Thursday, October 2, 2008

Two Tenets, Two Truths

The crisis that is affecting financial markets around the globe finds its basis in two tenets that have been fundamental to the American way of life since the dawn of the Republic. To wit, everyone has the right to own a home and everyone has the right, within the confines of the law, to make as much money as possible. These are not ignoble sentiments; indeed, America has become the world’s largest economy and most powerful nation – lifting much of the world from poverty in the process – through innovation and commerce that is made possible by private ownership and free markets.

But when these fundamental beliefs are stretched to absurdity, in defiance of common sense, the results can be dire. In this case, mortgages were for decades granted to people who could not afford them. Financial institutions, meanwhile, saw opportunities to make slightly more money than they could through other investments by bundling these ill-considered loans together into Mortgage-Backed Securities (MBS). The rest is history.

First, to the matter of home ownership: In 1977, President Carter signed into law the Community Reinvestment Act (CRA), which stipulated that mortgage loans should be given to a broader base of Americans, including and especially those with lower incomes. The CRA was strengthened by President Clinton in 1995. Clinton’s Secretary of Housing and Urban Development, Andrew Cuomo, was forceful in demanding that lenders, as well as the government-sponsored agencies that backed them, Fannie Mae and Freddie Mac, give mortgages to as many poor and minority applicants as possible. It was mandated that unemployment and welfare payments be included as legitimate income for mortgage eligibility. Lenders found themselves scrambling to ensure they had enough CRA mortgages on their books to avoid lawsuits or charges of discrimination. The priority was carried into the early part of this decade, with President Bush boasting that more Americans owned their own homes than ever before. The good intention, of course, was to let everyone own part of the American Dream, regardless of their socioeconomic status. The unfortunate result, however, has become a matter of global concern.

The way in which this national miscalculation became a worldwide phenomenon is that mortgage-backed securities were purchased en masse by banks and financial institutions in numerous countries. When the American real estate market declined, mortgages went into default and MBS notes lost their pricing. By purchasing MBS paper, financial institutions had been hoping for slightly higher returns than could be achieved through more conventional securities. Whoops.

Americans have always been protective of their property and rights. As others have observed, these are folks whose forefathers rioted because the British put a tax on their breakfast drink – and it wasn’t even coffee. But somewhere in that justifiable urge to acquire and own according to diligence and talent, some room must be left for caution.

The simple lessons are these: Do not lend or borrow what cannot be repaid, and do not risk your entire financial well-being for a slightly higher return.

America is a good and resilient country. Capitalism is, as Churchill described democracy, the worst system in the world, except for all the others. Difficult as the present crisis may seem, we will get through this. Let us hope that government and citizens alike have learned what they should.
Caldwell is President of Caldwell Asset Management, Inc.