I’m assuming that most the readers of this blog are not (like me) reading virtually every opinion and analysis of what happened in financial markets over the past few years. So, I’m going to try to give a somewhat brief version of what I think happened, pulling together what I’ve read so far. I’m not going to list a lot of references – if you’re interested in some, ask me.
I. Long Term Trends
1. The Unequivocal Goodness of Housing in the United States. The “American Dream” since the Depression (and the formation of Fannie Mae and Freddie Mac) has been to own a house, and home ownership has steadily risen until it is now about 65% of the population. I’m not going to debate the merits of this cultural phenomenon, just stating it. The population and politicians alike think that the more people own houses, the better. So there are many, many programs to help those with marginal credit get homes (as most of those with good credit already own or live in NYC). Even now, it continues.
2. The demand for riskless assets. Let me explain this one, because it is important. Governments want a bank account just like you and I. When you get your paycheck, you want to put it somewhere safe until you need the money, so you get an FDIC insured checking account. These don’t exist for governments. Remember, currency now is basically backed by “the full faith and credit of the XXX Government” which is to day, when you give someone $1, you are basically giving them a check that says the US government backs the value of this note. So what does the government do?
Well, the US government is unique, we won’t get into that. Everyone else wants dollars. Or rather, Treasury Bills, which are basically IOUs written by the government — but this isn’t all that different from a dollar bill, right? They are written in dollars and repaid in dollars. A typical Treasury Bill will pay $100 in some set amount of time (3, 6, 9 months, 1, 5, 10 30 yrs) at some interest rate (3% or something). Foreign governments see these as their checking account. When they have some extra cash or want a “savings” account, they buy treasury bills.
Note for later: US Treasuries are AAA rated assets.
II. Medium Term Trends
3. The Asian Crisis in 1997. In 1997, most of the southeast Asian economies (Malaysia, Thailand, Phillipines, etc.) had currency and debt crises. The IMF was called in and administered some stiff medicine: large cuts in subsides and programs, currency stabilization, etc. But mostly, what these governments learned was that they never, ever wanted this to happen again. So, when their economies picked up again after 2000, they did what anyone would do who just went through a crisis like that: they started saving a bunch of money. China, nearby, wasn’t involved in the crisis, but saw the effects. China, already saving money, saved even more.
4. The Dotcom Bust, Y2K, and September 11th. These three events seemed like they were going to topple the US Economy into a recession, so the Federal Reserve responded by keeping interest rates very low for very long. I won’t go into exactly what this means, but basically they were making it so that money could be borrowed cheaply; this is way to ‘stimulate’ the economy. When you can borrow for less, you’re more likely to spend more.
5. Government Regulations which favor AAA assets. This was known as the Basel Accords, which mandated that banks hold a certain amount of “safe” capital for every dollar (or euro) of “risky” capital, weighted by how risky it was. Makes sense. Riskier capital requires more safe assets. Safe assets were defined as AAA rated by ratings agencies.
Note, banks don’t really like AAA assets because they don’t make much money on them. Remember the “cheap credit” that the Federal Reserve enabled after 9/11? The lenders make virtually nothing on it. So what banks want is the highest interest they can possibly get on AAA rated assets if they have to hold them.
======= Now, how do these trends come together? ======
Result 1: The United States gets cheap, cheap credit. Everyone: businesses, banks, consumers. Cheap credit almost always finds its way into housing, so housing starts to become more in demand and prices rise. Housing looks like a pretty good investment.
Result 2: AAA assets get expensive, yet they pay virtually nothing. Why? All of the Asian governments want the really safe AAA assets, eventually growing economies like Brazil, India, and Eastern Europe join them. Most of these government just want a safe place for their money. But all of the major multinational banks need AAA assets also. But the US only needs to issue so much debt. Even if you can borrow for cheap, eventually you run out of things to buy, right? So these AAA assets with very low interest rates which banks don’t want to hold anyway get more and more expensive to buy. But they have to buy them because their governments require them to do so. Banks don’t like this.
III. Necessity is the Mother of Innovation.
Result 1 meets Result 2. Banks come up with a way to convert risky home mortgages (and other risky loans) into (mostly) AAA assets via all these fancy acronym-named products you’ve heard of. Here are the “good” things that happen as a result:
A. Foreign banks get their ‘savings accounts’ at a lower cost. Banks didn’t want AAA US Treasuries anyway, so they don’t buy them any more, which reduces demand for them, which reduces the cost to those who do actually want them.
B. Banks buy these securitized AAA assets which allow them to comply with their regulations, but make more money.
C. More and more “marginalized” home buyers are able to buy houses. This is great, right? I’ll post some other time on subprime loans and why nobody should ever, ever get one. If we want more people to own homes, we need to help them get better jobs and better credit, not allow them to “buy” a home with awful credit.
IV. Supply and Demand still work.
As banks securitize and buy these AAA groups of home mortgages, more and more people become “eligible” to buy houses, so housing demand rises and rises, more and more homes are built. When prices go up, everyone looks like a genius. We now know how this ends. These new AAA packages of mortgages were not so “riskless” after all. In fact, nobody ended up being able to understand exactly what they did when home prices didn’t rise all the time.
V. Some Thoughts on Other Culprits
Credit Ratings Agencies: These are the guys that decided that a bunch of mortgages put together in a pot and stirred could be AAA. Those that say “the government did it” will note that the Ratings Agencies are Outsourced Government Regulation because they decide what is AAA and what is not and most government regulation is tied to holding AAA rated securities. I don’t think you can say they caused the crisis per se, but they could have stopped it. But, as is usually true, all of the A students worked at the banks, the C students worked at the ratings agencies and really wanted to work at the banks. So they thought the bankers were really, really smart. Sure, they’re AAA. Who am I to question it?
Secondly, in the name of “transparency” the ratings agencies published their methodology of how they decide on a AAA rating. So the banks knew how to make their products as risky as possible and still get AAA.
Greed. This one I don’t buy. Greed is as old as humanity, so I’m not sure how there was some new influx of greed which caused a crisis. Yes, there was greed. But that’s like saying Ambition and Desire for Power caused WWI and WWII. Sure they did. But we need a bit more, there.
Bad Incentives for Bank Traders. Yes, this is true. These guys formed these securitized assets which had multi-year payouts and they were compensated when they sold them. So they got massive bonuses in 2002-2006 and then no penalty when it all came down in 2007-2008. But this is just a “commission” style sales model – just like cars, houses, etc. It certainly didn’t help, but there is no real evidence that it caused the crisis. In fact, recent research has shown that the banks with the strongest incentives to be cautious – i.e. the ones whose CEOs and top executives had the most to lose if things went badly – were Lehman Brothers and Bear Sterns. The executives at JP Morgan, B of A, etc. had much less equity and would have lost a lot less, yet they were more cautious. It seems that corporate culture seems to matter a bit more than contracts. JP Morgan famously refused to securitize mortgages back in the late 90’s because they weren’t comfortable with how to price them (see Gillian Tett’s Fool’s Gold).
There may be more, but that’s all I’ve got for now. Hopefully that has helped a bit piece together what happened in 1500 words