How will this financial crisis end?

by Mark G. Holbrook, ECCU President/CEO
(Originally published as a post within ECCU’s former e-publication, The Buzz.)

Whether you call it economic turmoil or a financial crisis, the looming question for ministry leaders is how it’s going to play out. No one knows when it will end, but we do know how we got here and how to restore confidence in our banking system.

What happened?

First, it’s important to realize that this financial crisis is not like the Great Depression:

  • During the Depression, unemployment was at 25 percent. Today it’s 6 percent.
  • During the Depression, thousands of the banks failed. Even the worst projections today are that 200 banks (out of 5,000) may fail.
  • Most of the nation’s 8,000 credit unions are far more stable than banks.

The current crisis has little to do with oil prices, interest rates, wars, or trade deficits. This crisis was caused by the wildly unrealistic belief that housing prices would rise forever. Buyers and lenders across the country acted on this belief, creating a massive pool of loans with underlying values that could drop below the loan balances if home prices so much as sneezed.

Two major contributors to the crisis were subprime mortgages and securitization.

Subprime mortgages. Historically, banks required substantial down payments for mortgages, while a few government-sponsored programs allowed smaller down payments. In the 1990s lenders began to embrace the perceived mandate that home ownership should be available to everyone. Loans were soon available for little or no money down with interest-only payments. Many new homeowners had poor credit histories, and some dishonest lenders even falsified loan applications.

This was all done with the expectation that home values would keep rising, and with more buyers entering the market, they did.

The problem was exacerbated when historically conservative lenders, now at a competitive disadvantage, jumped in. The biggest setup for disaster came when government-sponsored giants Freddie Mac and Fannie Mae began to relax their credit standards. Highly leveraged loans now constituted a large portion of their portfolios.

Securitization is a means of bundling thousands of loans into huge pools which are then divided into smaller pools that offer varying levels of risk and yield to investors. This system was and is brilliant, but it began to be abused as lenders poured subprime loans into securitization pools.

Then investment banks began reducing underwriting standards and became less judicious in evaluating the quality of loans within these securities. They assumed a securitization system that had worked for 25 years would keep working. So the disease of so many poor loans began infecting the entire financial system. The impact was twofold.

First, banks that had invested in even the safest securities found that the market for their investments had dried up almost overnight. These banks couldn’t sell their securities to raise cash and couldn’t put them up as collateral to borrow. The result: many healthy banks suspended lending and began hoarding their cash

Second, funds began to dry up for banks that never invested in subprime loans or derivative securities, but relied instead on other financial institutions to fund their loans. These banks—including ECCU—found formerly enthusiastic partners suddenly unwilling to invest in their loans.

When the day of reckoning came and home prices began to tumble, thousands of marginal borrowers realized they owed more than their homes were worth, and the term “walkaway” entered our everyday vocabulary.

The value of securities plummeted and investment banks couldn’t sell them or pledge them against loans from other institutions. To help stabilize a weakened financial system, the federal government intends to purchase up to $700 billion in non-performing loans from ailing institutions through the hastily crafted rescue plan.

How will the crisis end?

For expanding ministries, this means financing has become increasingly difficult to find. That’s exactly where ECCU stands today. We continue to fund many loans from our own deposits, which continue to grow at a healthy rate, but access to additional funds though loan participations with other lenders remains limited. Thankfully, ECCU has never made or invested in sub-prime loans, and is well positioned to weather the storm.

The good news is that a finite number of subprime loans were made, and almost none in the past 18 months. These loans will work through the banking and investment system, unfortunately exacting a heavy toll along the way. The danger is that an extended period of tight money could propel the country into a severe recession.

This is why the government’s intervention makes sense. The bank rescue plan will help some troubled institutions survive, inject liquidity into the system, and help markets more quickly set realistic prices for securities. Less clear is the potential impact of the Treasury’s planned infusion of $900 billion for short-term loans to banks and even some businesses.

All this will help shorten the current crisis. But even optimistic analysts are now saying it will be a year or more before the market stabilizes and the banking system settles into its new normal. Many see this cycle running for two or even three years and beyond.

For ministries, the challenge will be to judiciously manage their funds and make adjustments that allow them to keep pursuing their mission.

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