NBC’s business channel CNBC is running a program called, “House of Cards” that explains in better detail than I’ve seen anywhere else what events led to the creation of the housing bubble. It’s easy for conservatives to blame liberals like Barney Frank who pushed for a lessening of mortgage standards (with the well-intentioned but misguided motive of seeking increased home ownership), as what caused this bubble, but there is much more to this house of cards than that. In fact, if you take this CNBC program at face value, it would seem Congress only played a minor role in what took place.
As in any perfect storm, several things had to come together for a bubble of this size to materialize. The first thing was 911. Wanting to keep our economy from collapsing and in order to keep liquidity in the market, Alan Greenspan cut interest rates dramatically. He knew this would cause a bubble in consumer spending spurred by increased credit from refinanced mortgages, but that wasn’t his primary motive. His primary motive was simply to keep our financial markets liquid and functioning.
A second factor was major scandals at Fannie Mae and Freddie Mac. Previously, because these two institutions were the primary buyers of mortgages, they set the rules for who could qualify for what. But once their reputation was tarnished, their standards were no longer considered golden and other, far less scrupulous companies starting pushing their own considerably less strict rules. It was only later that Fannie Mae and Freddie Mac joined the train that had already left the station, and lessened their rules as well.
But these lessened standards would have gone nowhere had there not been buyers for these sub-prime mortgages. So here we have a third factor. Wall Street had come up with a new way for dealing with risk. They simply cut up things like mortgages into many pieces and then spread out the risk to many investors using new instruments called CDO’s – or Collateralized Debt Obligations.
But this also would have gone nowhere if the ratings agencies hadn’t rated these new CDO’s as triple-A rated securities. And why did they do that? Well, for one, they didn’t really understand these new CDO’s. Almost nobody did. Even Alan Greenspan who had hundreds of Ph.D.’s at his disposal said he didn’t understand some of them.
Which means that Wall Street had come up with a fancy way to pass off bad debt without anybody realizing what they were actually buying.
But it gets worse.
A second problem with the ratings agencies (and the Wall Street banks) was that they had a lot of young people working on these issues who had never experienced a severe financial downturn. The ratings agencies actually started to believe that housing prices would NEVER go down! They built this assumption directly into their computer models and the models told them these debts were safe. After all, home prices were surging and virtually no borrowers were defaulting. What could go wrong?
And this led to another problem. The ratings agencies competed with each other for the business of Wall Street, but if you rated a investment product poorly, and your competitor didn’t, then Wall Street would simply go back to the rating agency that gave them the ratings they wanting to see. Thus, the ratings agency had a direct incentive to NOT question their models and to turn a blind eye to any dissenting opinions.
But it gets worse.
The feds could have stopped this bubble but they didn’t. Why? Well first they weren’t even aware of how large this bubble had become. Alan Greenspan said he couldn’t believe numbers a staffer showed him and told the staffer the numbers just had to be wrong. Sub-prime mortgages simply couldn’t be that large of a percentage of all mortgages!
Second, the feds presumed the banks would manage their risks appropriately. They couldn’t imagine that banks would allow the risk to get that out of hand.
Third, the economic boom was great for everybody. Given that the only way to stop a bubble is to burst it, and given that so much good was coming out of the economy, and with so many more people than ever owning homes, then why do you want to stop it? Moreover, even if you do think it should be stopped, the feds knew Congress would be VERY unhappy to see a downturn in the economy caused by bursting the bubble, so you tell yourself you just can’t do anything about it.
But it gets worse.
Once the “food-chain” was created that was enriching so many people, it was impossible to stop it. Wall Street was making tons of money off of repackaging these loans so they wanted more. If one Wall Street firm tightened up its rules for the kinds of mortgages they wanted, then the other firms would snap up the mortgages you didn’t want and you would lose the money. The mortgage originators were finding new ways to make loans to ANYBODY, no matter how unlikely it was that the loan could be repaid, and Wall Street was rewarding them by buying up those loans, so any originator who didn’t follow suit was quickly left out of the stream of cash that was flowing to everybody.
Everybody was making money. Homeowners who refinanced. Mortgage originators who gave mortgages to anybody. Wall Street who chopped up the mortgages and resold them in the CDO’s. Ratings agencies who were paid to rate all these CDO’s. Local governments who profited from the inflated home values. State governments who profited from increased spending. Feds who profited politically from increased homeownership.
The whole world made money. The world became richer. Millions upon millions were literally lifted out of poverty because of this bubble. And someone was supposed to stop this?
Not very likely.
So who’s to blame for this mess?
Alan Greenspan says it’s the nature of human greed. Humans will always do this, and this kind of a mess will certainly happen again. While that’s likely true, the thing that is most to blame in my view for this present mess is Wall Street’s creation of these CDO’s. The ratings agencies should never have rating many of these CDO’s as triple-A securities. Their models were clearly in error and they have the wrong incentive structure. But it was the complexity of these CDO’s that made it inevitable that the true risk would not be understood or appreciated. It was because of the complexity that investors world-wide had no idea what they were really investing in and forced them to trust the rating agencies. And it was in large part the complexity that allowed the rating agencies to fool themselves.
Which isn’t to say that the CDO’s weren’t masterful creations by brilliant and well-intentioned math geniuses. But their creations clearly got way out of hand.
CNBC’s program will replay a few more times including Monday night (Feb 16th), so check it out yourself.
What do you think?