Could the current mortgage crisis and bank bailout have been prevented for the American economy? There were several signs of a housing or mortgage crisis rearing its ugly head long before it occurred. There was a combination for a perfect storm brewing and could have possibly been averted if several things had not happened at the same time.

The Commerce Department reported in November 2006 that new home permits fell by almost 30% from 2005. There should have been a warning bell that sounded and alerted the country to the fact that we were moving toward a catastrophe with the mortgage industry. This is a leading indicator home closings would continue to decrease for the next three quarters.

The Fed or Federal Reserve chose to remain optimistic for the housing industry. The Fed felt strong employment figures along with low inflation rates and increased spending by consumers would pull the housing industry from their slump no later than spring. Unfortunately, this did not occur.

Another sign of economic distress for our economy was the inverted yield curve. The inverted yield curve was an indicator for historical recessions that occurred in 1981, 1991 and 2000.

An inverted yield curve is when the Treasury note short term yields are higher than long term yields. Typically long term yields or investments are higher simply because investors want a better return for tying up their money for a longer period of time. If investors foreseen the economy as slowing down they will more than likely invest in longer term bond investments until the economy revives or picks up again. Economists ignored this indicator because they saw lower interest rates than were reflected in previous recessions and the economy had a lot of liquidity that could refuel growth.

Many economists also predicted that if the Fed or Federal Reserve dropped the Fed Funds interest rate by the summer months, the housing decline had a chance to reverse itself and still allow for a 3% growth for the entire year. This type of growth will fuel the economy to turn around before it’s too late.

The 2007 GDP growth did come in at 2% which wasn’t bad at all. However, many economists and other specialists for the economy did not realize the magnitude of the subprime mortgage market. The subprime mortgage market produced a perfect storm of negative events to occur despite the GDP growth reflected for 2007.

Banks were lending too many borrowers that didn’t have the credit worthiness to borrow the amounts they needed to purchase their dream home. Yet, mortgages were still being provided. The secondary market allowed many banks to not worry about the credit worthiness of many borrowers because they could sell the mortgages.

Bad decisions by the banks and lending institutions along with unregulated mortgage brokers making loans to borrowers that were not qualified for the mortgage they received; a mixture of bad news was bound to come into play. Add on the fact that many home buyers received interest only loans in order to get lower monthly mortgage payments and the perfect storm was created. Declining home prices and mortgage rates reset at higher levels made many home owners unable to sell their home for profit or make their mortgage payments so they simply defaulted. This left the lenders holding the bag for many home mortgage loans.

The icing on the cake of the perfect storm was mortgages that were repackaged for sell as mortgage backed securities or MBS. Banks had computer specialists that evaluated these mortgages and identified high risk and low risk products. The computer programs used to determine the validity of a high risk or low risk product was so complicated that no one regulated or investigated what information or material was used for documentation. Some are questioning if anyone really cared to know.

As long as the mortgage arena had good times, no one took the time to intervene and research the analysis being used that determined how much of a bundle were subprime mortgages or what was in each product bundle. The high risk bundle gave a much better return for your investment. Everyone bought the high risk bundle despite the fact that no one knew exactly what was in each bundle.   When times turned bad and the high risk bundle began to lose value the high risk bundles were sold. Since no one, but the computer analysis could understand what the high risk bundle contained the resale value of these products was very unclear to investors.

Many buyers of MBS were banks, investors, pension funds and hedge funds. The risk was spread throughout the entire economy. Hedge funds are not regulated by the SEC or Securities Exchange Commission and are permitted to use derivatives to borrow money when they make their investments. This type if investment for hedge funds did create higher returns on the market. Though, there are greater losses also seen when the economy is on a downturn which made the impact of the downturn terrible for these investors. March of 2007 made it clear that these hedge fund investments into the housing market could be detrimental to our entire economy.

As summer progressed banks began to feel the crunch and became unwilling to loan to each other with the fear they were receiving a bad MBS in return. No one could determine how much bad debt they had on their books because of the formula that was followed with purchasing the high risk and low risk bundles. No one wanted to find out how much bad debt they had because they could receive a lower credit rating, stock would fall and they faced an inability to raise the capital needed to stay in business. The stock market responded with a see-saw attitude throughout the summer as market watchers attempted to figure out how bad things were overall.

By August of the summer of 2007 credit was so tight the Fed loaned banks throughout the industry $75 billion dollars to restore their liquidity long enough to determine and document their losses and get back to the business of lending money. Banks did not get back to business of lending as usual and instead stopped lending to anyone. This started a vicious cycle.

With banks not lending money and cutting back on mortgages, housing prices fell even further. Falling house prices caused more mortgage defaults which increased the bad loans on the bank’s books. Bad loans on the banks books caused them to loan even less and the cycle began again.

The next eight months saw the Fed lower interest rates from almost 6%, 5.75%, to 2% as well as pump billions of dollars into the banking system in order to restore liquidity. Banks did not respond to the stimulus and still did not trust each other and refused to loan money to each other. The Treasury Secretary, Henry Paulson, realized in November of 2007 that it no longer was a liquidity issue with the banks but a credibility issue. They no longer trusted each other. He attempted to correct this by producing what is referred to as a Superfund.

The Superfund created by the Treasury Secretary used $75 billion in private sector funds and investments to purchase bad mortgages that were then guaranteed by the Treasury. The Superfund was a terrific idea that was too late. By the time the Superfund was created the economic panic was flowing and $75 billion was no longer enough to stem the panic.

There were two simple things that could have been done to prevent the crisis. The first and foremost should have been regulation of mortgage brokers making bad mortgage loans along with hedge funds that were heavily invested with too much leverage in the market. The second thing that could have prevented the crisis was earlier recognition banks had a credibility problem instead of a liquidity problem after their bailout and their refusal to loan money into the economy. The Treasury decision to buy the bad loans was a good decision that came too late. If the Treasury decision was done before November of 2007 it wouldn’t have cost $700 billion dollars.

A lot of the crisis could be blamed on financial innovation that outran human intellect. The potential impact of new financial products, like MBS and derivatives, were not understood many times even by the creators of these products. Regulation of these new financial products could also have softened the blow to the economy.

The emotions of fear and greed may have also had some impact on our current situation. There will always be innovative ideas that come to the industry that impact it and there may always be repercussions that aren’t totally understood until after the fact. However, we should try and identify issues and concerns immediately to make certain they have the least amount of impact to our economy overall or before a crisis do occur.