Debt ceiling: 10 Life Lessons beyond that Crisis

According to Barry Ritholz in today’s Washington Post, the debt ceiling is hanging heavy over our heads. But that’s not the only reason it looks dark down here. We’ve got some major and prolonged challenges: ongoing debt issues, structural unemployment, a housing overhang and continued economic frailty.How did we get here….If this were a college final exam, it would be in essay form. But because it’s summer, and most of you are out of school, consider this the answer key to that exam.

1 Rates: After the dot-com implosion and 2000 market crash, the Federal Reserve lowered rates to 2 percent for three years, including a 1 percent rate for more than a year. That monetary policy was unprecedented. It had an enormous impact on various asset classes, including dollars, real estate, bonds, oil and gold. Had rates been “normal,” it is doubtful we would have seen a 41 percent drop in the dollar from 2001 to 2008.

2 The rating agencies: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings — all originally served bond investors, who paid for their research. But that model changed in the 1990s to one that was funded by the syndicators and underwriter of structured financial products such as mortgage-backed securities. Essentially, bankers “purchased” the rating they desired. As a result, the performance of the rating agencies decayed…..

3 The radical deregulation of derivatives: The Commodity Futures Modernization Act of 2000 was a highly unusual piece of deregulatory legislation. It created a new world of uniquely self-regulated financial instruments — the credit derivative. Unlike traditional financial instruments — bonds, stocks, futures, options, mutual funds — it did not require anything from underwriters or traders. No reserve requirements against future obligations, no counter-party disclosure, no exchange trading needed, no capital minimums. This had an enormous impact on risk management, leverage and mortgage underwriting…..

4 Subprime loans: More than 50 percent of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30 percent were made by thrifts also not subject to routine supervision. With this, traditional lending standards disappeared. Millions of unqualified borrowers poured into the residential housing market as overleveraged buyers.

The irony is that dropping credit standards is a key factor in just about every bubble and financial crisis in history. Call it a lesson never learned..

Read more at http://www.washingtonpost.com/business/debt-ceiling-10-lessons-beyond-that-crisis/2011/07/25/gIQAWlCmhI_print.html