What Caused The Financial Crisis?

Reporting Jason DeRusha (WCCO) Sep 18, 2008 10:53 pm US/Central

It's been a gut-wrenching time on Wall Street, with large institutions collapsing and the government stepping in. So what started this mess?

"Step one was risky, inappropriate, unfair mortgage lending," according to Prentiss Cox, a Professor at the University of Minnesota School of Law, and a nationally-known expert on the housing crisis.

If "you don't have this imprudent, crazy mortgage lending, you don't have this financial crisis. It's that simple," Cox said.

Cox tracks the problem to late 2007 and early 2008, when some mortgage lenders were aggressively pushing subprime loans to people by fraudulently overestimating the value of the homes or overstating the lender's income.

"There was a period, a go-go period over the last five years in particular, where it was all about getting the fees on the loan, and almost no attention about whether the person could pay the loan," Cox said.

When those people couldn't pay, they lost their homes. That led to record numbers of foreclosures.

"These mortgage loans went into default before the first payment was made," said Cox. "Housing prices, which had been rising in an untypical and unsustainable manner, and mortgage defaults then became locked in a self-reinforcing downward spiral."

The next domino to fall was the shady lenders who pushed those bad loans; they went bankrupt.

"Then all the institutions that funded the lenders, taken these things and put them into what's called securities and sold of little pieces, but retained some of the riskier pieces, were now on the hook," Cox said.

The investors took on too much risk, too much debt and collapsed. Bear Stearns, Lehman Brothers, Merrill Lynch and AIG all got caught up in the mess, according to Cox. That's led to government bailouts.

Cox said nothing in the broader economy triggered this current financial crisis.

"That's what the shocking thing is about this whole process," he said. "Risky and imprudent and unfair mortgage lending practices caused people to lose their homes even when they had jobs. And the result was it happened in such large numbers, and there was so much money involved, that that has spread to the entire economy."

The government is spending billions of dollars to bailout corporations but Cox said it wouldn't be practical to spend that money instead on bailing out the people with foreclosed homes.

"Many of these homeowners have no hope of making payments even with a subsidy," he explained, as many of the subprime loans were "fraudulent loans designed to just bleed money for the loan originators or others from the initial closing."

Cox also said the cost of bailing out homeowners would be "substantially higher" than bailing out businesses. The administrative costs of contacting hundreds of thousands of foreclosure victims, and paying them would be substantial, according to Cox.

"Giving government money to homeowners to pay off loan arrearages would amount to the same thing as a bailout of the lenders and mortgage securities holders because the homeowners would be using the money to pay the lenders," he added.

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