Understanding the Financial Crisis
[By Bill Henderson, cross-posted on ELS Blog]
Like everyone else, I am struggling to get my head around exactlywhat happened to produce our current financial crisis. That is aprecondition of anticipating the longer term consequences. In a singleparagraph, this is what (I surmise) happened.
Sometime during the 1990s, momentum began to build on Wall Streetfor securitizing home mortgages in new and exotic ways. Residentialreal estate seemed like an attractive business because the yields weredecent, the historical default rates were low, risk of loss wasmitigated by pooling thousands of mortgages (which were, themselves,divided into parts), and the underlying assets (homes) generally wentup in value, sometimes by a lot in major metropolitan areas. Institutional investors had an insatiable appetite for these debtinstruments, which were graded as safe by all the major ratingagencies. Further, respected companies like AIG wrote insurance onthese instruments on the theory that they would never have to pay. Allthe risk was supposedly hedged by “credits swaps,” which are fancy andunregulated contracts between private parties. So money gushed in. Because virtually any loan could be sold the next day to Wall Street(who, in turn, could repackage them for a large profits within a shorttime), banks and other mortgage originators could make money with norisk (zero risk!). This cycle continued even though the pool ofmortgage applicants became weaker and weaker–eventually people with(a) bad credit, (b) no assets, and (c) no job. This had thepredictable effect of driving up the price of real estate to a frothybubble.
If we want to get back to good old-fashion, sane capitalism whererisk is actually assessed before a lender gives a borrower money (and Ido), we need to know what the underlying asset (a home) is reallyworth.
Here, the news is not good. According to this storyin the New York Times, the price of real estate could tumble throughout2009. Frankly, this is where analogies to the 1930s seem like theyhave some traction. When an average person’s largest asset turns outto be a terrible investment, they have lost a lot of money in thestock market (any opinions on privatizing Social Security now?), and banks are failing left and right, it has adevastating effect on society’s ability to pool risk–all the moneyends up in the mattress, so to speak. No surprise, people like mygrandparents who lived through the Great Depression tended to be verycautious and risk averse with money.
Frankly, the issue now is not how to regulate Wall Street–theinvestment banks are gone. It is how to unwind this mess. The largertragedy here is not the loss of money; it is the loss of trust byordinary people in basic financial and commercial institutions. Theyworked hard and played by the rules. Yet many of their homes will beworth less than what they paid for them, and retirement seems beyondreach. Unregulated capitalism failed. Like it or not, government isthe only entity that can fill the breach.
These two stories from This American Life, both 1-hour long audios, are the two best resources I have found on these topics:
- The Giant Pool of Money, May 9, 2008
- Another Frightening Show on the Economy, October 3, 2008