Fix it, fix it!

John McCain has correctly pointed out that the mortgage crisis resulted from giving loans to people who couldn’t pay them back. But there’s more to the crisis.

The rest lies in what Obamanites are barking. One word: “deregulation.”

Undecided voters hearing these followers must think they’re either being more concise than “Family Guy’s” Olli the Weatherman in their explanation, or they don’t know what they’re talking about and are satisfied with regurgitating the party line.

But there is some truth in this word, if explained.

Banks rely on the fact that in reasonable market conditions only a small percentage of lenders will remove their money from the bank on any given day. The amount to cover this small proportion of total lenders is held by the bank on hand, and the rest is invested. However, if a run on the bank were to happen, the banks would go bankrupt, and the people who were owed money are left short.
In many respects, the financial market works the same.

Regulations were in place requiring investment banks to have enough capital reserves to make good on all their obligations even if a run on the bank occurred. But under former Federal Reserve Chairman Alan Greenspan, the market was deregulated so investment banks were allowed to operate in the same manner as the aforementioned banks.

This deregulation created a fundamental problem in the credit market that was just waiting to blow up at the first problem, hence the mortgage crisis.

Deregulation largely affected credit default swaps. Credit default swaps can be thought of as insurance. Think about your car insurance. You pay a company some money every now and then, a premium, for the guarantee that if something happens to your car, they’ll cover the costs of fixing it.

Similarly, banks have been buying up “insurances” or credit default swaps for houses to cover against their potential default. From 1997 until mid-2006, during which time the credit market was partially deregulated, housing prices continued to increase.

There were relatively few defaults because homeowners could, if they needed to, sell the house or get a piggyback loan. As long as housing prices continued to increase this was true.

So companies that held “swaps” to guarantee houses rarely had to pay for a default and at the same time received premiums. In this market, the premiums become essentially easy, risk-free cash. So, investment banks bought up as many of these swaps as possible.

Under a regulated market, investment banks would only be able to buy up as much of these insurances or swaps as they had capital reserves.

But the market was unregulated recently, and investment banks bought up more swaps than they could pay back if all insurances were triggered at once. Again, this, like a run on the bank, would not occur in reasonable market conditions.

When the mortgage crisis broke and more houses defaulted than would normally be expected, all these people defaulting came to claim their swaps. Those over-extended investment banks weren’t able to pay off all debts, and declared bankruptcy.

Regardless of who gets elected, we need to restore underwriting standards and reregulate the credit market. Both candidates are partially correct and any solution must include both their propositions.