Bank. My contract is worth more than $95,000 because of the interest I pay. By selling it, my local bank made a profit and got more money to lend so others around here can buy and build houses. That keeps carpenters, plumbers, electricians, excavators, dry-wall contractors, and others busy, giving us a healthy economy.

Most students understood this much. Then it got more complicated.

Fannie Mae and Freddie Mac were created by government, I explained. Together, they control $6 trillion in mortgages - half of all American mortgages. When they buy a mortgage, they guarantee it - like a parent cosigning a loan for a teenager to buy a car. If the teenager doesn’t make payments, the parent must. When Fannie Mae or Freddie Mac wanted to sell sub-prime mortgages, few wanted to buy because they were such a bad risk by nature. So, Fannie Mae and Freddie Mac bundled sub-prime mortgages with prime mortgages. Those packages became “Mortgage-backed Securities” which could be sold and re-sold because buyers believed that if they failed, government would fix everything - be the parent making payments for delinquent teenagers, so to speak. Wall Street jumped on and rode the ensuing boom. So long as house prices continued rising, sub-prime mortgagees could flip their properties and even profit, but as soon as prices leveled off and then fell as they inevitably do, foreclosures skyrocketed and it all caved in. Businesses most heavily invested caved with it, including the allegedly private Fannie Mae and Freddie Mac. Neither the Republican Congress nor the Democrat Congress saw it coming and they should have. Neither Clinton nor Bush saw it either. Some individuals did, but they didn’t blow the whistle loudly enough. Anyway, nobody listened.

Who is responsible for sub-prime mortgages at the root of all this? There’s plenty of blame to go around, but it started with the Carter Administration’s “Community Reinvestment Act” in the seventies. Standards to screen bad borrowers were relaxed. Buyers flooded the market and prices went up in the 1980s housing boom. Then President Clinton ordered standards lowered still further in 1995 so more “minorities” and other low-income people could own homes. Welfare payments qualified as “income.” Even illegal immigrants got mortgages with no money down. Uncle Sam became Jolly John. All this triggered a second housing boom now gone bust. Trouble is, this bust is so big,“experts” predict it may bring us all down with it unless the federal government solves the mess it created. Are they Chicken Littles and Henny Pennys warning us the sky is falling? Government wants us to buy back those dubious securities for up to $700 billion and sort out good from bad, claiming taxpayers will get their money back and more. Others doubt it.

Nearly every student learned something about the problem, but none understood it all. Neither do senators, congressmen, or voters. Neither do I. Not fully. Still, many think government must do something. If we do, hopefully we won’t make things worse.


Django said...
This comment has been removed by the author.
Django said...

Unfortunately, if there is one thing you can count on Congress to do, it's to misunderstand a problem and try to fix it in ways that will not help or hurt in the long run.

That the House didn't just sign the first bill that was thrust in front of them (at the behest of their angry constituents: "Who are they, asked the Representatives? It's been so long we'd forgotten they existed!") is an encouraging sign. However, with all of Congress anxious to get back to their home states and campaign for their own elections, they most likely will continue to rush to a solution without proper analysis or looking at all of the options. The good news is that every day that goes by and a bill *isn't* signed, is a day that shows the world that the sky *hasn't* fallen and eases the panic mentality.

Tom McLaughlin said...

Hi Django,

I agree with your analysis. The stock market dove, but leveled off and even rose some yesterday. No, the sky isn't falling yet and that's good.

You must be the Django from North Lovell, right? Could there be another? Doubt it.

Django said...

It is indeed me.

A google alert I had set up for "Lovell" picked up your blog a couple of months back. Added it to my RSS reader and the rest is a history of your words.

Jason said...

To keep up with Wall Street expectations, Fannie Mae held onto more mortgages and mortgage-backed securities for investment purposes. The same practice nearly drove the company into bankruptcy in the early 1980s. Once again it was spared in 2008.

Anonymous said...

Tom: Just read your piece; I think it's the best attempt to describe this mess I've seen so far.

There is one matter I'd like to raise however. You did not address or even mention the Global aspect. Overseas banks, as foolish and greedy as our own, gobbled up these mortgages and are now also facing the same consequences. I see today that the 4 largest European economies are scheduled to meet to see what, if anything. they need to do. Should be instructive to see their reaction.

It does bring up another, very unpopular, topic. Does it not seem that all the major problems of today are Global in nature, and the number is increasing steadily?
Logically does it not seem that we will have to face facts at some time in the near future and sart support for some type of World Supervisory Power; one with teeth enough to enforce it's proposals?
I think we all agree that the Un is not structured to be that body and that a third system is necessary. Gordo

Tom McLaughlin said...

Mandating that banks lend to people who can't pay back loans was dumb to begin with. Let people save their money for down payments, or let them declare all their income. Many work in the underground economy and hide their income to avoid taxes.

Government should regulate banks in FDIC/FSLIC and should bail out depositors as promised, but shouldn't bail out the banks themselves. Let's hope we've learned our lessons on this, but we'll see.

I'd like to see the UN disbanded, or at least let the US resign from it and evict them from NYC. We're better off without them.

After that, let's participate in smaller organizations like the E8, IMF, NATO, etc. as long as it's in our interest to do so.

Anonymous said...

The timing of what has been brewing now for decades is curious. A down economy is largely thought to be an advantage to the Obama campaign that is supported to the point of being owned by George Soros. Soros has been convicted in France for market manipulation, and the timing could hardly have been worse for the McCain campaign. Could this be Soros protecting his investment in the left?

Anonymous said...

Tom: Too bad you disagree about the coming of a World Authority. You are in the vast majority. Hope all the potential Global catastrophies on the edges of all current radar screens will blip out. Gordo

Anonymous said...


I am not ready to buy my own house yet, but I am worried about what expenses may come with the buying of my house. I was wondering if you could write an article and elaborate more on prices and taxes of what buying a house might cost me. It would be very much appreciated. Thank you for expressing your views, I enjoy reading what you have to say.