The 2008 Crisis, Revisited (Andy Terry Commentary)

by Andy Terry  on Monday, Sep. 23, 2013 12:00 am  

Andy Terry

Depending on your particular economic and political worldview, the cause of the 2008 financial meltdown was, in no particular order: Wall Street greed, individual greed, Barney Frank and home-ownership “promoters,” mortgage brokers, sub-prime loans, Alan Greenspan and The Fed, credit default swaps, greedy investors, speculators, unethical or incompetent rating agencies, Republicans, Democrats, Congress and presidents.

All the above conspired to create the perfect storm for the meltdown. In a gross oversimplification, the bursting of a real asset bubble (housing) was exacerbated by a vastly interconnected financial structure where a pulse in one area reverberated in others.

After the dot-com bubble burst and the 2001 recession, the Fed pursued a continuous low interest rate policy. Low interest rates drove investors, and particularly institutional investors, including those in other countries, to seek higher yields.

Mortgage-backed securities offered higher yields at seemingly low risk because rating agencies determined that that risk was low and issued high credit ratings. Investors lined up for the free lunch, a lunch that became very expensive a few years later.

Wall Street greed packaged and promoted, sometimes unscrupulously, mortgage products and fed them to the greedy investors, and all got fat together. Then they collectively choked.

Consumer greed: As housing prices continued their lofty assent, homeowners tapped their home equity to the tune of more than $2 trillion to support loftier lifestyles.

Politicians: A pro-housing policy, supported most vocally perhaps by U.S. Reps. Barney Frank and Maxine Waters (who pushed for no-down payment loans), but supported by congressmen and presidents from both parties, encouraged home ownership — particularly for those who couldn’t afford ownership before. “Affordable housing” became a mantra ... never mind that housing is affordable where it is easier to supply relative to the demand and is very unaffordable in places where building codes and restrictions limit supply while demand grows.

Fannie and Freddie were encouraged to extend their “guarantees” to subprime and other questionable loan types. Many homeowners lined up for the free lunch where they could get loans for whatever payment they desired. Of course, the bill showed up for this lunch as well when the payments “reset” to the true cost of credit. The political victims who couldn’t afford houses in the first place became the political victims who were now having their houses foreclosed upon.

Subprime, Alt-A and credit default swaps: Subprime and Alt-A, properly priced, are no different conceptually than the riskier, below investment grade debt of corporations. Yes, those were called “junk bonds” in the financial press, so these are “junk mortgages.” Had investors known more about what they were buying, they probably wouldn’t have bought them in the first place, and with no buyers, fewer may have been originated. CDSs actually provided a way for investors to hedge against the risk in these junk mortgages, and for speculators to bet against the housing bubble. CDSs aren’t problematic per se, but the infrastructure for insuring performance on the contracts and mitigating counterparty risk wasn’t adequate.

Part of what makes economics a dismal science is that lunches are never free. There is always an opportunity cost — you could have gone to the gym or taken a nap, instead of indulging in the free lunch. When something in the marketplace appears too good to be true, then it is likely just that.

It was too good to be true that those who previously couldn’t afford a house suddenly could, even though their incomes hadn’t changed. It was too good to be true that mortgage-backed securities offered attractively higher yields than Treasuries but with the same risk. It was too good to be true that homeowners with no skin in the game, those with either no equity or negative equity, would not walk away from their mortgages.

It was too good to be true that relaxed lending standards, regardless of noble intent, would not lead to more defaults or that homeowners could tap into their bubble-inflated home equity to live a life previously beyond their means with no future consequences. Further, it was too good to be true that the massive fees to mortgage brokers and investment bankers wouldn’t lead to some unscrupulous behavior.

When so many things are too good to be true simultaneously, there is a “perfect storm” for a crisis.

Andy Terry is an associate professor of economics and finance in the University of Arkansas at Little Rock School of Business. Email him at HATerry@UALR.edu.

 

 

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