Financial Crisis Lingering Effects, Causes, and Cures
By Edelman and Flinchbaugh
© Copyright Agri-Pulse Communications, Inc.
ME. Professor, the recent political rhetoric on creating jobs and supporting entrepreneurs raises the focus on financial system claims of plenty of loanable funds for "good" deals. Yet, many entrepreneurs continue to find difficulty in accessing capital. The role of the financial system and capital markets are critically important in creation of jobs and new businesses. I used to have a mistaken notion that all lenders were the same. But that is not true. Not all lenders make loans to entrepreneurs or start-ups, and debt financing is only part of the picture.
BF. Entrepreneurship by its very nature signifies capital that is at risk. The top priority for the financial system is to provide safety and soundness for depositors. The old adage that financial institutions only lend to those who don't need the credit partially explains the inherent gap in entrepreneurial finance. Since the 2008 global credit crises, loan underwriting standards have been raised by financial institution regulators to assure safety and soundness. So if everything else remains constant, lenders require more equity to do a loan deal today than prior to the recession. Due to record incomes, low debt, and rising asset values, agriculture has not felt the change in underwriting standards as much as other sectors that have relied more heavily on debt during this past decade.
ME. Of course the housing bubble started it all. Now since housing values have declined in much of the domestic market, many homeowners in the more populated regions of the nation are underwater on their mortgages. This has created a modern day liquidity trap. The Federal Reserve has interest rates near zero, but the actual interest rates being paid are typically much higher. A large portion of borrowers collectively are either not able or interested in taking on more debt. Many are unable to refinance at lower interest rates because their assets are not quickly converted to cash and they are "underwater" on their home mortgages, meaning their house would be appraised for less than the mortgage. Of course, this is not true for farmland that is finding new peaks and now typically purchased for cash with very little debt.
BF. Well it was the Community Reinvestment Act (CRA) that required lenders to arbitrarily give loans and provide home mortgages to borrowers in low income areas that would not otherwise have been made. Fannie Mae and Freddie Mac, which are government sponsored enterprises that provide a secondary market for home mortgages, overindulged themselves by accepting too many mortgages based on housing loans that should never have been made. Many investors including community banks lost their investments in Fannie and Freddie when the Treasury injected new capital. Now we are left with the aftermath and we can expect our national economy to continue to be sluggish during the backlog of houses on the market. This will continue until we work through the foreclosures and until housing values start to recover.
ME. Not so fast. Most of the problem was not caused by poor people wanting to buy homes in low income areas targeted by CRA that have been "red-lined" in the past. Nor was the initial frenzy cause by Freddie or Fannie. It was more directly caused unregulated mortgage bankers and brokers that sold mortgages with sub-prime interest rates to borrowers who would not cash flow at prime rates and who anticipated continuing appreciation in home values. More often than not, these home-buyers were in new housing developments located in growing regions of the country. Their mortgages were improperly packaged into securities, improperly rated by securities rating firms, and improperly insured by large insurers like AIG and then leveraged and sold on Wall Street by the large investment banking firms. Before the housing bubble, Freddie and Fannie accounted for half of the secondary home mortgage market, as the sub-prime and unregulated mortgage lending peaked in 2007, Freddie and Fannie's share of the market declined to a fourth of the total market and the rest was sold on Wall Street. So Freddie and Fannie joined the sub-prime shell game, but they joined it later than most because their leadership apparently thought it was necessary to stay competitive.
BF. Because taxpayers had to bail out Freddie and Fannie, many financial market policy watchers and certainly the former Freddie and Fannie investors including community banks who lost their investment would say that Freddie and Fannie should not have joined the sub-prime mortgage lending shell game at all. Now we have the implementation of the Dodd-Frank Wall Street Reform Bill to supposedly close the gap in regulatory authority that existed, but only time will tell whether it is effective and whether the costs of the additional regulation are worth the benefits.
ME. Dodd-Frank does two things in particular. It creates a Consumer Protection Agency housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information regarding mortgages, credit cards, and other financial products, and to protect them from hidden fees, abusive terms, and deceptive practices. It also requires each of the large Wall Street financial firms that are considered "too big to fail" without harming the economy, to write strategic plans for safe liquidation in the event of a failure. New capital and leverage requirements are imposed to make it less desirable to become "too large." It also provides new rules for transparency and accountability for credit rating agencies to protect investors and businesses. It strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest, and manipulation of the system that could benefit special interests at the expense of taxpayers and citizens.
BF. Well how come none of the Wall Street executives have been brought to justice yet? Not one?
ME. That is a good question and one that both "Occupiers" and "Tea Partiers" would like answered.
BF. The "Rule of Law" has separated the United States from other nations. Perhaps one of the problems is that some market segments were previously unregulated, other segments did not do their job, and many behaviors could be called "unethical." "Unethical" does not necessarily mean illegal in a court of law. One hopes that Wall Street money isn't clouding the justice system.
ME. Well money does provide the fuel for the political process and campaigns are in full swing. One wonders if we will see anything unfold before the election.
BF. Don't hold your breath.
* Dr. Edelman is a Professor of Economics at Iowa State University and Dr. Flinchbaugh is an Emeritus Professor of Agricultural Economics at Kansas State University.
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