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How Subprime Borrowing Fueled the Credit Crisis

By Shah Gilani
Contributing Editor
Money Morning/The Money Map Report

Once upon a time, generous-minded social engineering resulted in the Community Reinvestment Act, which forced banks to lend to disadvantaged borrowers who otherwise couldn't get mortgages to buy homes.

But because these potential borrowers were financially disadvantaged, they also represented a bigger credit risk. Banks didn't like being told to make mortgages to high-risk borrowers because they wouldn't be able sell these loans off to anyone else.

Fannie Mae (FNM) and Freddie Mac (FRE) were mandated to insure these higher-risk loans so that with a de facto government guarantee these "subprime" mortgages could be repackaged and sold, removing them from the inventory of the originating bank.

Thus the seeds of the subprime mortgage debacle were planted.

A series of devastating events – the bursting of the tech stock bubble in 2000, the 2001 terrorist attacks on U.S. soil, and the war on Iraq and the spike in oil prices, to name the key ones – posed serious recessionary threats.

The U .S. Federal Reserve aggressively lowered interest rates to stimulate the economy. A long period of low rates reduced returns for investors, but simultaneously afforded borrowers cheap financing. Wall Street went to work manufacturing all manner of products to squeeze extra yield out of this ultra-low-interest-rate environment.

Subprime collateralized mortgage-backed loans, similarly structured and packaged commercial mortgage-backed loans, leveraged corporate loans, and derivatives (especially credit default swaps), were manufactured in massive quantities.

Many of the products were rated investment grade by the major ratings agencies, which were incongruously but handsomely paid by the manufacturing banks to rate their products. Higher ratings meant easier sales and greater profits.

Buyers of the products, including the banks themselves, used cheap financing to leverage returns by borrowing from each other to create and buy more and more products.

Low interest rates were driving homebuyers to banks and mortgage finance companies, most of which were offering cheap "teaser" rates and no-document "liar loans" – all in a mad rush to capitalize on what was actually a rapidly inflating housing bubble.

Consumers were flush with credit and used it, as Wall Street took credit card receivables, packaged them into pools, sold them, and gave the proceeds back to credit card issuers, who then offered the public even more credit in a competitive horn of plenty. Then the housing bubble burst, and the music stopped. Banks were afraid to lend because they had lent too much to too many suspect borrowers, including each other, meaning their collateral was depreciating faster than any econometric model had ever calculated.

As banks' capital evaporated, lending stopped everywhere. The securities markets imploded, leaving us in a state of suspended animation in which there's no longer any way to borrow, produce and spend.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Suzanne | January 13, 2009

    Actually, the Community Reinvestment Act (CRA) did NOT mandate that banks lend to "disadvantaged borrowers who otherwise couldn’t get mortgages to buy homes." What CRA does require is that banks with community branches in disadvantaged communities stop discriminatory practices called redlining. Redlining means that no matter what the credit worthiness of a borrow is, if he or she lived within certain boundaries, banks summarily dismissed their loan applications. While redlining is technically illegal, banks continued to practice it anyway. CRA said that if you want to do business in a community, you need to find ways to invest in it.

    This worked very well for over 30 years. According to an independent study of 2006 mortgage loan data conducted by Traiger & Hinckley LLP, CRA actually deterred banks from engaging in the kinds of risky and subprime lending that are provoking the foreclosure crisis. In fact, the findings show:
    1. CRA banks were significantly less likely than other lenders to make a high cost loan;
    2. The average APR on high cost loans originated by CRA banks was appreciably lower than the average APR on high cost loans originated by other lenders;
    3. CRA banks were more than twice as likely as other lenders to retain originated loans in their portfolios; and
    4. Foreclosure rates were lower in metropolitan statistical areas with greater concentrations of bank branches.

    The conclusion is that CRA actually deterred irresponsible lending. Whether you agree with CRA or not, these are what the numbers show. The Treasury Department, the Office of Thrifts, and the FDIC have all stated that CRA is in no way responsible for the situation we are in today. Please stop spreading this lie or we will never be able to resolve the problem.

  2. Gail Devine | January 14, 2009

    During the peak of the housing boom my husband and I sat back and discussed on several occasions how long this housing boom could last and what was going to happen when it popped. Never did we think it would affect the economy the way it has nationally, and globally. So now we look at the winner’s and the losers, and unless you stuffed your money under a mattress you no doubt lost a great deal of money, and or jobs.

    Let’s make it clear I am not necessarily talking about money lost from this economic disaster; I’m talking about thousands of jobs lost (which also relates to oney), I’m talking about the fabric of our housing market. Architects/Designers start the design process for a client, which generates jobs for Engineers and the title 24 compliance (if you live in California). Those jobs generate jobs within our states and counties which in turn creates revenues for local counties/cities to keep those offices running. I’m talking about the contractors and sub-contractors that need supplies to build. I’m talking about the companies that make those supplies to build or remodel homes; I’m talking about state tax dollars from selling supplies to build, I’m talking about the home owner who spends more money to accessorize their home.

    This housing disaster we happen to be in was instigated from not just ignorant desperate Americans who wanted a slice of the great American pie but also by very brilliant key government officials (no names mentioned here since there are so many) preying on those same people. I believe these government officials pushing the need to get poor people into homes they could not afford and other third party individuals who pushed the sub-prime paper loans to enable a individual who didn’t qualify for a home should be held accountable. If they have any conscience what so ever I would think they would feel bad about their part in this disaster, but from personal experience these types of individuals are saying “it’s not my fault their was a legal loop hole, the home owners should have know better”. Even better “It’s just business, nothing personal”, from all of us affected by the above government officials and sub-prime pushers, it is very personal especially when your on the verge of loosing everything beyond your control.

    We hear now that we need to focus on a resolution on the sub-prime sector in order to get housing back on track, but we are yet to here how we will help the people who create the jobs in the housing sector; Architects/Designers, Engineers, Builders, Suppliers, etc. These businesses produce a multitude of jobs through a trickle down effect. I recognize we need to focus on the sub-prime issues (cause, and recourse), but by bailing out bad individuals who made bad decisions, and not prosecuting the “sub-prim pushers” you are punishing everyone who did the right thing needed to get a slice of the American dream, and now risks loosing it all.

  3. Emrah | September 21, 2010

    To Gail Devine: A couple of things I wanted to point out, it's there & you're.. Not their and your.

  4. Emrah | September 21, 2010

    Oh, and loosing is spelt with a single o.

  5. Alex | February 3, 2012

    "What CRA does require is that banks with community branches in disadvantaged communities stop discriminatory practices called redlining", (from Suzanne) – for banks it was an order to provide loans in "disadvantaged communities". When politicians run the economy, especially banking sector, we were, are now and will always be in financial crises, one or another.


  1. […] If helping struggling borrowers pursue their homeownership dreams was such a noble cause, it might have been incumbent upon the senator to not block legislation advocating the curtailment of predatory lending practices. From 1989 through 2002, federal records show that Sen. Gramm was the top recipient of contributions from commercial banks and among the top five recipients of campaign contributions from Wall Street. [Click here to read "How Subprime Borrowing Fueled the Credit Crisis."] […]

  2. […] Originally posted here: How Subprime Borrowing Fueled the Credit Crisis […]

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