The System of the World (Part One)

...or "Dude, where's my economy, stupid?" In which your humble scribe begins to explain the current financial crisis while attempting not to overwhelm or bore you with economic jargon or political double-speak, as he is neither an economist or a politician and honestly doesn't care a whit whether or not you are impressed with his knowledge or vocabulary.

1970

Welcome to Yortown, USA. It's a growing community. We've got our share of issues, but life is simple and prosperous with good schools, plenty of stores, a couple of small factories and a well run bank with a great sense of civic responsibility serving as the economic center. People deposit their money there and are offered an interest on those deposits. By loaning that money at a higher interest rate to qualified borrowers the bank is able to meet that obligation and turn a profit that keeps the bank operating.

Joe wants to open a widget factory. He lacks the funds needed, but Joe is a widget expert and the demand for widgets exceeds supply. He's been a member of the community for some time, has been diligent in repaying some smaller loans over the years, will be investing some of his own funds in the enterprise, and can secure the loan with the property and equipment he will purchase with it. There is still risk involved, but the bank determines that risk is low enough to make the loan. They do, Joe starts the business, it succeeds, and he makes scheduled payments as required.

Joe also creates ten new jobs. The people he hires work hard to help make the company grow. Their pay increases with the success of the factory. They spend money in the local community, other businesses benefit. They deposit money in the bank. They - like Joe - establish themselves as worthy of credit. They each accumulate sufficient funds for a down payment on a house. One by one they apply and are approved - in addition to good jobs and credit history that down payment represents a willingness to reduce the risk borne by the bank. Since the property serves as collateral for the loan, the bank is assured of receiving something worth more than the amount they've risked if the borrower fails to pay them back. (The bank doesn't want that to happen, however, because if the loans are repaid as scheduled they're going to make a lot more.) Money circulates, builders are paid to build houses (and they use some of their profit to buy widgets), Fred sells his house to Ernie and buys a larger one, furniture and appliances are purchased, the store hires new workers, etc. etc. etc. Times are good, and everybody is happy.

Except for Steve. Steve was the tenth of Joe's widget makers to go to the bank and apply for a loan. When he got there he was told, "Gosh, Steve, we'd love to help you, you're exactly the sort of person we want to loan money to and we're confident we'd profit from the transaction but nine other folks just got approved and we've exhausted our supply. But come back in a few months and try again."

Steve contacts Bob the Builder, with whom he'd been discussing building a house. "Sorry Bob, I won't be buying a house after all. The bank has no more money to lend."

"Uh oh," thinks Bob. "I'd better cancel that order for 5,000 widgets if people aren't going to be buying houses." He does. Joe realizes he in turn will have to cut back on hours at the factory. "Oh no", reply nine of his best workers, "we just bought houses!"

"I'll be okay," thinks Tom, "my wife works at the appliance store. So we'll get by."

But "I can make my mortgage payment," thinks Bill, "but I won't be able to buy Helen that new washer and dryer I promised her..."

Etc., etc. etc...

Fortunately, there are reasons that Steve's experience at the bank doesn't actually happen here in Yortown. One of the main reasons is that the bank doesn't actually keep all those mortgages and wait all those years to re-acquire the funds - they can sell them. In fact, they sell most of them to this big company up in Washington D.C. called Fannie Mae. And then they can take the money from Fannie and loan it to Steve.

And Bob the Builder doesn't have to cancel his widget order, and instead of cutting hours Joe has to hire another guy.

Etc., etc., etc...

"What's this Fannie Mae?" You ask. Well, back during the Great Depression times were tough. Money wasn't circulating, and the Federal Government took a lot of steps to try and fix the problems. Lots of folks here in Yortown had differing opinions on how much of that was right and how much was wrong, but one thing is for certain - Franklin D. Roosevelt kept getting re-elected.

Anyhow, one of those New Deals was the creation of The Federal National Mortgage Association, which folks shortened to Fannie May.

Early History
The FHA Administrator chartered Fannie Mae on February 10, 1938. The impetus for creation of Fannie Mae was twofold: the national commitment to housing and the inability or unwillingness of private lenders to ensure a reliable supply of mortgage credit throughout the country. The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans that had been originated by private lenders. After World War II, Fannie Mae's authority was expanded to include VA-guaranteed home mortgages.
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1968 Charter Act
The 1968 Charter Act split Fannie Mae into two parts: Ginnie Mae and a reconstituted Fannie Mae. Ginnie Mae would continue as a federal agency and be responsible for the then-existing special assistance programs, and Fannie Mae would be transformed into a "government-sponsored private corporation" responsible for the self-supporting secondary market operations. The reconstituted Fannie Mae was to be stockholder-owned and managed. Fannie Mae retired the last of its government stock on September 30, 1968, and transformation to a government-sponsored private corporation was completed in 1970.

Emergency Home Finance Act of 1970
The Emergency Home Finance Act of 1970 created Freddie Mac and authorized it to create a secondary market for conventional mortgages. Parallel authority and limitations to deal in conventional mortgages were given to Fannie Mae.

To alleviate credit concerns raised by acquisition of conventional mortgages (that lack federal backing), several eligibility restrictions and/or risk sharing requirements were imposed on the mortgages Fannie Mae could buy.

Anyhow, here's part of the reason for the changes made in 1970:

The inflation of the late 1960s brought about a new crisis in mortgage lending, second only to the Great Depression in the 1930s. Interest rates to borrowers increased while government regulations limited the interest payable on investments in depository institutions. As a result, investors, seeking a higher return, moved funds out of savings institutions when mortgage money was at a premium.
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Inflation, high interest rates, the increasing cost of land and building materials, and a shortage of mortgage money made the price of a new home unaffordable for many families. In 1970, the average home was financed with a conventional (as opposed to a government-backed) mortgage amount of $32,000; five years earlier the average mortgage amount had been $27,000. Likewise, the average monthly payment for the 1970 house was $271 per month; the 1965 homeowner had paid $187 per month. Most troubling of all, the average interest rate increased from 5.5% in 1965 to 8.75% in 1970.

The "money squeeze" was the primary cause of the high cost of mortgages. Potential depositors, attempting to maximize the return on their money, were "investing in corporate and Government securities that offer[ed] higher interest rates than [did] mortgages, leaving a shortage of funds for home loans." FHA and "G.I. Loans," which allowed for lower down payments, did not solve the problem entirely because these loans carried higher monthly payments.

An additional cause of the tight money was the numerical discrepancy between the generations. In 1970, the baby-boomer generation entered the home-buying age. The savings on deposit in banks and savings and loan institutions typically came from the investments of older and more financially established members of the middle class. However, the sheer multitude of new homebuyers created a demand for mortgage money that overwhelmed the ability of the older generation to save. This was not, however, the entire story: the unusual inflation of the late 1960s and the higher prices paid by lending institutions to borrow money must bear the brunt of the blame. But it is clear that the generational discrepancy exacerbated the already difficult situation.

A mortgage credit crunch ensued, and the emergency brought about congressional action. The Senate Committee on Banking and Currency examined one proposal that contemplated expanding the purchasing power of FNMA to include conventional mortgages in addition to its power to purchase FHA and VA insured loans, thus expanding the secondary market. An investment revolution flowed from this simple proposal. Within twenty years, mortgages became marketable commodities, and mortgage financing became a multi-trillion dollar international industry.

There were some lean times, too, of course. But mostly it seemed like there was nowhere to go but up.

For a while.

More details to follow in our next installment, and we'll keep it simple as we can. (But it is the economy, stupid.)