Lets Reflect, 5 years later.

I was recently asked to, in order, rank the following groups to blame for the 2008 financial crisis:

-Consumers
-Wall Street
-Government
-Lenders
-Realtors
-Secondary Market

This question really had me reflect on the crisis 5 years ago and how we have recovered or changed policies since then. In order to rank these groups to blame for the crisis, I had to revisit exactly what happened in the economy that resulted in a crisis. Most arguments you may find throughout the web pick sides and blame one group over another, but to me its about a domino effect which really makes each group equally responsible for the crash. Like a perfect storm, the 6 groups above did exactly what they needed to do to contribute to a crisis. At the end of my explanation below, I will rank the 6 groups based on their fiduciary duty to another and how each betrayed that duty. However, to say one group was more responsible for the crash over another is impossible to do. Without the actions of any one of these groups, a crash would either not have happened or not have been nearly as bad.

The stock market hit an all time high in October 2007 when the Dow Jones Industrial Average exceeded 14,000 points. However, with in the next 12 months the economy started its decent to an ultimately crash in October 2008 and into 2009 which later became known by many economists as the worst financial crisis since the Great Depression. So what happened in the 12 months leading up to October 2008 that transpired into the worst financial crisis of our time? To answer this we have to travel back in time to 1977 when the Community Reinvestment Act (CRA) was passed by congress to encourage banks to meet the borrowing needs of low income producing communities. That's right we can actually trace the roots of the economic crisis the Jimmy Carter days! A year after CRA passed congress put a quota on the amount of mortgages banks or lenders needed to sell in order to make it known that home ownership was attainable by every single American. Making lenders meet a certain quota meant lowering restrictions borrowers needed to meet. This legislation (directly and indirectly) involved the government as a stakeholder in lending, banking and real estate.

Fast forward 15 years during Clinton's administration and you will see several changes in legislation and reform to the CRA which made lending even less restrictive and allowed for even more people to qualify for mortgages. In 1994 Congress increased the mortgage quotas on banks from 50% to 65% of Americans who should own a home. In 2002 the housing bubble was eminent but to avoid a crash and keep housing prices high, the FED kept rates low. With low rates and lending restrictions removed, houses were selling faster than ever and prices were rising at historic rates.

In the early 2000s mortgages were being written to almost anyone that walked in the door. The risk of default was no longer an issue for lenders because they simply sold the mortgages off to large institutions on Wall Street. So with no risk of default, lenders were lending faster than ever. The legislation that was put in place by the government leading up to this time period created many loopholes in mortgage lending in order to provide home ownership to Americans.

A new product emerged called a collateralized debt obligation (CDO) The way the product works is subprime mortgages are bundled up with prime mortgages which the Wall Street banks then offer in the secondary market. The rating agencies rated these investments as AAA investments because of 2 reasons: The prime mortgages were mixed in. The second reason is the notion that even if the sub prime mortgages were defaulted upon, the value of the home would continue to rise. Therefore, the bank could repossess the home and sell it for a profit, making the CDO still valuable.

So now the lenders are happy because the requirements to receive a mortgage are more lenient AND they can sell off the mortgages to wall street (minimizing their exposure to risk of default). This resulted in over selling mortgages to pretty much anyone who walked in the door. There are accounts of people with annual salaries below $50,000 being approved for million dollar homes.

Since there were so many people being approved for mortgages and not enough houses to sell, construction companies were building large developments which were advertised and being sold by realtors. Realtors were advertising the homes as a win win scenario for consumers because they made people believe that housing costs would always continue to rise and even if they couldn’t afford the home, they could sell it in the future for a huge profit.

Finally, some people in Wall Street figured out the scheme before others and created a product called a Credit Default Swap (CDS). This was basically an insurance policy on the MBS so if the value of the MBS declined, the value of the CDS rose. The CDS was a derivative of the MBS (basically a short on CDO).

Through 2007, home prices continued to rise but during 2007-2008, people started defaulting on homes faster than ever. The reason was because of variable interest rate mortgages. The lenders offered variable rates to people, which, to the unwise seemed like a great deal. This means that the consumer would pay for example 2% interest for the first 3 years, then after 3 years they would start paying 8% interest, increasing their monthly payment significantly. Most consumers who bought homes during the bubble, bought from 2004-2008, which is why during late 2007 people started defaulting due to the variable interest rates. So when everything went down in 2008, the MBS and CDO, which were in pretty much every institutions portfolios, became pretty much worthless.

While the CDOs were quickly loosing value, the large institutions who were selling these CDOs were buying CDSs. This means Wall Street knew the CDO product they were selling was worthless but kept selling it. At the same time, Wall Street was buying large numbers of CDSs which during the crash became very valuable and the originator of those contracts were left with hundreds of billions of dollars in debt and with no cash.

So the crash of 2008, just like during the Great Depression was one of no liquidity. The large institutions who bought all the CDOs in the secondary market lost their liquidity. Insurance companies who issued the CDS lost all their money to pay out the claims. Wall Street firms were left with toxic assets on their balance sheets which rendered them no value and out of cash. There were a few firms invested in the CDS who were doing better than others, but still everyone lost in this game.

Based on the sequence of events, it is hard to place more blame on any group, however, some groups had a fiduciary duty to be responsible enough to not breach any moral code. This is why the following is how I rank these groups from most to least to blame:

1)Lenders – Had the responsibility to only sell to credit worthy individuals. Even though the government made it legal for lenders to sell these very subprime mortgages, they had a moral responsibility to decline certain consumers and they didn’t uphold. They had a fiduciary duty to make the consumer aware of exactly what they were doing and disclose in a better way the teaser rates and what would happen when those rates are no longer available.

2)Realtors – They too had the fiduciary duty to provide realistic opportunities for their clients and not try to oversell a home which is very obvious the consumer cannot afford.

3)Government – Although they have the highest level of fiduciary duty to the consumer, they put in place policies that were meant to provide consumers with more opportunity, however, these policies were too lenient and were abused by lenders. They are still somewhat to blame for allowing lenders the opportunity to make so much money on the backs of Americans.

4)Wall Street – Although, they were providing services that are typical for investment banks (for example buying the CDO’s from lenders and selling them to the secondary market), the Wall Street banks got greedy and started selling products which they knew did not have value. They were also buying the CDS’s while selling CDO’s to their clients. The products they sold ended up in large institutions which affected every day American's pentions, annuities, and other investments.

5)Consumer – Although the consumer is always right and they are to blame for the crisis too. They became greedy and irresponsible, buying homes they could not afford.

6)Secondary Market - This group is least to blame because they were simply adding these products to their portfolio’s which were advertised to them as a great investment and the investment was supported by rating agencies. The only people who really knew it was going to fail at the end were a few people in the large Wall Street firms. The secondary market was just the victim, however, since the secondary market was the direct link to every day Americans, they could have been more selective on what their portfolios held.