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Possible Lessons from the Financial Crisis
We Need More Investment and Less Speculation
When attempting to explain the financial crisis of 2008, many people turn to one of two competing narratives. If you know a person’s party affiliation or political ideology, you can generally predict the narrative that he or she prefers. Each narrative begins with the same basic fact: banks and other financial institutions made a lot of bad loans, and many Americans were more than willing to take those loans to get into homes that they could in no way afford. When we reached a point where enough people were unable to make their payments, the complex house of cards built on these bad loans started to collapse. The narratives differ, however, in terms of who they primarily blame for this situation. As with all political debates, these competing narratives demonstrate the degree to which we humans shape reality to fit our ideologies.
Conservative Republicans tend to blame the borrowers for being foolish enough to take on risky loans and the government for aggressively promoting home ownership. Some individuals were not responsible enough to bother understanding the documents that they were signing. Others were well aware of the risks that they were taking and hoped to sell off their homes when prices went up. Either way, these irresponsible borrowers deserved to lose their homes and take a hit to their credit ratings when the market went south. And some conservatives, following this line of thinking, also believe that the financial institutions deserved to go under as well. Unfortunately, many banks received generous government bailouts, with the government rescues and takeovers of Fannie Mae and Freddie Mac being the most offensive examples. Because these Government Sponsored Enterprises had operated for years under the assumption that they would be bailed out should times ever get tough, they were less careful about buying, packaging, and backing home loans than they otherwise would have been.
Many conservatives, however, tend to limit their complaints about large financial institutions to those Government Sponsored Enterprises. Unlike Fannie Mae and Freddie Mac, who are generally perceived as part of a misguided big government, the large commercial banks, investment banks, and financial institutions such as Countrywide and AIG tend to be viewed as victims of this big government. Due to government regulations designed to increase the percentage of American homeowners, financial institutions were pressured to make risky loans to low income people. Then, in order to offset the inevitable risks, many of these loans had to be subprime, involving higher interest rates. In addition, many of these risky loans were sold to large financial institutions, repackaged as pools of loans, and then sold to investors. In theory, these various forms of mortgage backed securities would guard against risk since the odds were low that a large enough percentage of them would default to cause a problem. But as continued government pressure led to increasingly risky loans, the crisis eventually came. Had government just butted out of the mortgage market and given financial institutions the freedom to make more economically sound decisions, a crisis of this magnitude could have been avoided.
Liberal Democrats, on the other hand, do not pin most of the blame on either government regulations or on low income people taking on risky loans. Instead, they blame the financial institutions that were issuing the loans and/or creating the complex financial instruments that few people understood. Rather than being pushed into this behavior by government regulations, they were motivated by the large profits generated through loan origination fees, real estate commissions, and the sale of mortgage backed securities to investors. Since bankers and managers often received much of their pay in the form of bonuses or stock options, the tendency was to focus on short-term profits rather than on the long-term sustainability of what they were doing. The smart ones who recognized the house of cards that was being created either bet on the failure of some of these investments or bailed out before the crash, and as many homeowners ultimately found themselves with foreclosure notices, no one asked the people who made off like bandits to give any of that money back. So the wisest bankers and investors kept their profits, and few were prosecuted of any crimes because they had apparently not broken any laws.
The government’s main mistake, therefore, was not pushing financial institutions to issue bad loans. Bankers and brokers, after all, were more than happy to be “pushed.” Rather than suffering from the effects of excessive regulation, the financial sector crashed due to a lack of regulation. Given the attitude of Bush-era Republicans toward government regulation in general, this should not be surprising. More than anything else, the crash of 2008 revealed a lesson learned on several occasions in the past. Without a certain degree of effective regulation, individuals motivated purely by profit will take actions that can threaten the general public interest. Unfortunately, by waiting too long to intervene, the government bailouts were far more expensive than it would have been to implement effective regulations in the first place. But given the potential scale of the oncoming catastrophe, the federal government had little choice.
Having read and listened to various financial commentators over the last five years, I believe that there are elements of truth to both of these narratives. From what I can gather, the primary impetus to start issuing and packaging the bad loans, as liberal Democrats generally argue, did not come from the government. Instead, it came from the various individuals and financial institutions that stood to gain in the short-term from these actions. But by placing the blame on negligent Republicans who had too much faith in the free market, Democrats are dodging their responsibility. As many Republicans claim, liberal Democrats wanted to see the level of home ownership increase in the United States, particularly among low income people. So you would be hard pressed to find many Democrats in the early to mid-2000s calling for the government to reiin in the financial sector. Few politicians, after all, wanted to come across as individuals standing in the way of home ownership.
By focusing on the blame game played by Democrats and Republicans, attention has been shifted away from the major financial institutions that were able to manipulate quite successfully both liberals and conservatives. By portraying themselves as advocates for low income people, organizations such as Fannie Mae and Countrywide were able to form strong alliances with liberal housing advocates, organizations, and politicians who would strongly defend their (supposed) efforts to get poor families into homes. This also created the impression, should the whole thing crash and burn someday, that the push to issue subprime loans to poor people was coming primarily from the various housing advocates and the government, not the private institutions issuing, buying, and/or repackaging the loans. With Republicans, staving off regulations was easier due to their general faith in lightly regulated markets. A few Republicans, including President Bush himself, did make some calls either to privatize fully Fannie Mae and Freddie Mac or at least regulate their practices more closely, but these major financial institutions had too many Congressional allies in both parties for this to go anywhere. And even if the Government Sponsored Enterprises were reformed, it would have done little to rein in the behavior of the hedge funds, investment banks, and commercial banks that collectively played an even larger role in the crisis. So in my view, the main sin of politicians on both sides of the aisle was being so easily manipulated into negligence.
