It must be a hard wired human trait that we believe nearly every misfortune or crisis that we encounter is the first, and worst...and never our fault.
It is easy to understand the emotional desire to equate financial losses as theft. It allows you to mentally defer personal responsibility, and even better, demand "justice" from higher authority. It provides a greivance and a sense that the law should make you whole. But this idea is both flawed and dangerous.
The current economic crisis is actually not that difficult to understand. Fundamentally, it is a housing bubble that -- like all bubbles -- has burst. It was not driven by nefarious, crooked "wall street" criminals. It was a broad-based, international, overheated market that caused home prices to rise so quickly and for so long that people lost appropriate valuation of real estate. In addition, a combination of factors culminated to undermine the broader economy. It is a warning tale of the law of unintended consequences more than true crime.
Real Estate has historically been a "boom-bust" market. Prosperity drives demand for homes that are relatively long lead production items -- demand can easily outpace supply when it takes years to plan, zone, acquire, and build housing developments. Prices for existing homes rise, and builders start new projects. Prices accelerate as demand for materials cause spot shortages. By the time the market is sated, there is almost always a glut of houses...causing prices to fall as supply exceeds demand. It has happened repeatedly for as long as man has bought and sold buildings.
The current boom was partially heated by public policy decisions -- historically low mortgage rates, and community development rules loosening credit standards for sub-prime buyers. Banks developed new tools to mitigate the high foreclosure risk of these subprime loans -- mortgage backed securities (MBSs). These are basically bonds backed by a large number of mortgages. The idea being that while a single loan carries a risk of failure, a thousand such loans dilutes the impact of a few foreclosures. Being subprime, MBSs had the added benefit of paying much higher interest than the prime rate. The paper is also backed by the collateral of the houses themselves -- and in a heated market, the houses were perceived as appreciating assets. The result was a huge increase in demand for houses (due to easy access to low cost loans) and a huge new secondary mortgage market. Clearly a recipe for a bubble.
But the thing that made this bubble so much more pervasive than previous busts is the gradual infiltration of MBSs into nearly all financial institutions. Fifteen years of constant growth in housing values, plus the advantage of <4% spreads between prime and subprime mortgage backed securities caused massive investment in these high yield, theoretically low risk securities. Everyone was buying them. Domestic and global corporations of all stripes used them to to pad their earnings. Average investors purchased Real Estate Investment Trusts (REITS) for their portfolios, as they paid higher yields than regular corporate or government bonds, and were perceived as less risky than stocks.
The need to feed this market created huge incentives for lenders to expand the potential pool of homebuyers to provide new securities to package and sell. This required offering increasingly risky loans to eager homebuyers who were willing to overpay for homes they could not otherwise afford. Home equity loans, Jumbos, balloon loans, interest only, etc. Buyers accepted these loans in the hope that increasing home values would provide equity, and the upwards ride would never end. The government backed giants, Freddie Mac and Fannie Mae served as a safety net, willing to buy packaged securities no matter what the risk.
Investment Banks purchased huge amounts of MBSs, which they then used as collateral for other financial transactions -- often leveraged up to 50 to 1. They sold insurance (credit default swaps) against default of the mortgage securities -- effectively profiting twice -- while doubling their risk.
Everyone got what they wanted. Consumers got houses, and those who saw their homes greatly appreciate used their windfall equity to borrow money for new cars, vacations, additions/upgrades, and other houses. Federal, State, and Local Governments achieved their policy objectives of broadening the homeowner class, and got to reap the new tax revenue to finance billions in unrelated policy objectives from education to childrens healthcare to public works. Homebuilders and suppliers provided massive employment, and every bank and corporation involved in the buying/selling of securities turned huge profits that were then distributed to shareholders and employees -- creating a broad economic boom that carried the Dow past 14,000. What's not to like?
Well, a funny thing happens when supply exceeds demand. More in Part II.