Main Street vs. Wall Street

Unless you have been living in a cave, you would have seen the near constant coverage of the financial crisis facing America and the debate about it which erupted a week or so back. (And even living in a cave is no excuse, since bin Laden is undoubtedly aware of this too.)

Perhaps the most staggering aspect is the sheer scope of what it will cost. Treasury Secretary Paulson told the Congress the price tag would be at least $700 billion. That's $700,000,000,000, a number Paulson pulled directly from his ass in order to adequately cover the forecast debt.

Now that it looks like the Congress has got something hammered out, to be voted on today and passed on by Monday, the focus will likely shift away from the shock and awe of the price tag and more earnestly focus on how we got here.

What I find most interesting is the way some pundits and analysts favor a "spread the blame around" approach. When talk of the nuts and bolts of the crisis come up, invariably one will hear at least some blame leveled folks who bought homes they couldn't afford. Bullshit.

Okay, this one is going to get long, so strap yourself in or maybe bookmark this post for later reference. I will devote some page space to examining the passed bailout proposal along with the actual nuts and bolts of the problem in later posts. Right now, I want to focus on the actual mortgages people lost their homes as a result.

First of all, it's worth mentioning that, despite what you might be told, it's not your job to qualify for a loan from a bank. You have your income, any existing debt, and a goal in mind of what you want to buy, but that grants you zero power to tell the bank to loan you money. Instead, banks have a responsibility of qualifying you against set standards in order to minimize any risks associated with giving you a loan. This is the responsible thing to do for account holders in the bank, whose money is being loaned to you, and any investors depending on the bank to make a profit.

So, let's begin with a little story. Back in 2002, John and Jane Taxpayer walked into Local Bank Branch, seeking a home loan. Their dream home cost $200,000. Their combined income was about $120,000 per year, and they had about $20,000 in outstanding debt, mostly from credit cards, student loans, and some medical bills. They were paying out around $3500 per month against this debt, along with their existing rent payments. This makes their debt to income ratio about 35%, which is not bad considering the national averages.

As of 2002, Federal interest rates had been cut down to 3.5%, almost half of what they had been at the start of the year. Banks, of course, tack on their own percentage points, which meant that an average home loan in 2001 stood at around 6.5%. This isn't shabby at all, considering where rates had once stood. Thus, our happy couple walked into the bank, having already done the math themselves expecting to pay $1264.14 per month over 30 years to move into their new home.

The problem was that John had some bad credit, left over from his college days, and Jane had filed bankruptcy against some pretty big medical bills only 5 years before. The debt they were paying on was what they managed to squeak out past that bankruptcy. Thus, their combined credit score was simply not one that would allow them to get this loan.

The banker explained it to them, watching the disappointment creep across their faces. "I'm sorry," he said, "you simply don't qualify for this." As they got up to leave, the banker stopped them. "Wait, there may be a way around this. Here is the name of another banker, down the street. He has some options available to him I just don't have and he might be able to help you."

The Taxpayers thank the banker, take the card and head down the street. What they don't know is that they are heading to an office owned by the same bank they just left. In fact, it's the exact same bank, but with a different name on the building. When they arrive and begin talking to the new banker, they can't believe their ears! He doesn't need to know their income! He doesn't need to know their debt! He doesn't even run their credit scores! In fact, he even tells them he can loan them $250,000 instead of just $200,000, providing them with a nice boost of funds to make improvements or remodeling to the house. It's a dream come true and they can barely contain their excitement.

But John pauses for a moment and looks at the banker with suspicion. "What's the catch? How are you able to do this and what's it going to cost us?"

The banker smiles broadly and explains that this is all perfectly legal, but given the risks associated with making a loan to John and Jane, the bank must charge a higher interest rate than usual and the Taxpayers must agree to sign an ARM (adjustable rate mortgage) which might change their monthly payments a bit as interest rates change. It's called a sub-prime loan. "Doesn't that sound fair?" the banker asks, hands wide in supplication.

John thinks for a moment and replies "It all depends on the interest rate, I guess. We could afford more than the 6.5% everyone else is asking, but not much."

The banker sticks his fingers in his ears, "No, no, no, I don't want to know what you can afford! Besides, I can give you this loan at 6.5% too."

John and Jane are puzzled. "But you just said we would have to pay a higher interest rate to cover the risk. How did you come up with the same interest rate as everyone else?" Jane asks.

"Ah," the banker replies,"that's because we aren't using the Federal interest rate as a base. We can go much lower than that for our money using the LIBOR rate which currently stands at around 1.8%, which allows us to charge a higher interest rate to cover our costs, but keep what you pay pretty much in line with everyone else. In fact, I hear the LIBOR is even set to drop next year, so your payments will actually go DOWN. Now, doesn't that sound fair? Do we have a deal?"

John and Jane huddle together for a moment and run some quick calculations. If what the banker says is true, their monthly payments for this even bigger loan would still be around the same as they had expected to pay and might even go lower still! There was news that the Fed was cutting interest rates right and left, so surely their rates would stay low too! It was too good to pass up. John looked into Jane's eyes, tears of joy welling up at the thought of moving into their dream home, after so many years of renting and trying to dig themselves out of debt.

"Deal!" they both say in unison.

And so our happy couple signed their loan and moved into the home of their dreams!

The banker's prediction came true, the LIBOR rate did go down. By the end of 2003, the $1580 payment they had begun paying at the beginning of their 30 year mortgage had dropped to $1482.
By mid-2004, it was lower still, at $1476.

But then something happened. The LIBOR rate, which isn't set or controlled by any government entity, began rising. John and Jane's monthly payments started going up.

By mid-2005, their payment had ballooned to $1713 per month. A few months later, it was $1957. John and Jane were worried. Their payment was growing larger than they anticipated it would. Their monthly expenditures were growing tight and by now, Jane was pregnant. Surely, things wouldn't get much worse!

They did.

By the end of 2006, John and Jane were paying $2157, over $500 more than their original payment.

The first month of 2007, they were late with a mortgage payment. The subprime loan they signed had no grace period for being late, and they were immediately hit with a late fee of $150. Their payment rose that month by an additional $100, due to the changing LIBOR, and they were late again the next month. Another late fee. Another tick upwards on the LIBOR.

John and Jane were panicked. They simply couldn't meet their monthly mortgage payment, especially as it continued to rise and they paid late, resulting in fees. By the middle of the year, they missed a payment, and were late on the next one. They missed another payment.

The bank foreclosed immediately.

As of 2005, there were 129,000 foreclosed-on homes in the US. By 2008, there were 811,000. By 2009, that number is expected to swell by 60%.

Given a median home price of $216,000 in the US, that comes out to approximately $300 billion, half of Paulson's made-up number of $700 billion for the bailout of the financial industry, and even less than a third of the possible $1.5 trillion it will actually end up costing.

John and Jane aren't to blame for this. They assumed a debt they could afford when they signed it. Predatory lending, preying on the hopes and dreams of those who get turned down right and left from traditional lenders, along with fuzzy math tied to some off-shore interest rate, and the utter failure of lenders to qualify borrowers for the loans being given out put the initial blame squarely on the banks and not the home owners.

The banks dropped the ball here, not the home owners. John and Jane Taxpayer took out a loan in good faith that they could pay it. It wasn't their job to qualify themselves for the loan.