I'm no expert on matters economic, but I've been doing some reading recently, when I need to take a break from writing my thesis. I set out to try to find an answer to "how the heck did this happen??" While the complete history of the financial crisis has yet to be written, much of the commentary will likely revolve around the following:
1. Easy money for far too long ....
The fed dropped interest rates from 6.5% in mid-2000 to 1.75% at the end of 2001. By June of 2003, the rate had been cut to 1% where it remained for nearly a year.
Many would say the Fed had it right -- to insure against a Japan-style stagnation, interest rates needed to be low. Things were looking pretty good in 2001, with a mix of solid growth and low inflation, and talk of a "new economy" only served to bolster the Fed's case and polish the credentials of Fed Chairman Alan Greenspan.
However, while traditional measures of inflation looked tame, easy monetary conditions helped create and inflate one of the largest U.S. housing booms in history. Because the U.S. Consumer Price Index measures RENTS, not rising home values, the spike in housing over the first half of this decade was not captured in official statistics and was ignored by many at the Federal Reserve.
So, lower interest rates allowed homeowners to assume more debt, with the extra debt used to purchase even larger homes and loads of other consumer goods. Real estate became the darling of investors, and the more home prices soared, the more households used their homes as ATMs -- extracting more equity while going deeper into debt. Simultaneously, the availability and popularity of subprime and Alternative-A mortgages skyrocketed, rising to 40% of the total U.S. mortgage originations in 2006 vs a share of roughly 10% in 2002, and further inflating the housing bubble.
2. Technological advances that helped spread loans, capital and risk ...
Typically a virtue, technology became a vice that helped spark and spread the global financial crisis. In particular, the use of technology and innovation increased the velocity and volume of loans to home owners.
Technology also allowed the rapid spread of these new products to all corners of the globe, so when the U.S. housing bubble burst, and delinquent loans related to U.S. subprime borrowing started to rise in early 2007, the effect was felt not only on Wall Street but around the world. The impact has been severe in Europe, where the region's banks have written off more than $200 billion in bad loans in the past two years.
3. A lax regulatory environment combined with benign neglect
The jury is still out when it comes to regulatory oversight (or the lack thereof) and the role U.S. rating agencies played in allowing the spread of bad loans and high-risk securitized debt (see below). Undoubtedly, the debate on Capitol Hill will continue for some time as regulators and legislators assess how and why such a large, unregulated, so-called "shadow" banking sector emerged in the U.S.
More certain is this: there was a collective failure in establishing an effective regulatory framework in connection with originating mortgages, the spread of derivatives and other securities, notably credit default swaps and collateralized debt obligations. Little oversight, the lack of transparency, a general sense of complacency -- all of these variables played a role in creating a regulatory environment that fostered excessive risk taking by various financial players.
4. The securitization of debt ....
Greenspan noted that "innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers." "Structural change" was certainly a key factor in sowing the seeds of the financial crisis. What changed, in particular, were the ways banks and financial institutions packaged and sold complex securities like derivatives, collateralized debt obligations, credit default swaps and other instruments to investors all over the world. The securitization of debt was instrumental in triggering the explosion in leverage and debt over the past few years, fueling ever rising levels of risk-taking and debt obligations at home and overseas.
5. Excess U.S. spending ...
While many Americans are furious with U.S. banks, regulators and legislators for the damage wrought by the financial crisis of the past 18 months, U.S. households played a leading role in perpetuating and deepening the crisis. By saving too little while spending and borrowing too much over most of the past few decades, consumers have done their part in creating the mountain of leverage that now overhangs the U.S. economy.
Between 1992 and 2005, the financial balance of U.S. households swung from 3.7% of GDP to -3.6% of GDP. Behind this swing was a sharp decline in the U.S. personal savings rate and huge borrowing related to the U.S. housing boom, factors that encouraged excessive borrowing to purchase homes and a surge in mortgage equity withdrawals. The home equity loans that allowed consumers to tap into their homes' value to purchase trips, technology toys, and to a lesser extent home improvements, ended up both devaluing their homes, and sinking the economy further into debt.
6. Global savings glut ....
While the current global financial crisis was largely "Made in America," the United States is not the only party at fault. Also culpable are the excess saving nations of Asia (think China and Japan), where the penchant for "exchange rate protectionism" over the past decade created a massive reserve of excess capital. Over the balance of this decade, this excess savings -- dubbed by the Fed as the global savings glut -- was recycled into U.S. securities. This abundance of cash helped keep U.S. interest rates low, which in turn fed the borrowing binge in the U.S. In other words, we borrowed from China and Japan in order to keep our interest rates low, leading to more debt all around.
The huge accumulation of foreign exchange reserves, by definition, represents a massive outflow of official capital. Asia was not the only source -- many nations in the MIddle East also exported excess savings to the U.S. Without this excess savings, it's unlikely the leverage in the U.S. would have built up to the epic proportions it ultimately reached. For the first time in our history, we have a huge chunk of U.S. holdings used as collateral for loans received from foreign investors. And given the current foreclosure climate, those U.S. holdings are at greater risk than ever.
