I don’t normally blog on current events, but (thanks to my wife Ruth), I’ve found two journalistic productions that work wonderfully together to illuminate the ties among the mortgage crisis, the larger credit crisis, and the potential economic meltdown that we have been facing for some time. I think that these issues deserve discussion from a historical point of view, because they represent a historic transformation of the financial sector of the economy, and these changes seem to leave us with financial problems of historic proportions. I’m not actually prepared to do that historical analysis here, but I think it’s crucial to get a big picture sense of what happened.
On May 9, 2008, This American Life aired a radio show that brilliantly revealed the connections between ordinary borrowers (people seeking mortgages), mortgage brokers, and Wall Street investors. Called “The Giant Pool of Money,” this episode explains how and why investors not only bought into sub-prime mortgages but in fact demanded (in an economic sense) that banks and brokers issue more and more risky mortgage loans, which were then bundled up and sold off as mortgage-backed securities and their even riskier offspring, collateralized debt obligations. I think that this radio show is a great place to start to understand the credit crisis, because it connects financial deals to real people and their stories. (You can listen to the show online or read a full transcript for free.)
A great follow-up to “The Giant Pool of Money” is Dean Starkman’s “Boiler Room: The Business Press is Missing the Crooked Heart of the Credit Crisis,” which appeared in the Columbia Review of Journalism(Sept./Oct. 2008). Starkman tips his hand with his title, of course, but the essay rewards a careful reading (despite the fact that he’s addressing an insider audience of financial journalists).
Together, these accounts suggest that the mortgage and credit crises have complex causes, including (but not limited to): the existence of more than $70 trillion that investors wanted to keep safe while earning a modest return; a super low interest rate on U.S. treasury bonds that sent investors looking elsewhere for easy interest income; and a booming real estate market.) They also suggest that it’s simply not fair to blame imprudent borrowers for the crisis. Yes, there were homebuyers who bit off more than they could chew, and there were speculators trying to flip houses to get rich quick as real estate markets boomed, but these factors simply do not explain the crisis. These borrowers were only able to get credit because investors, banks, and mortgage brokers not only enabled them but even begged them to finance or refinance, often playing fast and loose with borrower qualifications and loan terms in order to make the sale — and sometimes just plain lying.
In sum, our financial institutions, operating with little or no government oversight, changed their own procedures so that they could give mortgages and home equity loans to just about anybody, often without any verification of income or assets. Agents and banks thus made irresponsible loans because there was demand (again, in an economic sense) for them to do so from financial institutions higher up in the food chain — namely, from Wall Street investment firms (many of whom are now going belly up). Because the banks were generating mortgages specifically to sell them, they didn’t have to worry about the risks involved — the risk simply wasn’t their problem. Meanwhile, bond rating agencies supported the fiction that bundles of high risk mortgages were as safe as (but more lucrative than) government bonds. The result was a positive feedback loop between the credit bubble and the housing bubble. (For evidence regarding irresponsible lending and unethical lending practices, see Gretchen Morgensen’s August 26, 2007, New York Times article, “Inside the Countrywide Lending Spree.” See also Charles Duhigg’s “Pressured to Take More Risk, Fannie Hit a Tipping Point,” also in the NYT, Oct. 4, 2008, regarding the investors who bought into risky mortgages. Countrywide, now owned by Bank of America, has settled a lawsuit brought by 11 states by setting aside $8.4 billion in aid and by agreeing to allow mortgage holders to renegotiate their mortgage terms.)
It is in some way accurate, then, to blame this crisis on “greedy” Wall Street investors, as some pundits and politicos have done, but this explanation is both simplistic and inadequate — there is more to the problem than the moral failings of individual actors. The real roots of the crisis are structural. In the absence of adequate regulations, many financial institutions (from the top at Wall Street on down the ranks) systematically engaged in reckless, irresponsible behavior, boosted by — but by no means justified by — irrational optimism about the invincibility of the American housing market. If you set up a system that rewards reckless, irresponsible behavior (in the form of giving out-sized profits to brokers and banks who sold more and more increasingly risky mortgages), then you shouldn’t be even a little surprised by the results. Wagging our fingers at a few “greedy” Wall Streeters neither diagnoses the problem nor solves it Moralizing may well be in order, but moralizing won’t solve our current crisis or prevent future ones.
We live in an era of massive financial institutions (banks, investment firms, insurance companies, etc.) that are “too big to fail” without toppling our national and perhaps global economies. This economy of bigness has generated a great deal of wealth, but much of that wealth seems vaporous (and some of it has indeed evaporated); furthermore, this wealth is more unequally distributed in the U.S. than it has been at any time since the 1920s — so much so that even notable conservatives, such as Alan Greenspan and David Frum, have begun to express concerns about the long-term sustainability of our economy.
I’m going to leave the historical commentary to more qualified scholars, but I can’t resist making this one point: the political founders of the United States understood very well the dangers of concentrated, unchecked power. Not only did they fulminate against such power in their revolutionary pamphlets, but they attempted to frame governments that would limit the concentration and exercise of power. We live in a very different world than that of the late 18th century, but I think that it’s safe to say that we should revive that old republican (small “r” — no connection to today’s political party) suspicion of concentrated, unchecked power, wherever it may occur, whether political or economic. To recognize this need is to understand that the moral failing at the root of this financial crisis is more collective than individual.
ADDENDUM (Oct. 6, 2008)
This American Life has done it again, with “Another Frightening Show about the Economy.” Take a listen to brush up on commercial paper, “breaking the buck,” and credit default swaps — the last of which led to a $60-trillion, unregulated, opaque, speculative market that knit the financial industry together into a stunningly insane MAD (mutually assured destruction) pact. Meanwhile, Congress and the regulators stood idly by.
ADDENDUM (Oct. 9, 2008)
In a story on Alan Greenspan’s legacy, the New York Times discusses the largely unregulated market in “derivatives,” which includes the aforementioned credit default swap (CDS). Overall, the size of this market grew five-fold over the past five or six years, to over $500 trillion, with the CDS making up about 10% of the total. Greenspan’s dictum was that this market was best left to regulate itself. His longstanding position was this: get out of the way of these really smart people, and they will generate a lot of wealth. Indeed. In a speech last week, apparently, Greenspan blamed an excess of greed for the problems in the derivatives markets.
ADDENDUM (Dec. 6, 2008)
Paul Krugman has published an interesting overview of the crisis (an excerpt from his forthcoming book on the subject). He doesn’t point any fingers, except to note the lack of regulation of the “shadow banking system,” but he nicely explains the global dimensions of the crisis.
ADDENDUM (Dec. 18, 2008)
The New York Times has published a story titled, “On Wall Street, Bonuses, Not Profits Were Real.” The story looks at the bonuses paid to executives and traders for Merrill Lynch (recently bought out by Bank of America), and it suggests that the hefty bonuses ($5-6 billion in 2006) played a significant role in driving the company towards destruction by encouraging highly speculative investment practices aimed at short-term profits and based on wishful thinking. See my comments above in paragraph number 6.