Wednesday, September 17, 2008

Thinking Biblically about the Banking Crisis

David Kotter is the Executive Director of The Council on Biblical Manhood and Womanhood. I've found him to be a reliable, insightful voice on the intersection of theology and economics. He has an MBA, has taught economics, served as a finance manager for Ford Motor Company, and has done a lot of thinking on the topic. So I decided to ask him a few questions in an attempt to think biblically about the banking crisis that is currently underway.

What is happening in the present banking crisis?

Last night the federal government committed to lend $85 billion to the insurer American International Group (AIG), on top of the $200 billion of capital promised to keep Fannie Mae and Freddie Mac solvent in July and $30 billion for Bear Stearns in March. In other words, more than $1,000 for every man woman and child in the country has been directed in various ways to resolve the present banking crisis. At this point, you might be wondering why this happened and what benefit you can expect to receive from your thousand-dollar share.

Why is this happening?

There are plenty of root causes for the present crisis, depending on whom you ask and where you look. Some point to the several years of artificially low interest rates from the Federal Reserve Bank. These led to an explosion of home building and enabled families to stretch into larger houses. Others blame lenders for creatively introducing no-documentation and interest-only loans as a temptation to over-extended buyers. There is certainly individual responsibility involved whenever anyone signs the imposing mortgage document packet. In any case, many people borrowed money to purchase houses and this increase in demand increased the price of houses.

At the most basic level, a $100,000 mortgage loan on a house (at 6%) is a promise to pay back about $215,000 over the next 30 years in 360 convenient payments. This promise is obviously valuable to a commercial bank, and can be sold to other banks or even consolidated and sold to large investors as a Mortgage-Backed Security (MBS). If the promise is not kept, the lender gets the house to offset the decreased value of the promise.

Problems arose last year when many people failed to keep their mortgage promises. This year a staggering 25% of all subprime loans are delinquent or in foreclosure. In essence, the valuable promises that were being bought and sold are now worth much less. Further, the houses backing the promises are often worth much less because so many are being sold at distressed prices.

Therefore someone has lost a lot of money (a.k.a. a crisis). The mortgage promises are no longer worth what banks paid for them and the underlying real estate is often worth less than the loans. Precisely, the real problem was that the risk of default was underpriced, or not completely taking into account by insurers and purchasers of mortgage-backed securities. Now that the default rate turned out to be much higher than credit scoring agencies predicted, the key question is who will ultimately bear the cost of these multibillion-dollar losses.

Certainly the shareholders of investment banks like Merrill Lynch, Bear Stearns, and Lehman Brothers have realized tremendous losses. This has forced these companies into bankruptcy or distressed sales to other firms. The shareholders of Fannie Mae and Freddie Mac lost almost all of their equity when these government sponsored enterprises were forced into conservatorship by the government. AIG, which sold insurance against the risk of default of mortgage backed securities, gave up 80% of the firm to the US government in exchange for a two-year loan at 11% interest.

This is where your thousand dollar contribution enters the picture: it represents your share of the government bailout to partially offset these losses and keep most of these firms afloat. If they all fail, the borrowing and lending that efficiently directs capital in a modern economy will grind to a halt. If none of them fail, the Federal Reserve will introduce a "moral hazard" that will reward risky behavior and encourage more in the future. This is a good reason to intercede for “those in authority, that we may live peaceful and quiet lives in all godliness and holiness” (1 Timothy 2:1).

By the way, you won’t receive a personal invoice for the thousand dollars; it will just be added to the national debt. Ironically, for many people this is larger than the stimulus payment sent out earlier this year, and there is no guarantee that the taxpayers won't be asked contribute yet more as the crisis unfolds.

What effect will this have on the wider economy?

Undoubtedly this crisis is having widespread effects on the economy, although economists disagree as to the extent at this point. AIG is one of the 30 stocks in the Dow industrials, so the evaporation of the equity in this company was a major contributor to the 500 point drop in the market on Monday. Investors are now suspicious of other banks, leading them to sell those stocks as well. Banks are increasingly reluctant to make mortgage loans and this makes it more difficult for individuals to purchase a house. A huge inventory of houses on the market in many areas is resulting in neighborhood blight and further depresses prices. Individuals whose houses are declining in value are curtailing other large purchases, and this further weakens the economy. High gasoline prices and a weaker dollar only contribute to the malaise.

On the other end, we must keep this in a wider perspective. Though some laugh when they hear "the fundamentals of the economy remains strong," this is actually true. For example, the unemployment rate has risen to 6.1% (which is a challenge if you have personally lost a job), but this rate is still lower than the peak in 2003 and is better than many European countries today. Further, despite the rampant media discussion of a recession, the economy has been growing for the last two quarters. This bubble, like the “dot com” bubble and even the tulip mania bubble of 1637, will eventually be resolved as banks and investors accurately report their losses and adjust accordingly.

What effect will this have on individuals?

For believers, this is just one more reason to "not love the world or the things in the world" which is "passing away along with its desires" (1 John 2:15, 16). In Louisville we have been without electricity since Sunday, and it makes me increasingly grateful that our God is independent and powerful enough to accomplish his good will every moment. Lighting candles each night reminds me that I am not!

Although it will be harder to obtain aggressive mortgages, Christians who are practicing prudent financial stewardship (modest houses, large down payments, monthly payments easily within their means, diligent participation in the work force) should not have much problem. Everyone will want to verify that their savings account is government insured, but believers with a generous "wartime mindset" should have no trouble keeping their bank accounts under $100,000 FDIC limit. Above all, don't be anxious about your life, what you will eat or what you will drink, nor what you will wear. Remember that journalists, markets, and lemmings tend to move in herds. The media never reports on thousands of planes that land safely, but solely focuses on one that doesn't. In that light, if you are saving for retirement more than 10 years from now, this actually would be a good time to invest in the stock market. But don't let your IRA be a substitute god or distract you from treasuring Jesus Christ (Matthew 6:24-34).

Is it right to pray for the economy?

I think it is appropriate to pray for the economy. After all, God said to Jeremiah, "Seek the welfare of the city where I have sent you into exile, and pray to the Lord on its behalf, for in its welfare you will find your welfare" (Jeremiah 29:7). When the economy is strong, people are able to work and support their families, believers have greater opportunities for generosity, and many benefit from this common grace.

We can pray for integrity and wisdom for government officials who are faced with the incredibly complex task of regulating investment securities and banks in a way that is transparent and serves all of the varied stakeholders. We can pray that those who are willing to work will be able to find gainful employment. We can pray that greed would be restrained at all levels, from the leaders on Wall Street to individual families tempted to live beyond their means. We can pray for ourselves that we will participate in the national economy that keeps in mind the time is short and the present form of this world is passing away (1 Corinthians 7: 29-31).

Many thanks to David for taking the time to answer these questions!