The new semester is underway and I’m teaching an honors course: “Consumerism, Politics and Values.” We start with the book The Big Short by Michael Lewis, describing the housing bubble and derivative market mania that caused the collapse of the economy in 2008.
The housing bubble and subsequent crisis was created by the big banks who were able to pull off the equivalent of a high stakes ponzi scheme and get away with it. Alan Greenspan, onetime devotee of Ayn Rand, even admitted that events had proven his “markets get it right” philosophy wrong.
Markets don’t always get it right; unregulated, markets can create calamities. We shouldn’t forget what happened.
Back in 2000 we entered a recession thanks to the puncturing of the dot.com bubble. It had been a classic bubble and when the bubble burst the economy went into a needed recession to balance out the excesses of the late 90s. Then on 9-11-01 al qaeda attacked the US with a devastating blow to the American economy. The blow wasn’t a direct result of the terrorist attack, but an indirect one – the federal reserve decided to offer extremely cheap credit to help pull us out of the recession. That turned out to be poison. That is the one area where the government shares the blame – bad monetary policy. But that alone could not have created this crisis.
The housing bubble was also not a sub-prime lending problem, nor one related to Fannie Mae and Freddie Mac. They had their faults, some extreme, but nothing they did could have caused the economic collapse. What happened can best be viewed by considering risk and incentives.
Risk: Between 2002 and 2005 virtually all risk was removed from the mortgage market – or so it seemed. Banks and mortgage brokers knew they’d sell their mortgages to one of the big Wall Street banks. That meant they had no risk – so every home loan was a win for them, regardless of whether the lender could pay it back. The banks then took the mortgages and turned them into mortgage backed derivative bonds which they sold, pushing the risk to the investors. These bonds received a AAA rating from the rating agencies, meaning they were viewed as the safest form of investments. 98% of mortgages get repaid. Investors gobbled them up, thinking they were essentially risk free. There was, it seemed, no risk!
Incentives: Mortgage brokers thus had incentive to cheat – to make loans they knew couldn’t be repaid. This started the housing market booming. As prices went up, banks, brokers and buyers had incentive to create risky mortgage instruments. Since value was going up so fast, it appeared that if you could buy a house at $100,000, it would be worth as much as $150,000 in two years. So if you couldn’t afford a standard mortgage, you could buy one with artificially low payments for two years. At that time the house would be worth more, you could refinance at a standard rate and take out a home equity loan for easy money. Everyone wins! Meanwhile, the banks gobble up more and more mortgages as they are making massive amounts of money – hundreds of trillions of dollars in mortgage backed derivatives!
As with any bubble, everyone thinks all is great until it pops. Housing prices started to drop in early 2007. The first pain was in the worst loans, the subprime market. No one panicked – that market wasn’t big enough to cause a crisis. Little did people realize that the entire derivative bond market, even bonds with the best loans, were toxic.
Soon prices started to drop. Thanks to the people at CNBC and the other business “reporting” networks, people had the belief that real estate prices might level off, but wouldn’t go down. While some like Peter Schiff had been warning people, most of the media were predicting real estate price growth as late as 2007. People simply didn’t believe the party was ending.
Many people were directly affected. People who had adjustable mortgages planning to refi with a higher value ended up bankrupt. People who bought the AAA ranked derivative bonds ended up losing their entire investments. This included groups like fire departments and school systems which thought a AAA bond was no-risk. People who had been doing real estate speculation thanks to the rising prices went from being nouveau riche to old fashioned poor. Those who simply bought houses at record high prices ended up under water – they often owe tens or even hundreds of thousands of dollars more than their homes are worth.
Of course, this all lead to massive loses on Wall Street and an economic downturn that is still with us today. People totally outside the housing market lost their jobs or their investments when the economy tanked. The ones who suffered the most were the poor. The wealthy can take a hit on their portfolio and still enjoy nice homes and an easy life style, after all.
Yet the ones who did this – the ones who created the derivative bonds and then worked to disguise or avoid risk, taking massive short term profits even knowing that in the long run everything could collapse – they’re doing well. No one had to repay their bonuses or their income from the bubble years. Most simply found new work. Sure, Bear Stearns, Lehmann Brothers, and a number of other banks went under. Yet the people working there found other work. Some probably ended up with a dramatic downsize in lifestyle, but prison time or actual penalties? Nah, they were just doing business.
Many people are still livid about the lack of accountability, but that’s the its always been. The wealthy have power and clout, and can usually avoid accountability, especially if they’re in the financial sector. In this case both Democrats and Republicans accepted the free market mantra and refused even modest regulation. Yet tighter regulation might have avoided the collapse and we’d be at 5% unemployment now.
It’s also proof – absolute proof – that the ideology that the market is always best is dead wrong. It is just as wrong as the Communist belief that a state run economy is more fair. Ideologies delude more than enlighten. Reality is messy, ambiguous and paradoxical. People enslaved by simplistic ideological beliefs tend to interpret reality in a way that suits their beliefs and avoid cognitive dissonance at all costs. We need accountability, rule of law, and transparency — especially in the market.
So now six years from the collapse we’re still reeling, trying to correct imbalances that could have been avoided. The people who created the mess and made huge profits off the bubble got away with it.