Financial Crisis Timeline

I was tipped off by John to a Fast Money video on CNBC, which explains the following three pieces of legislation that set the stage for our current financial crisis.

[Image: Graph of DOW Index highlighting three years with influential economic legislation. Courtesy of Google.]

• 1999 – Congress passes law allowing Fannie Mae and Freddie Mac to accept weaker credit
• 2001 – 9/11 caused Federal Reserve Chairman, Alan Greenspan, to drop interest rates very low
• 2004 – SEC grants exemption to 5 firms allowing them to borrow against their reserves at a 40:1 ratio

It is important to consider these events before you hop on the hate-train, because two of them were passed with the best of intentions for our society and our economy.

1999 – Congress allow Fannie Mae and Freddie Mac to accept weaker credit

This legislation was aimed at allowing more people to own homes.  From a sociological point of view this was a good thing.  This allows you to bring home-ownership into the realm of possibility for lower income individuals and families.  This directly impacts young professionals and minorities by allowing them to build equity in an asset rather than renting which has no return on investment (ROI).

As a counterpoint to this social theory, Arnold Kling at EconLog posits that the housing market is out of balance as one of four case points against the bailout plan.  He elaborates with the following:

In both the homeowner segment and the rental segment, we see high vacancy rates. That means that we have an excess supply of housing units. Housing construction needs to decline further, and prices need to fall more.

An even larger imbalance in the housing market is that we have the wrong people in the wrong houses. I am referring here to home borrowers, meaning people who are nominally owners but who put down so little money for their purchase that they are better described as living in borrowed homes. Until we get people out of houses that they cannot afford, the market will not be in balance.

Both ideas have their merits depending on how you prioritize social and economic agendas.  However, the real lesson here is to understand that this legislation created looser credit standards, adding more risk to the marketplace.

2001 – 9/11 caused Alan Greenspan to drop interest rates very low

The events of September 11th were an outside force on the marketplace, forcing Alan Greenspan to drastically lower interest rates.  His hand was forced to make borrowing easier to keep the economy functioning.  Otherwise, banks would hoard cash putting a halt to lending, projects, and business.  We are seeing the same result now, but for different reasons – the value of assets has become unpredictable.

Again, this was another move inspired by the good intention of keeping our economy out of gridlock in order to work through recovering from the effect of the attacks on our economy.

In this case, the lesson is that money was cheap, incredibly cheap because of the rock-bottom interest rates.

2004 – SEC grants 5 firms 40:1 borrowing ratio

Perhaps the lynchpin or tipping point in the sequence of events could be pointed at this piece of legislation.  If it serves any proof, consider the fate of the 5 firms who approached the SEC to enact this exemption.

• Morgan Stanley – transitioned from investment bank to traditional bank holding company
• Goldman Sachs – transitioned from investment bank to traditional bank holding company
• Bear Sterns – emergency loan from Fed to avoid bankruptcy, sold to JP Morgan Chase
• Lehman Brothers – filed for bankruptcy, sold investment-banking and trading divisions to barclays
• Merrill Lynch – sold to Bank of America

After the legislation, these banks were allowed to borrow $40 to every $1 they had in reserves, compared to a previous ratio of 12:1 – a more than three-fold increase. This meant that these 5 firms were allowed to run at a greater risk than previously by order of three, creating the “leverage disaster” we see today.

This financial crisis is often uttered in the same sentence as the events that led to the Great Depression of the 1930s, but we all have to understand that this is very different.  Our current economy is much more diverse and far more complicated.  It is robust enough to weather many storms and bad mistakes.  So, when we enter territory that is this unstable and uncertain, we must understand that it is the complex result of many bad decisions and many individuals.

If you enjoyed this post, please leave a comment or subscribe to the feed and get future articles delivered to your feed reader.