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Property Debt Is At The Heart Of The Financial Crisis

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We have yet to address the cause of the crisis

By Conrad Voldstad

Published: July 6 2010 16:29 | Last updated: July 6 2010 16:29

With the debate about US financial reform finally, it appears, about to end, should we all feel safer and more confident that a crisis will not recur? After all, the root causes of this crisis (including derivatives) have been identified and addressed. Measures have been taken to prevent system-wide bail-outs.

We agree wholeheartedly with the need for financial reform and support many of the derivatives provisions in the bill. But have we addressed what actually happened in the financial crisis? Or have we left the real culprit lurking, ready to resurface and create more instability in the financial system?

It’s clear today – and it was clear three years ago – that the culprit is real estate exposure. Bad lending, driven by poor underwriting standards and awful risk management, created and drove the crisis.

Derivatives, of course, played a role. These financial instruments were and are a means of hedging and taking on risk. Some market participants used them to take on real estate risk. But history shows it’s not the product itself that causes crises. It’s the underlying risk discipline. The savings and loan crisis of 1989-90, the Japanese property bubble of the 1980s, and events such as the Panic of 1837 occurred at different times in different places. But what they and other crises have in common is a weakening in risk management standards and practices regarding real estate value and exposure.

Looking at the 2007-09 financial crisis, a similar pattern emerges. The casualties had one big factor in common – real estate exposure – which they took on in different ways. First, consider AIG. While a large portion of its risk was taken via derivatives, there is no doubt that what turned bad was the underlying real estate risk. It also took large positions in the cash subprime market and its cash losses may well exceed whatever losses it suffers on its derivatives position.

What about the other casualties? The biggest are Fannie Mae and Freddie Mac. It has just been reported that their losses so far top $160bn and they could go much higher.

Then there are the two banks that had to get a second bite of government support. Both were very active creating collateralised debt obligations out of subprime mortgages and got stuck holding the bag when the music stopped. Let’s also not forget Washington Mutual and Wachovia, victims of residential mortgage problems, which no longer exist as independent entities.

The investment banking industry was also feeding at the trough of the real estate lending boom. Bear Stearns was rescued but nearly $30bn of real estate exposure was left at the Fed. Lehman failed and its failure was a result of soured real estate.

There’s more. Countrywide, America’s largest mortgage lender, was bailed out by Bank of America. Others, such as Indy Mac, American Home Mortgage and New Century Mortgage, died with nary a whimper. All were victims of poor residential real estate lending. There are dozens of other banks with more than $1bn of assets that failed because of real estate problems.

If imitation is the greatest form of flattery, AIG certainly had its admirers. Real estate destroyed virtually the entire credit insurance industry, which diversified from insuring public finance and drove its business into the ground in the space of a year. Who are these groups? Big players such as Ambac and FGIC, and smaller ones like SCA (now Syncora), ACA and CIFG. MBIA is trying to separate its public finance business from its structured finance portfolio, the home of its mortgage business. Only Assured Guaranty is still writing business and it too has been seriously weakened by its foray into insuring residential mortgages.

As incredible as it may seem, there are yet more casualties. The mortgage insurers, for example, fared just a bit better than their credit insurance cousins. But companies such as Radian Group, MGIC and PMI remain shadows of what they were.

It seems strange that all these mortgage losses have not drawn the attention of lawmakers. Should we not have strict mortgage standards imposed on banks with access to FDIC insurance? How about revising the GSE’s lending standards? Surely, the non-bank mortgage lenders and originators can be regulated either directly or through management of the mortgage market itself.

Regulation that focuses on markets and instruments may help. But regulation would be much more effective if it focused on risk. Regulating risk, especially real estate risk, should be the objective. The casualties of the financial crisis were not the victims of derivatives. They were the victims of poor lending and risk management, and there is no assurance these will not resurface as they have so often in the past.

So the question remains: after all the effort that went into US financial regulatory reform, are we really safe?

Conrad Voldstad is CEO of the International Swaps and Derivatives Association

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Yup - House Price Mania &


are the route cause of it all.............

AND YET - I have a strange feeling the whole thing is going to happen all over again..... :unsure::rolleyes:

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Yup - House Price Mania &


are the route cause of it all.............

AND YET - I have a strange feeling the whole thing is going to happen all over again..... :unsure::rolleyes:

Yes, I'm convinced that debt-based asset prices will be forced to adjust in the next 3-4 years. All banks (and by extension, Western economies) are zombies otherwise. No money in the kitty for Great Bailout 2.

On a related point, I just viewed 2 great properties. Both could be considered "forever" homes, but priced at £600k and £750k respectively its hard to make any case for purchasing either (50% LTV). Given the following risks over the coming years, why would anyone sign up to 25-30 years of debt slavery at such levels:

1. Unemployment (UP)

2. Interest Rates (UP)

3. Pension requirements (contributions, UP)

4. Healthcare in later years (contribution, UP)

5. Day-to-day inflation (UP)

6. Income from partner (DOWN, due to children)

7. Taxes (UP)

8. Cost of private services to replace reduced State services (UP)

9. Real wages (UP or FLAT at best)

Given the above, its hard to make an investment case for house buying ATM.

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There has been no reform of the US financial system.

In fact the situation is worse - almost total regulatory capture by the too big to fails.

Economic suicide.

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