In the end. all of the factors just mentioned -- many of which are interrelated and mutually reinforcing -- helped spawn one of the greatest credit booms and subsequent busts in financial history. Fixing the financial and regulatory system in the U.S. will take time and is likely to be a key challenge for the Obama administration. That being said, one thing is certain: a new global regulatory infrastructure is coming -- and it is likely to be the most sweeping change in decades. To set the U.S. economy on a firmer foundation, the U.S. needs to save more and consume less. And many parts of Asia, notably China, need to focus on domestic-led growth rather than export-led growth in order to rebalance global growth once and for all. In other words, while it might seem advantageous to invest heavily in the U.S., it would do China and other foreign investors more good to invest in their own economies. It wouldn't hurt the U.S., either, to reduce the amount of leverage to external entities.
We're not out of the woods, but it helps to understand how we got here in the first place.
Primary source: William Fleckenstein, "Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve," McGraw-Hill, 2008. ISBN 0071591583 -- this is the book that seemed to provide the best insight and explanation of the economic craziness of the past decade or two.



posted by BajaHorseLady
Write in Guestbook
posted by island602
I would just add that maybe under item 3, not only was there a lack of regulation, but there were conscious decisions not to regulate instruments of insurance (credit default swaps) as insurance, thereby making them exempt from the regulations that protect investors from fraud and under captitalization. If all those mortgage backed securities had been backed by real protection the house of cards might not have fallen.
Write in Guestbook
posted by angelwings47
Good Job!!
Write in Guestbook
posted by johnH56
1. The rise of money market funds in the late 60's created pools of capital outside of the banking system. Checking accounts now got interest via money market funds. These funds had an appetite for more risky investments. This first step in providing average americans access to higher yields for their savings had many unintended consequences. Money markets lead to the rise of mutual funds with an appetite for all sorts of investments. Individual Americans got into the habit of reaching for yield and investing in the latest hot mutual fund. Today there is more net worth in mutual funds than in banks.
2. The rise of the high yield debt markets, as a precursor to debt securitization. Michael Milliken may have gone to jail but his legacy went on to the sliced and diced debt markets. He proved the thesis that risk in debt could be spread over asset classes and debtors. And the risk factors could be quantified for someone other than bankers. His ability to provide huge amounts of debt lead to wheeling and dealing on an unprecedented scale in America. Repayment of that debt lead in part to offsourcing American industry to obtain lower prices for labor and materials. The corporate raiders developed into a management class that demanded high personal compensation. The successors to Milliken became the investment bankers of today and hedge funds of one sort or another.
3. The rise of an "ownership" philosophy. It has long been known that the difference between the poor and the middle class was what they used their income for. The poor rented. The middle class owned. And the home was the largest single assset of the middle class. Politicians promoted policies designed to create "Ownership" at all costs. During the last decade the percentage of home ownership by Americans increased by nearly 10 full percentage points.
One of the more interesting parts to the increased "ownership" was that local governments got into the act with systems development charges piled on systems development charge.
The end point of all this was that new buyers were being saddled with exhorbitant charges to be financed over 30 years without any regard to affordability. And the new buyers were least able to afford those charges.
It always amazes me how good intentions can end up in strange places. We are there now.
Write in Guestbook
posted by LanaM
The bottom line is that it isn't JUST the fault of Wall Street, it isn't JUST the fault of the banking industry, it isn't JUST the fault of Congress -- there are MANY players who contributed to the current situation. That's why there will be no easy way out.
Thanks for your comments!
Write in Guestbook
posted by okhela
I find this construction interesting. Blaming the nations of Asia for their practices because those practices don't serve American purposes. If America was dis-satisfied with Asian practices, why isn't it just as legitimate that America change or modify it's practices?
Write in Guestbook
posted by cls6926
I find this construction interesting. Blaming the nations of Asia for their practices because those practices don't serve American purposes. If America was dis-satisfied with Asian practices, why isn't it just as legitimate that America change or modify it's practices?
I believe this to be a very astute and important comment. We love living for today in this country and in the process foresaking tomorrow for yesterday. I supose there is plenty of blame to go around but like it or not we have to take our share of it. We have played and now it's time to pay.
Write in Guestbook
posted by LanaM
I HOPE I conveyed the point that the U.S. needs to change its ways. I did say "While the current global financial crisis was largely "Made in America," the United States is not the only party at fault" -- that the U.S. bears the bulk of the responsibility for the current mess, but I also believe that there are other, perhaps lesser, guilty parties.
W/r/t global savings glut -- This is only one of MANY issues that combined to create the current mess. My point there is that, while it served U.S. interests at the time -- it kept interest rates artificially low -- those funds would be better invested locally. Investing locally would seem to me to be advantageous for Asia and the Middle East, rather than dumping their excess cash in the U.S.
It is certainly "legitimate that America change or modify it's practices" -- and I tried to say exactly that, although it's apparent that I didn't communicate it as clearly as I'd hoped. But the crisis isn't JUST a U.S. problem -- it's a GLOBAL problem, and requires a global solution. Others outside the U.S. may find they, too, have to modify their practices.
and cls6926 -- I did reiterate "To set the U.S. economy on a firmer foundation, the U.S. needs to save more and consume less." I think that at least partially addresses your "living for today ... foresaking tomorrow for yesterday" concern, yes? If not, let me reiterate the point: people in the U.S. spend far more than they should, and save far less than they should. This has to change.
Write in Guestbook