How bubbles build- and burst!
"The first law of economics is there is no free lunch. The first law of politics is to ignore this law." So said Thomas Sowell, an American Economist and senior fellow at Hoover institution, Harvard.
And truer words haven't been spoken, for it doesn't even take a flip through history books to provide evidence, all you have to do is read the news! Yet among the uncertainties that we face today, it doesn't do much harm to blow the dust and look into the past.
The 2008 financial crisis, is just one of the most recent 'economic crashes' that we have seen, albeit certainly not the first as only merely recall the 'south-sea' bubble or the 'mississippi company' to see evidence that indicates that such crises have existed as far as you look. The housing bubble brought great implications for thousands of workers and nearly brought the global financial system to its knees. It's often been blamed upon 'wall-street greed' and has shown to be a great motivator for the 'occupy wall-street' movement that started in 2011.
However, the story isn't as simple as a bunch of rich men in suits stuffing their pockets while the poor starve- albeit it does play a role. It's important to look at the historical steps that lead up to the building of the bubble. Fannie Mae and Freddie Mac, established during the great depression and 1970s respectively, were US 'government sponsored enterprises', and quite literally the worst of both worlds in terms of their structure. They were privately owned, but directed by government agencies, thus when they made losses the taxpayer footed the bill but their profits went into private pockets. Their government backing made them safe bets and allowed them to borrow at lower costs to finance their operations.
Fannie Mae and Freddie Mac while being in the mortgage business did not explicitly lend to homeowners. Instead they bought home loans from mortgage companies and banks, insured them and sold them as securities for investors- thus creating a market known in the financial world as the 'secondary liquid market' that allowed the banks to get their money back, and continue lending to homeowners.
The 'community reinvestment act' established in 1990s required these companies to invest in areas with lower income. As their required quotas increased, these companies found it harder to find eligible candidates, so they started trading in sub-prime mortgages. These were riskier bets, but with government backing the still got AAA ratings, the highest ratings there is, by agencies like Moodys, along with the seeming 'immortality' of the rising house prices.
As for the banks, artificially low interest rates by Alan Greenspan at the FED after the dot com boom left them finding better investments and with access to cheap credit. Seeing the mortgage market as prospering they borrowed money as ‘leverage', making money by buying large amounts of mortgages and selling them as shares in CDO (collateralized debt obligation). These CDOs with safe, ok and risky ‘slices’ going to different types of investors. The ‘safe’ part also has the option to get insured for a small fee, called a CDS (Credit default swap), this was done by insurance agencies like AIG. The bank sells these ‘slices’ to investors, bankers and investment funds, making millions and paying of their loan. As the demand for these CDOs increased, banks also dove into the sub-prime market.
People disagree on whether it were the banks that were pressuring Fannie Mae and Freddie Mac to dive deeper into riskier sub-prime loans, they were publicly traded after all, or whether it was vica versa. In either scenario, both the government directed and private companies continued providing risky loans once again in the hopes that prices in the housing market keep their rising trajectory.
These subprime mortgages were very high risk, with an equally high return, but as the money was being pumped by the government through Fannie Mae, Freddie Mac, FAG etc, even in cases of default, investors didn’t see many losses as the housing market was so overinflated. With these government investments only, it is that wall street first started to securitize such risky assets, as AIG did. Rising demand and government pressure to fill quotas even lead to predatory loans that started with low interest but soon inflated to the extent, that borrowers could no longer afford it.
As borrowers began to default, houses came up onto the market, 'bursting' the bubble and making prices fall- right of a cliff. Seeing how intertwined these securities were, bankers, insurance companies and mortgage lenders, companies went bust and the stock market panicked and fell into free fall as investors took their money out of shares and into long term government bonds. Many foreign banks were also active participants in the US housing market, so they saw losses as well, add to that the great financial global intertwinement and uncertainty, and it didn't take too long for the crisis to go global.
Economist Peter Wallison discussed the onslaught in an interview in 2011. He said that in his previous role as general council to the treasury department in the Reagan administration during the 1980s, they were concerned about the secondary lenders (Fannie and Freddy), but were unable to take action due to the vast powers these institutions held. He called them out for hiring ‘good lobbyists’ and said they had the support of home builders and the realtors. State and local housing policies even worked to restrict the supply of housing, driving prices up even further during the boom while encouraging borrowers to walk away from their mortgages during the bust.
He lamented the ‘150 billion’ at that point that the American public had given to keep Fannie Mae and Freddie Mac alive. He believed that loans to low income households would be a ‘social’ and not an economic policy. And believed that the government shouldn’t force publicly listed private sector companies to take them on but rather carry the risk itself, any losses to be funded by the taxpayer of course, but not dragging down financial institutions with it.
Of course his view is one not agreed to by many different schools of thoughts. The FCIC, which he was a part of and chided for bowing to mainstream media views, in it's reports blamed insufficient regulation of financial agencies and mortgages. The view, as previously mentioned, is the one that has prevailed. It lead to the 'Dodd-Frank' act, which placed major regulations on the financial industry, however it recently saw a rollback after losing favour, in a shocking bipartisanship feat.
It takes good time to look into much of these dry financial terms, yet the bottom line is this- It's easy to blame crises like the financial crash of 2008 or the covid one see now on convenient scapegoats, just as the economical answer to both appears to be conveniently Keynesian. As governments push the pedal on spending in hopes of recovering the economy today, we shouldn't make the same mistakes as in the past. Yes, we need stimulus but blind borrowing hasn't treated us well after 2009. It won't tomorrow either. With the rise of populism, sound economics has often taken a back seat. 'No free lunches,' I repeat, we will have a price to pay, it's better to recognise it now, or lament later!