Mar 16, 2009

By Najib Aminy

It’s hard to ignore the fact that the U.S. economy is in shambles but it’s easy to get lost in the complexities of how this latest recession ultimately began: sub-prime mortgages.

Sub-prime Lending

Usually whenever middle-class, or any-class, Americans buy a house, they take out a mortgage, a loan contracted to a bank – which owns the property until the mortgage is paid off. One generally must have good credit, employment stability, and decent stream of income to apply for a mortgage.

This stopped being the case several years ago. Banks started to offer mortgages that were easier to apply for, which ultimately led to the highest percentage of homeownership in American history: 69.2% in 2004, according to a Census Bureau study. The nature of these “easier” mortgages varied, from no income-no asset loans to adjustable mortgage rates, which offer below market interest rates for the first couple of years before resetting to higher rates of interest.

These loans were given to people who were, as borrowers, “sub-prime” – they failed to meet the standards of government lenders, the financial institutions Freddie Mac and Fannie Mae. Applying these standards would mean looking at measurements, such as the size of loan, the borrower’s debt-to-income ratio, or their ability to document their income.

The Perils

But what these sub-prime borrowers failed to realize was that the initial 2 or 3 percent rate they were paying on their mortgage would double – if not triple – to a rate at which they would be unable to pay. “Interest rates were very low under very good conditions in the short run, but they were set up to explode in the long run,” said Hugo Benitez-Silva, a Stony Brook professor in economics. “The broker who was sitting in front of this family knew that this person could not pay two years from now unless he got promoted and earned twice as much.”

So why would banks offer these loans knowing that they could not be paid? For profits – money made from mortgaged-backed securities. Brokers from small banks across America took these sub-primed mortgages, bundled hundreds of them together, and sold them to the bigger banks like Citibank, Chase, and Bank of America to name a few. The promise of these mortgage-backed securities was a high interest rate, ultimately a return of investment anywhere from 5 percent and up.

These big banks would then sell these securities to various investment companies, or even international banks such as those of the Swiss and the Japanese. Meanwhile, these securities that have now traveled across the world are all backed up bad mortgages – international players had paid for the right to collect back borrowed money which couldn’t be repaid.

How Could It Happen

“There was this big sort of chain of people from the broker until the last guy buying it that no body remembered it was garbage,” said Benitez-Silva, who is also the director of Graduate studies of economics.

This scheme was concocted in reaction to Alan Greenspan, former Chairman of the Federal Reserve, and his decision to drop the interest rates of government bonds to roughly one percent. This forced companies and people willing to invest to look to an alternative source of investment, as government bonds tend to be the safest form of investment but not necessarily one with a large return. Looking for the next big thing, specifically something with a low risk/high return promise, investors fell in love with mortgage-backed securities. Because the demand was high, banks offered more lenient loans and mortgages to fuel the money making. But where was the oversight?

It was there, but the overseers, too, were just as corrupt. These rating agencies – such as Standard and Poor’s and Moody’s Corporation – are companies of finance and have economists that look at these bonds and grade them. “Well, they were really good friends with people at Citibank, Chase, and Bank of America, so the guy from Chase would say ‘I have this bond, it’s all these mortgages – great quality – give me triple A score,’” Benitez-Silva said. “Over a big T-bone steak, the rating agency would say, ‘Well you have never failed me’ and that it is when it started to snowball.”

The same sub-prime mortgaged loans were given triple-A scores – a rating equal to that given to famously reliable government bonds – and being traded all across the world. Yet, as the people at the very beginning of this chain of financial opportunity stopped paying their mortgages, houses were being foreclosed, and owners of these mortgage-backed securities began losing money.

The Consequences

This led to all these banking companies panicking and selling their troubled bonds only to realize that every other bank or security holder was doing the same, thus making the price go down to zero. Now the choice to put these assets on the balance sheets of banks, which had once seemed to be a profitable move, is revealed to have been a troubled investment.

So that leads to where the economy is today. It’s not that there is no money to go around, rather the economic difficulties stem from the simple fact that people aren’t spending and banks aren’t loaning. After witnessing the poor leadership and operation of American banks, investors want to go somewhere safe with their money until the market rebounds. So they are putting their money into U.S. treasury bonds that offer little to no interest at all.

Banks, who rely on investors and whose assets have dried up due to troubled assets cannot offer loans as they did in years prior. Without access to loans, there is less spending. Due to the decreased spending, companies and manufacturers are producing less and laying off many of their workers. For those that still have a job, spending is tight as the uncertainty of job security looms all across America.

The Response

Enter President Obama. Not even 100 days into his administration, the former Illinois Senator submitted his $800 billion economic stimulus plan to Congress last month. With the help of Democrats and a few Republican Senators, his bill was approved. But will that be enough?

Economics Professor Michael Zweig doesn’t seem to think so. “I had this friend who was a nurse who told to me to take two aspirin instead of one,” he said. “She said it was a better guarantee my headache would go away. Obama has given the nation one aspirin.” Zweig, who is the Director of Center for Study of Working Class Life at Stony Brook, said he does not think Obama’s stimulus plan will create enough jobs. “So when the time comes to take the second aspirin because the problem is still there, people are going to be more reluctant because they will say the first one was not effective.”

When he looks for causes of the crisis, Zweig points to the deregulation of the financial sector in 1999, when banks could offer investments and insurance policy to consumers, under the Financial Services Modernization Act. “It no longer becomes a Republican or Democrat problem, but a problem of the corporate elite,” Zweig said. “These banks and investment companies get away from government regulation, avoid taxes, and make money.”

Climbing Back

And that is what makes this recession so unique from the past recessions that America has faced. “Not a crisis of middle class or poor, it’s the rich,” Benitez-Silva said. “Obama is not talking to the poor or middle class, he is talking to the rich and trying to convince them that it ok to spend.”

It is spending that leads to production and increased employment – resulting in a daunting outlook for graduating students. “Students cannot control the job market, nor can they control what other candidates from other universities do; they can only control their own actions,” said Marianna Savoca, director of Stony Brook’s Career Center. “A student graduating does not have to worry about millions of jobs he or she only has to worry about finding one job.” Stony Brook’s Career Center offers a range of career services from looking over one’s resume to giving career advice among other resources in order to help prepare students entering the job market.

Benitez-Silva, originally from Spain, has noticed one positive from this whole economic negative. “What is most impressive about the U.S., regardless of how bad things get, there are always people that have a positive view about the future, for one the youth,” he said. “The youth have had a tougher time competing with the fat cats. Now the cat is the thin cat and is afraid and the youth can be the top dog.”