Uncertainty is creating and driving fear

It has abdicated its role in overseeing the operation of the banking system. This occurred initially in the 1990s when Greenspan warned of the impending problems with Fanny Mae’s lending policies - and the Federal Reserve did nothing. I believe it did nothing because the large banks saw massive profits for themselves. The Federal Reserve sat on the sidelines and merely watched when Clinton and a bipartisan Congress changed the Glass Steagall Act in 1998 and allowed what had been previously outlawed - trading in mortgages.

I believe both Greenspan and current Chairman Bernanke are greatly influenced by the larger New York based banks.

Similarly, the current Secretary of Treasury Henry Paulson is bathed in the New York cronyism. He worked for Goldman Sachs until a year or so ago. He was once the member of the Federal Reserve Board of Governors from New York.

I believe Benanke’s and Paulson’s proposed US$800 billion bailout was originally intended to be distributed to those New York banks. I believe the Republican revolt where Congress initially refused to pass the bailout, absolutely prevented that course. Later changes to the package have resulted in Treasury and the Federal Reserve having to deal responsibly with taxpayers’ funds.

Clinton, in 1998, did away with the Glass Steagall Act. During this process the re-enforcement of President Jimmy Carter’s Community Reinvestment Act was included. The Glass-Steagall Act was enacted after the Great Depression of the 1930s. Among other things, it prevented investment banks from trading in mortgages: that same law also prevented trading banks from selling and parcelling mortgages. And that's exactly where the big banks of the Federal Reserve recognised the possibility of future massive profits.

I opine they encouraged Greenspan to do nothing. Carter's Community Reinvestment Act was an utter stupidity. Its purpose was to encourage lending organisations to lend to the poor and disadvantaged so they could enter the home ownership market. They, I believe, never had a hope of repaying any loans in the longer-term. These two rather simple acts were where the corruption of the system began.

The mechanic’s of the melt-down were complex. Fannie Mae and the two abovementioned Acts was at its heart. Fannie Mae was formed to only buy mortgages that had been executed between banks and borrowers. The repeal of the Steagall-Glass was a Republican proposal; bi-partisan approval was gained in Congress and was followed by Clinton’s approval. As a trade off the Democrats gained a strengthening of the Community Reinvestment Act, that included punitive clauses. This proposed that financial institutions provide loans to people who wouldn’t ordinarily gain home loan approval. It was directed towards minorities and the poor. Clinton also approved this Act.

The specific effects were: Clinton pressured the banks to initiate these altruistic CRA loans and Fannie Mae accommodated them. Fannie Mae under Franklin Raines was the first financial institution to parcel and on sell them as derivatives. That enabled refinancing as the loans defaulted. As the banks realised they had no liability for these bad loans naturally they embraced the process with gusto. They were getting great fees with no liability.

Daniel Mudd, Franklin Raines successor at Fannie Mae, oversaw the massive expansion of the parcelling and selling of the derivatives and naturally trading in them on Wall Street was raised to a fine art and exploded across the world.

The mortgage brokers' role was simple, for they presented very plausible reasons for people to enter into agreements for the low start loans. They were not dealing with idiots. The two reasons were, first, repayments initially for the first two years were lower than rents and, second, as the market values of houses increased many loans were refinanced, with the increased equity as deposit, or they were sold before the bust with windfall profits to the buyer.

In 2006 and 2007 The Federal Reserve increased interest rates. What followed was a stall in the housing market, housing prices fell and the inevitable happened. When values and sales prospects fell, refinancing became a huge obstacle. This, coupled with the incremental interest and end of the low-start period (after two years) of non-repayment of principal, made it stupid for most sub-prime borrowers to keep their house.

In the US mortgage liability ends with the mortgaged house and any short fall in debt at the repossession sale is carried as a loss by the bank (in most early cases it was Fanny Mae). This is why almost all sub-prime, Alt-A and Jumbo loans are suspect.