The average person knows that the economy is in recession.  They see that unemployment and mortgage defaults increased.  They are aware of the difficulty of obtaining a mortgage to buy a home, let alone one that can be secured with little or no down payment. They see the number of bankruptcies and curtailed retail sales. They believe that the current recession occurred due to those economic factors and a “crisis of confidence” that led to a meltdown of the financial markets. But where is the blame for this one?  It wasn’t the economy that caused the recession it was the lending community.

Since the early 1960s, recessions have come along periodically about every 6 to 8 years. Each has generally been started by a different initiating cause.  Amazingly, not many seem to anticipate them, particularly real estate developers, real estate lenders and those in government. When there is an economic boom they act and plan as if it will continue forever. Ultimately a recession occurs, the availability of credit is restrained, mortgage defaults, unemployment and bankruptcies rise, tax revenues and retail spending declines, and confidence in the economy is lost. When credit begins to ease confidence slowly rebuilds and the economy rebounds.

Economic collapse and restoration are all about confidence. It is interesting to note that if you look at the word e-c-o-n-o-m-y. “Con” implying confidence seems to be implied right there in the middle.

The financial collapse that led to this current, deep and lengthy recession was principally caused by financing abuses created by the lending community. Rising unemployment, declining tax revenues, reduced retail sales and tighter credit are by-products of this recession, not the causes. The “Wall Street” Investment banks (really stock and bond brokerage firms that in the early 1990s decided to become “lender-sellers” or “conduits”), the commercial banks, Fannie Mae, Freddie Mac, the Securities and Exchange Commission, the rating agencies, (Standard and Poor, Moody and Fitch), appraisers, as well as American, European and other Foreign investors all played a role and at some level are all to blame.

Approximately 52% of all debt in the U.S. is currently held by commercial banks. Another 10% is held by insurance companies.  However, by 2006 the mortgage backed securities/ capital market (MBS), which included Fannie Mae and Freddie Mac residential and multi-family mortgages, had become the lender of choice for most mid and long term mortgages.  The Wall Street investment banks had grown the MBS market to about 30% of the entire financing market.  Investors from all over the world were buying American MBS. Commercial mortgages were being provided at up to 85% of often all to often grossly inflated appraised values.  Many were written for ten year terms on an interest only basis that did not require any amortization.

The problem arose due to a lack of accountability.  The rating agencies set the guidelines of what they would and would not accept as individual loans that would go into a pool of MBS that they would rate.  What started out as a “secondary market” also became a “primary lending” market.  Investment banks, inexperienced brokers, mortgage companies and even banks suddenly became “lenders’ but were actually “conduit” lenders originating loans.  They could originate and supply residential mortgages to Fannie Mae and Freddie Mac as well as residential and commercial mortgages to the investment banks that bundled them into pools, had them rated and then sold the MBS.  None of the parties along the way in that process had any recourse responsibility unless they committed a fraud.

All each party in the process cared about was the loan’s ability to be qualified to go into  an approved pool and be sold. Each entity would then receive a fee for their role in the process with no responsibility whatsoever if the loan went bad.  The fee income and servicing revenue to the investment banks was incredible.  Over time, the investment banks that had the necessary relationships with the rating agencies kept pushing the rating agencies to allow more and more liberal loan underwriting.  The capital markets were efficient and became like a Horn of Plenty to the real estate financing industry. The supply of cheap and liberally underwritten mortgage money appeared unending. To meet the demand for this money, more and more inexperienced and ill-trained employees were hired by the various companies.  Car salespersons became mortgage brokers. With no recourse, “prudence be damned” and it was. “Caveat emptor-let the buyer beware” became industry standard as lenders gave loans that the borrowers could not afford. Prudent lenders were often pushed to the sidelines as they could not and would not compete with the Wall Street MBS financings.  They were often ridiculed as being too conservative. Experienced mortgage professionals only shook their heads at what was occurring but said nothing.

Based on the then perceived success and durability of the MBS market many lending institutions reduced or eliminated their in-house mortgage departments and seasoned staff.  They turned to purchasing MBS to fill that portion of their investment portfolio. e.g. stocks, bonds and mortgages. Some ventured into purchasing the non-investment grade portions of MBS to secure a higher yield.  The investors all relied upon the ratings of the rating agencies and had no way to independently perform due diligence to see if what they were acquiring was the quality they were being told.  Many, but not all, insurance companies, banks, credit unions and other lenders were all “in the game”.  But the dam was about to burst.

