Who can understand what happened to produce what looks like a U.S. recession? Blawgletter hears that, at the simplest level, lenders believed borrowers’ promises of intention and ability to repay far beyond honest limits. They "credited" obvious lies. Shame on the liars — but also on the believers.
Who deserves the greater blame? We don’t know for sure and expect that it varies from case to case, but some overall responsibility must go to the policy makers who lived through the last bunch of dumb loans and the awfulness that followed. People like Alan Greenspan and Ben Bernanke.
If you remember the S&L crisis in the late 1980s and early 1990s, you know what we mean. In that debacle, savings and loan associations and banks all but threw money at speculators, especially those of the real estate variety. Developers of grandiose projects knew, if only for a little while, that their genius would make their reckless gambles pay off. And lenders and borrowers grossly inflated valuations in order to support the lending decisions that enriched them.
Well, it has happened again. This time, an S&L owner didn’t arrange for an appraisal to overstate a property’s value or get a straw man to buy a property at a ridiculously high price. No. This time firms like Goldman Sachs, JPMorgan Chase, Morgan Stanley, Bank of America, and others (Bear Stearns R.I.P.) dodged regulatory oversight both by securing changes to applicable law and, largely as a result of their new freedom, by creating financial instruments that nobody ever heard of before. They thus created a "shadow" banking industry, one that the Federal Reserve and state regulators couldn’t (or at least didn’t) reach.
"Shadow" sounds ominous, so let us explain. The Fed and the U.S. Comptroller of the Currency respectively oversee bank holding companies and national banks, and state agencies do likewise with state institutions. But the distinction between commercial banks — which take deposits and use them to make loans — and investment banks — which as far as we can tell do whatever they want to — has all but vanished.
After the Great Crash in October 1929, Congress required strict separation between commercial banks and companies that underwrote offerings of stocks and bonds. The goal was to prevent banks from taking excessive risks, as they had done before the crash and ensuing Great Depression. Repeal of the Glass-Steagall Act in the 1980s and 1990s freed Wall Street to charge higher interest rates and to mix commercial banking operations with the arms that floated securities, provided brokerage services, and even invested for their own account — all far riskier endeavors.
Enter subprime mortgage lenders like Ameriquest and Countrywide. They originated (or, often, bought) residential real estate loans to people whose credit profiles didn’t support a bank loan. Wall Street, including formerly stodgy commercial banks, furnished the money so that the mortgage lenders could fund the subprime loans. The Wall Streeters also bought back the loans, combining hundreds of them in what they called "securitizations" — debt instruments whose value depended on the creditworthiness of subprime borrowers and the value of the underlying real estate. Then the same Wall Street firms sold the "mortgage-backed securities" to pension funds and other customers. They reaped profits on the loans and profits on the securitizations. Boo-yah!
Sounds simple, right? Elementary, my dear Watson? Very well. Because now the story starts getting weird.
Wall Street firms found yet more ways to make money, this time by creating financial instruments that they called "collateralized debt obligations", "interest rate swaps", and other "derivatives". We don’t pretend to understand what those things involve, who in his or her right mind would buy them, or how they might differ from flipping a piece of Texas land three times in one day. But we do believe that the lack of legal and regulatory restraint encouraged the bold to do what they do best — to go way beyond reason in the hope that the party would last just a little while longer.
Well, the party has crashed and burned. The, um, optimistic borrower now owns a house worth less than the loan, and the, er, overconfident lender can’t get its money back. Recession city, baby.
Will the grown-ups who ought to have seen this day coming get their comeuppance? Hide and watch, we say. Hide and watch.