In Monday's post for The Washington Monthly, Kevin Drum posed a great question about the banking industry's response to the sub-prime mortgage crisis. Now as you know, I'm by no means a financial wizard nor do I have an advanced degree in economics. However, as an American consumer who'se been watching the state of the consumer over the past few years I took a stab at posting a reply to his question.
Here's the question:
" Like a lot of people, I've spent a fair amount of time over the past few months trying to understand the subprime debacle: CDOs, SIVs, mezzanine tranches, the housing bubble, diversification correlations, etc. etc. And some of this stuff I've finally figured out. Sort of. But there's one part that I still don't get, a piece of the puzzle where a card always seems to get palmed with no further explanation. For example, here's Jared Bernstein explaining what happened when the housing bubble burst:' Then the loans started to go bad, but because they were squirreled away who knows where, no one knew quite what to do. So the part of the economy that provides credit froze up, and without free-flowing credit, our economy can't expand.'
I'm not trying to pick on Jared; his post just happened to be handy. But why is it that "the part of the economy that provides credit froze up"? There always seems to be some hand waving at that point, and aside from bits and pieces that I can't quite put together into a cohesive whole, there's never an explanation of why a meltdown in one particular(admittedly large) sector of the financial industry caused the entire commercial paper market to essentially freeze solid.
So consider this post a public plea for someone to explain that particular part of the puzzle in layman's terms. Why are the credit markets frozen?
The following is my reply to Kevin's question. Of course, it's rather simplistic but he did ask for a reply in layman's terms.
After reading the warnings about sub-prime mortgages and stories about the escalating home foreclosure rate over the past two years, I can only conclude that the credit market froze because the banks were waiting for an excuse to freeze it.
Maybe I've been listening to too much of Naomi Klein but I see the "Shock Dcotrine" in practice. I'm certainly no economist but this is how it appears to my eyes.
Just look at what has happened.
A few years ago Americans realized that they were drowning in debt and began declaring bankruptcy in record numbers. The banks then lobbied Congress and the bankruptcy laws were changed.
Americans then borrowed heavily against their home equity just to make ends meet. Some also transferred existing credit card debt to new cards offering low introductory rates. Many new home buyers (even those with good credit) entered into sub-prime mortgages that allowed them to purchase far too much home than they could reasonably afford. Credit flowed freely and Wall Street, foreign investors and the banks were making billions.
The banks were making billions in consumer penalty fees and steadily increasng credit card interest rates. Countrywide and Bear Stearns were well aware that they were sitting on tons of sub-prime mortgages and bad credit liabilities.
Now Americans with sub-prime mortgages cannot meet their payments when the rates adjust. Home property values have plummeted. Some Americans now owe more for their mortgage than the value of their home. Home foreclosures are at all time highs. And those who transferred credit balances to new cards can't meet their payments. American consumers have run out of money and assets to borrow against.
So after the banks had picked the American consumers pockets cleaned they froze credit. And when the banks froze credit, the politicians acknowledged "a possible recession", and gave The Fed an excuse to act. The bailouts began.
Bank of America bails out Countrywide, JP Morgan bails out Bear Stearns and The Fed lowers interest rates to make it easier for banks to borrow money from other banks.
If one didn't know better you'd think that the banking industry planned it.
It's Impossible to Shame the Shameless
The Economy Is Based on Borrowing
Seattle Intelligencer, April 3, 2005
Predatory Lending: A Virus We Can Eliminate
from Demos.org September 2005
New Survey Report Reveals Truth Behind Credit Card
Debt Explosion in the U.S.
Center for Responsible Lending October 2005
For Minorities, Signs of Trouble in Foreclosures
New York Times, February 2006