Very early in 2007 residential mortgage defaults were on the rise.  Many of those mortgages had been given to borrowers on a “NO DOC” basis requiring little or no equity money invested or proof of the ability to pay.  Many borrowers accepted loans at below market “teaser rates” for six to twelve month periods and when the subsequent higher rate was required they defaulted. Some were given mortgages that exceeded the price of the home and fees and closing costs.  Due to the availability of such ultra liberal and imprudent mortgage financing numerous inexperienced buyers became “investors” hoping to flip their purchase for even more dollars before ever having to make many mortgage payments.  All such loans became known as “sub-prime”.   Also due to liberal underwriting too many residential sub-divisions were created and being financed by banks leading to a gross over supply of new housing. When home prices stopped rising due to the over supply additional defaults started to occur.

An investment grade or higher rating from a rating agency signifies the lowest risk assigned to a debt security, whether it be a corporate bond or a residential or commercial backed mortgage bond (RMBS-CMBS).  Highly rated is highly rated-less than investment grade rated is junk and junk is junk. As the residential mortgage defaults rose, it had become obvious that the rating agencies had been way too liberal with their ratings of this product.  They even rated pools of CDO’s that were comprised of the less than investment grade rated portions of other MBS pools. Accordingly, investors stopped buying residential MBS.

In the April 2007 edition of the MidAtlantic Real Estate Journal, I questioned; “While those (sub-prime residential) mortgages were not secured by commercial real estate, as virtually all of these loans were ultimately securitized (i.e., as MBS rated by S & P, Moody and Fitch) in the capital markets, will a serious magnitude of defaults in that arena impact investor confidence in the capital markets for commercial mortgages?”

The answer was a resounding “yes”. As investors recognized that the rating agencies had been too liberal with their ratings it did not take long for their lack of confidence in the rating agencies to cause them to also back away from investing in CMBS product. By the fall of 2007 they had stopped investing altogether in any MBS product.  This led to the “crisis of confidence” and by early 2008 the collapse of the entire (non-government insured) capital debt market.

Lacking the ability to sell existing or new MBS securities, the values of existing MBS fell dramatically. Absent buyers, there was no way of accurately “pricing” the value of the existing MBS. As the prices of their MBS holdings were being reduced from quarter to quarter, for proper reporting purposes, commercial banks and Investment banks became insolvent.  Even the rating agencies began downgrading some of their previously highly rated MBS.

Fear gripped the market.  Existing lenders (many of whom, to compete, had been way too liberal granting financing) stopped lending or severely tightened underwriting and credit requirements.  The availability to obtain credit became virtually frozen. Business managers found it difficult to roll over existing debt or to borrow to expand.  The headlines in the media advised the populous at large that we were in a recession.  Businesses started cutting back and laying off.  Consumers cut back on spending.  By the latter part of 2008, the crisis had become so large that the federal government created its “bail out” funding package to restore reserves and inject fluidity into the banking system.

Much of the blame for the abuse of the MBS capital markets lies with the Investment Banking firms that pushed for more and more liberal financings to be accepted in MBS pools. They exerted tremendous financial and timing pressures on the rating agencies.  Greed influenced the market at every level of the MBS process. As much, if not more of the blame, lies with the rating agencies. They were supposed to be the “gatekeepers” of the industry.  They had initially developed very detailed and conservative guidelines of what constituted a “good loan” e.g.; LTV ratios, DSCR ratios, tenant and lease diversification, amortization, etc.  They also had established guidelines for what constituted a “good pool” e.g.; individual loan size limitations, geographic and property type diversification, etc. They dictated the amount of subordinated non-rated debt required (typically 22% to 28%) to be held in creating a loan pool in order for them to issue investment grade or higher ratings to the balance of a loan pool.  They issued the ratings that convinced investors that the “Investment Grade” or higher rated portions were just that, reasonably safe.  As the Chairman of the SEC, Chris Cox (who is also responsible for oversight of these entities) stated” When there was not enough staff to do the job right the (rating) firms cut corners” HOW PROFOUND!

With about 30% of all mortgage debt being held or funded in the MBS capital markets and as the MBS had become the single largest source of non-government insured mid and long term real estate financing, its collapse brought down the liquidity of the entire mortgage market, banks, investment banks, hedge funds and even some insurance companies.  We can all thank the members of the Wall Street firms, the rating agencies and similar market participants for the collapse of the capital markets, loss of investor confidence that has not yet significantly returned and for causing the restraint of the credit that caused the economy to spiral into the current severe recession.

My conclusion: It wasn’t the economy that tanked, it was this lending community that tanked the economy. Return to


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  26. It’s not just a muni/state issue, either – globally, sovereign debt is a millstone. For a sobering read, try Pimco’s Bill Gross’ take: Market Commentary/IO/2010/February 2010 Gross Ring of Fire.htm

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