Saturday, January 01, 2011

Looking Back At America - Part III

This is Part III in the Looking Back At America series, which presents the perspective of what today's America might look like to historians 100 years in the future. This series of articles is most easily understood by starting with the first installment.

It was during the mid-eighties to the late nineties that more and more middle-class Americans were becoming stockholders and investing, if somewhat tentatively at first, in the financial markets; buying stocks, participating in 401K plans, investing their savings with their eyes on big returns. People who had never owned stocks before – hadn’t even really thought about it – were now buying stock, afraid not to because they didn’t want to miss out on this incredible opportunity and be left behind on the road to riches.

The internet mania was coming into full bloom at the same time that banks were making it easier to borrow money. Because prospects were good, people had an appetite for risk, and many borrowed money to speculate on the Dot Com craze. The mania turned into a full-blown bubble by the late nineties and the stock markets experienced a meteoric rise, led by the technology firms and internet-based companies of the NASDAQ index.

People saw their investment portfolios double and triple in the late nineties, and they felt wealthy because, well, on paper they looked wealthy. The American middle-class fell in love with their newfound prosperity. They spent money freely, though their incomes had not improved significantly. It was okay, though, because according to their stock portfolios, they were doing just fine.

Credit cards were now available to anyone with a job, and people spent money they had not yet earned. Car loans were available with no money down, and in fact people could even finance the taxes they paid when they bought their car.

While previous generations worked and saved so that they could buy the things they wanted, people now bought first and paid later. The culture was changing. Being in debt became a way of life, but people did not worry much because their stock portfolios and 401Ks were doing quite well, thank you.

The Dot Com craze came crashing down as the NASDAQ tanked in April, 2000. Investors had poured hundreds of billions of dollars into companies that never produced a dime of profit, but whose stock prices had risen exponentially on the potential that they would become immensely profitable one day. Irrational exuberance was the fuel for the fire, but this insanity began to wane as the companies wallowed in losses before finally going belly up. Investors lost billions. People no longer felt so wealthy, and the economy went into a recession in late 2000 that lasted until 2002.

And it was during this time, the eighties and nineties, that commercial banks and investment banks were pushing for deregulation of the finance industry. They wanted the right to merge their operations, and expand into those areas that current laws prohibited.

The Glass-Steagall Act of 1933 came into existence as a result of the Great Depression, and imposed laws that kept commercial banks separate from investment banks. This act was designed to control speculation and avoid moral hazard. It was designed to keep an entity from being able to both grant credit and use credit; otherwise, banks could basically create and lend money to themselves for the purpose of speculation. It was designed to prevent another Great Depression, and it had.

Banks began lobbying to repeal this Act in the eighties, and the movement gathered steam going through the nineties. It was in 1999 that the critical decision was made to repeal Glass-Steagall. It was this decision that exposed the underpinnings of the global financial system to the rapacious corruption that ultimately led to The Great Collapse.

On November 12, 1999 President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which repealed Glass-Steagall and allowed commercial banks to operate investment divisions, and vice versa. This act gave birth to the exponential credit expansion of the early 2000’s. This was the first necessary ingredient in the recipe for disaster.

It was during the 2000-2002 recession that the Chairman of the Federal Reserve Bank, Alan Greenspan, lowered interest rates in an effort to provide a boost to the economy. And it did, as it opened the valve on the real estate bubble that would inflate for the next five years. This was the second necessary ingredient.

With the repeal of Glass-Steagall and a loose monetary policy by The Fed, large banks such as Citigroup, Lehman Brothers, Bear Stearns, Goldman Sachs, Wells Fargo, Wachovia, Washington Mutual, and Bank of America were now inventing new investment vehicles; creating exotic, complex securities - known as derivatives - that were sold mostly to institutional investors such as pension funds and mutual funds that were attracted by the strong returns promised by the banks. These investors were the teachers’ union pension funds, and the firefighters and police and autoworkers’ pension funds, and government employee pension funds, and the managers of corporate 401K plans.