I am not arguing, however, that the entire financial crisis resulted from a well thought out conspiracy of powerful institutions. In addition to those institutions that staved off regulations through effective lobbying, there were numerous individuals operating at each level of the supply chain: selling homes, issuing loans, appraising home values, packaging mortgages, guaranteeing investments, and rating derivative products. At each step of this chain, individuals were acting out of short-term self-interest, with all benefiting from the same basic phenomenon: volume. The higher the number of mortgages that flowed through the system, the more money could be made at each step in the chain.
Whatever narrative you might believe, the behavior of the years preceding the crisis demonstrated a problem that runs deeper than some bad home loans. For many years, some of the greatest minds in America have been drawn to the financial sector. They have gone there to apply their considerable intelligence and technical expertise to two activities: speculation and financial engineering. Some have studied the stock market using complex mathematical and statistical models, and when combined with supercomputers that can react much more quickly than any human, these algorithms have vastly improved the ability of the big players with access to this technology to outperform any small-time investors.
Others, particularly during the years before the crisis, used their technical skills to create complex financial products that they claimed could eliminate the risks from lending and investing. Pools of thousands of mortgages or other types of debt were compiled, and investors would theoretically get a consistent return from these often complex financial derivatives when borrowers made their payments. Since so many mortgages were lumped together, you could theoretically predict with some certainty how many borrowers were likely to default and therefore eliminate the risk. The problem was that the people originating the loans often did not care if the borrowers had any hope of paying. These brokers, after all, planned to quickly sell the loans to the institutions creating the pools. Home prices became inflated by all of the easy credit, housing speculation became increasingly common, the real estate industry became overgrown, and a false illusion of prosperity resulted from the “bubble,” leading people to spend beyond their actual means. But since many Americans were unaware of this shadow economy of complex financial instruments, and the ratings agencies assured investors “in the know” that these products were safe, the majority of people did not foresee the crisis that lay ahead. And the so-called “quants” that had developed the complex financial instruments had faith in their creations.
When many of these loans inevitably began to go bad, all sorts of banks and financial institutions were stuck with these investments, and no one knew what they were worth because few understood them. This ultimately led to mass panic, the financial bailouts, a decline in home prices, and lingering economic hardship. Almost six years after the peak of the crisis, the long-term impact on the financial and real estate sectors is still unclear. The financial institutions that were “too big to fail” are even bigger, making the prospects of future mass government bailouts a very real possibility. Fannie Mae and Freddie Mac are now owned by the federal government, and they play a larger role in the real estate sector than ever (often at significant taxpayer expense). In general, however, at least so far, financial institutions have not been lending nearly as freely as before the crisis, and faith in the financial viability of complex derivative products and in the “quants” who create them is not as strong as it once was. But since a wide assortment of financial derivatives do play an important role in helping the economy to function, and most commentators argue that the financial reforms passed since the crisis have been weak at best, one can imagine a future when a new generation of “quants” is given another opportunity get those complex derivatives right.
Meanwhile, those supercomputers utilized by the big-time financial institutions become steadily faster and more sophisticated, along with those algorithms designed to help them play the market ever more effectively. Given the enormous profit potential, one can understand why the financial sector continues to represent such an enormous chunk of the American economy. But with all of this focus on increasingly sophisticated financial engineering, many people have seemingly forgotten why banks and capital markets came into being in the first place. In theory, both are supposed to facilitate the transfer of money into the hands of borrowers and corporations, with this money then spent either on major purchases or the creation and/or expansion of businesses. In short, they are supposed to stimulate the production, sale, and purchase of goods and services.
What if more money was invested into the creation of actual goods and services instead of pure speculation? What if great minds were focused on innovative products rather than revolutionary investment strategies? We live in an increasingly competitive world, and the most successful nations will not be the ones that have the best financial engineers who create short-term profits for their investors and themselves. “Flipping” houses and day trading transfer income. These actions do not generate innovative ways of producing and selling goods and services.
I recognize that the stock market and the real estate industry play vital roles in generating income, creating jobs, mobilizing capital, and improving our future prospects for retirement. It is unhealthy, however, to have an economy where too much investment goes into purely speculative activities. We need innovators who develop valuable goods and services and financial institutions that have the foresight to invest in them. We need more long-term investments based on what businesses are doing and fewer short-term investments based on a hunch or a computer algorithm indicating that a stock will go up in the next few seconds, minutes, hours, or days. Who will be the next Alexander Graham Bell, Thomas Edison, Henry Ford, or Steve Jobs? God help us if minds like these innovators cannot find lenders and investors willing to make their ideas a reality. Or, worse yet, God help us if they devote their talents to analyzing the market or creating the successor to the “Collateralized Debt Obligation.”