Making sense of the financial disaster and how we’re fixing it
By Christine Loman
Economists say it is a story as old as the economy itself: Sometimes the markets go up, sometimes the markets go down. And other times the markets go into crisis mode, plummeting into a financial meltdown with a price tag Consumer News Business Channel estimates at 7.26 trillion.
It has happened before, they say. And it will happen again.
“It’s a very old story of overextending, making bad loans, making bad investments and not being prudent enough,” says Elia Kacapyr, professor and chair of the economics department at Ithaca College.
There remains a good deal of uncertainty about exactly what happened and why in the financial crisis that lasted from 2007 to 2010.
“I don’t think the experts even understand…We’re still looking for an explanation that really ties everything together,” says David Yermack, the Albert Fingerhut Professor of Finance and Business Transformation at the Stern School of Business at New York University.
Back to the Beginning
The story doesn’t start in 2007 when the crisis began or when the housing bubble burst. It began at the Great Depression; Congress enacted checks on the financial industry to limit the expansion of banks into other financial operations. These measures were passed into law with the Glass Steagall Act in 1933.
The erosion of the Glass Steagall Act spanned the administrations of ten different presidents and included action by the Supreme Court, the Federal Reserve and deregulation legislation introduced by Congress in 1982, 1998, 1991, 1995 and 1998.
Completely dismantled in 1999, it was replaced by the Financial Services Modernization Act in a year when the banks, securities firms and insurance companies spent $150 million in campaign contributions, according to “Sold Out: How Wall Street and Washington Betrayed America,” a report funded by the Consumer Education Foundation and Essential Information.
“We allowed banks to stop merely being banks and to get into other areas of trading and pursue profits in investment banks, sell you complicated financial products and so forth. The repeal of the Glass Steagall Act was part of that,” Yermack says.
Less than ten years later, everything would fall apart.
Consumerism Takes Off
With an ability to branch into other areas of trading came a shift in attitude. Commercial banks stopped thinking conservatively and started thinking like investment banks, according to “Sold Out.”
“There was a demand for the kind of high returns that could be obtained only through high leverage and big risk-taking,” the report states.
The impact of this attitude would be compounded by the intense consumerism of Americans in the early 2000s.
“There was an attitude in society in general that it was okay to spend like mad, the companies were encouraging us to spend like mad, the credit card companies were encouraging us to go deeper and deeper into debt,” Craig Mehall says. Mehall is the financial policy counsel at Private Citizen, a non-profit advocacy group.
The Housing Bubble
It was this outlook that helped spawn the housing bubble. It was the ignition point to the meltdown.
Prospective homeowners with poor credit histories were lured into homeownership with offers of loans with low teaser rates. Buyers were unable to pay their mortgages when the unaffordable interest rates of these predatory loans became realities.
Subprime mortgages inflated into a massive bubble. When it popped, 1.2 million Americans lost their homes, a report from April 2010 by the Mortgage Bankers Association says.
Financial institutions, the biggest names on Wall Street, had been repackaging these sub-prime mortgage loans and bundling them together in a process known as securitization.
They bought and sold these packages to each other, driving prices higher, betting that housing prices would continue to increase.
“It’s a very unusual situation… there were basically just a lot of buyers with no sellers and when mortgage securities ultimately got really overpriced, people tried to trade out of their positions but found there was really nobody able to trade with them,” says Yermack.
The sales of these mortgages went unreported to investors and regulators. Banks held these securities and other “toxic” assets in shadow markets, off the balance sheet.
“Sold Out” estimates that the size of off-balance sheets assets was 15.9 times larger than reported assets in 2007.
When housing prices stopped increasing and mortgage holders began to default on their loans, large amounts of these unreported securities plummeted in price.
A Lack of Regulation
At the same time, the market for derivatives—“financial weapons of mass destruction,” according to Warren Buffett, because they concentrated large amounts of risk in the hands of only a few dealers—was also unregulated.
A specific derivative, the Credit Default Swaps (CDS), was widely used by banks. CDSs operated as a type of insurance; banks could purchase a CDS to protect themselves if debtors, like the subprime mortgage holders, went into default. The seller of a CDS would then be liable for that debt.
It was a climate that allowed for corruption, Mehall says.
“When did it become okay for a business to rob, steal, and cheat but it’s not okay for somebody who didn’t put a suit and tie on to do it?” he says.
In the aftermath, some of America’s most revered financial institutions went bankrupt, were nationalized, or sold. Bear Stearns, the fifth largest investment bank in the country, failed and was taken over by J.P. Morgan, as was Washington Mutual. The U.S. Treasury nationalized Fannie Mae and Freddie Mac; the U.S. Federal Reserve bailed out AIG Corp, the world’s largest provider of insurance and significant seller of CDSs.
The bailout that followed totaled $700 billion and included the Troubled Asset Relief Program that allowed the federal government to purchase assets and equity from remaining financial institutions in order to stabilize the markets.
“I believe we would have had another Great Depression had they not done what they did. I think the actions by the Federal Reserve and by the U.S. Treasury saved an all out collapse of global financial markets,” says Kacapyr.
Mehall agrees, saying that the speed and aggressiveness with which the government acted were able to contain the damage done by the crisis.
The Plausibility of Prevention
Could the government have intervened before the crisis became full blown? Kacapyr says no.
“These [were] slow glacial things that are gradually moving forward over decades and they eventually come to a head. Can you imagine President Clinton saying, ‘We’ve just got to stop this’? Society just wouldn’t accept that, he wouldn’t be reelected. Did we intervene too late? I don’t think there’s anything the government could have done along this path,” he says.
The damage done by the financial crisis continues to linger. The so-called Great Recession— spurred by job loss in affected industries, an inability of banks to perform as banks, and a loss of consumer confidence— was only recently declared over.
While the bailout prevented the crisis from worsening, it has also helped to create a banking system that is made up of what Mehall calls “ultra mega banks.”
It’s the idea of too big to fail: Large financial institutions are too big to go bankrupt without causing the entire financial system to collapse.
Kacapyr says it’s an issue the government has punted on.
“There was an opportunity here to address that issue that sometimes is referred to as moral hazard where institutions are so big that they know if they fail colossally, they’ll be bailed out. For whatever reason, we decided not to address that issue right now,” he says.
And ten years from now, where will we be?
Christine Loman is a junior journalism and history major whose piggy bank got screwed by the recession, too. E-mail her at email@example.com.