This is where cause and effect begin to blur. Beginning in 2001, thanks to the easy money policy of The Fed, low interest rate mortgages were stimulating housing demand, and also creating a market for mortgage refinances. The mortgage industry was booming, aided by an easy market in which to fund these mortgages: the Big Banks. The banks bought these mortgages, pooled them and divided them into risk tranches, based on the credit-worthiness of the mortgages in the tranches. This process was known as “securitization”. They then packaged and sold these securities, known as Mortgage Backed Securities, or MBS, to the large investors (pension funds).

Because the managers of these pension funds had a fiduciary duty to buy only the highest quality securities, it was necessary for the banks to have these securities rated AAA by the rating agencies such as S&P, Moody’s, and Fitch’s. It is difficult to say with any certainty whether the analysts in the rating houses were corrupt, stupid, or both, but it is plain to see that they applied AAA ratings to securities that were clearly higher risk than what was specified by the rating criteria. This was the third ingredient in the recipe for disaster.

Now, with the path cleared for the pension fund managers to buy these AAA rated securities that promised 8% or greater returns, demand for these securities soared. The banks had a seemingly insatiable market for MBS. This gave birth to the massive sub-prime mortgage industry, as the banks created new types of loans that were marketed to people with worse and worse credit. The prime mortgage market was mature, but the subprime market had yet to be truly exploited, so the banks went after subprime borrowers with frenetic gusto. Banks were so anxious to create more mortgages that by 2005, a person with a 600 FICO score could buy a home with no money down and without having to prove they even had a job. Yet somehow the securities derived from these questionable mortgage pools were still rated AAA.

As mortgages became easier to obtain, and interest rates continued to fall, demand for houses skyrocketed and drove real estate prices into a mode of nearly exponential appreciation. From 2001 through 2006, real estate prices in many markets doubled every two years. In nearly all significant markets, property values appreciated a minimum of 75% in those years. This was the fourth, and most visible, ingredient in the recipe.

As property values appreciated exponentially, homeowners felt wealthy again. A home for which someone paid $150,000 in 2001 was worth $225,000 in 2004, and $350,000 in 2006. With all this equity, people could refinance at a lower rate, take out some cash with which to remodel their kitchen or buy a new SUV, and not see much of an increase in their mortgage payment. This felt like real wealth.

The construction industry boomed as developers built new neighborhoods as fast as they could buy up the land. Carpenters, electricians, plumbers, roofers, landscapers, all were thriving, and they were buying houses, too. The construction industry, both residential and commercial, provided a feedback loop and helped fuel the bubble.

And people speculated. People who had never built a house before were getting into the homebuilding business, buying lots and building spec houses, turning them and starting two more.

Another cottage industry that emerged was the House Flipping business. People who had never speculated in real estate before could get loans to buy second houses based on the equity they had in their primary residence. They bought homes, did a little landscaping and applied new designer paint, installed wood floors, and three months later sold the homes for 25% more than they invested. Then they did it again, and again. Many people generated substantial “wealth” in this manner.

Banks were now offering Home Equity Lines of Credit (HELOCs) to those homeowners with equity, which was just about anyone who owned a home for more than a week. This helped fuel a home remodeling frenzy as everyone now had to have wood floors, granite counter tops, and stainless steel appliances. But the difference with these loans was that the banks kept most of these loans on their books, rather than packaging and selling them. This would prove to be critical.

All of this development activity spawned new businesses to cater to the new neighborhoods. Grocery stores, dry cleaners, hair and nail salons, restaurants, gyms, flooring stores, landscape businesses, nurseries, and gas stations all sprang up around the new residential developments. Banks were handing out commercial loans with the same gusto as residential mortgages, and they packaged these loans into securities and sold them also.

Most big cities experienced expanding suburban sprawl. Counties and municipalities had to build new roads and new schools, new water treatment facilities and additional capacity on the power grid, but as property values increased, so did tax revenues, so these governments spent freely. They also sold bonds to raise money for their growing infrastructure needs, and as their coffers grew, so did their budgets, but this was no concern, as property values continued to rise. This was yet another ingredient in the catastrophic recipe.

But how could all of this be bad? From the outside looking in, America was thriving. Everyone had iPhones and flat screen TVs and shiny cars. If all of the previously stated ingredients looked good on the outside, how could they become so harmful when mixed together? How could this lead to The Great Collapse? An examination of the psyche of the American public will offer some insight.


Part IV will continue the construction of the historical perspective.

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