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Praise for Financial ShockPraise for Financial Shock
“The obvious place to start is the financial crisis, and the clearest guide to it that I’ve read is Financial Shock by Mark Zandi....It is an impressively lucid guide to the big issues.”
— David Leonhardt, The New York Times
“If you wonder how it could be possible for a subprime mortgage loan to bring the global financial system and the U.S. economy to its knees, you should read this book. No one is better qualified to provide this insight and advice than Mark Zandi.”
— Larry Kudlow, Host, CNBC’s Kudlow & Company
“Mark Zandi provides insightful analysis, thoughtful recommendations, and a comprehensible explanation of the financial crisis that is accessible to the general public and extremely useful to those who specialize in the area.”
— Barney Frank, Chairman, House Financial Services Committee
“In Financial Shock, Mr. Zandi provides a concise and lucid account of the economic, political, and regulatory forces behind this binge.”
— The Wall Street Journal
“If it’s growing like a weed, it’s probably a weed.” So I was once told by the CEO of a major financial institution. He was talking about the credit card business in the mid-1990s, a time when lenders were mailing out new cards with abandon and cardholders were piling up huge debts. He was worried, and correctly so. Debt-swollen households were soon filing for bankruptcy at a record rate, contributing to the financial crisis that ultimately culminated in the collapse of mega hedge fund Long-Term Capital Management. The CEO’s bank didn’t survive.
A decade later, the world was engulfed by an even more severe financial crisis. This time the weed was the subprime mortgage: a loan to someone with a less-than-perfect credit history.
Financial crises are disconcerting events. At first they seem impenetrable, even as their damage undeniably grows and becomes increasingly widespread. Behind the confusion often lie esoteric and complicated financial institutions and instruments: program trading during the 1987 stock market crash, junk corporate bonds in the savings and loan debacle in the early 1990s, the Thai baht and Russian bonds in the late 1990s, and the technology-stock bust at the turn of the millennium.
Yet the genesis of the subprime financial shock has been even more baffling than past crises. Lending money to American home buyers had been one of the least risky and most profitable businesses a bank could engage in for nearly a century. How could so many mortgages have gone bad? And even if they did, how could even a couple of trillion dollars in bad loans derail a global financial system that is valued in the hundreds of trillions?
Adding to the puzzlement is the complexity of the financial institutions and securities involved in the subprime financial shock. What are subprime, Alt-A, and jumbo IO mortgages; asset-backed securities; CDOs; CPDOs; CDSs; and SIVs? How did this mélange of acronyms lead to plunging house prices, soaring foreclosures, wobbling stock markets, inflation, and recession? Who or what is to blame?
The reality is that there’s plenty of blame to go around. A financial calamity of this magnitude could not have taken root without a great many hands tilling the soil and planting the seeds. Among the elements that fed the crisis are a rapidly evolving financial system, an eroding sense of responsibility in the lending process among both lenders and borrowers, the explosive growth of new and emerging economies amassing cash for their low-cost goods, lax oversight by policymakers skeptical of market regulation, incorrect ratings, and, of course, what economists call the “animal spirits” of investors and entrepreneurs.
America’s financial system had long been the envy of the world. It had invested the nation’s savings incredibly efficiently—so efficiently, in fact, that although our savings are meager by world standards, they bring returns greater than those in nations that save many times more. So it wasn’t surprising when Wall Street engineers devised a new and ingenious way for global money managers to finance ordinary Americans buying homes: bundle the mortgages and sell them as securities. Henceforth, when the average family in Anytown, U.S.A., wrote a monthly mortgage check, the cash would become part of a money machine as sophisticated as anything ever designed in any of the world’s financial capitals.
But the machine didn’t work as so carefully planned. First it spun out of control, turning U.S. housing markets white-hot. Then it broke, its financial nuts and bolts seizing up while springs and wires flew out, spreading damage in all directions.
What went wrong? First and foremost, the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined. At every point in the financial system, there was a belief that someone—someone else—would catch mistakes and preserve the integrity of the process. The mortgage lender counted on the Wall Street investment banker, who counted on the regulator or the ratings analyst, who assumed global investors were doing their own due diligence. As the process went badly awry, everybody assumed someone else was in control. No one was.
Global investors weren’t cognizant of the true risks of the securities they had bought from Wall Street. Investors were awash in cash because global central bankers had opened the money spigots wide in the wake of the dotcom bust, 9/11, and the invasion of Iraq. The stunning economic ascent of China, which had forced prices lower for so many manufactured goods, also had central bankers focused on fighting deflation, which meant keeping interest rates low for a long time. A ballooning U.S. trade deficit, driven by a strong dollar and America’s appetite for cheap imports, was also sending a flood of dollars overseas.
The recipients of all those dollars needed some place to put them. At first, U.S. Treasury bonds seemed an easy choice; they were safe and liquid, even if they didn’t pay much in interest. But after accumulating hundreds of billions of dollars in low-yielding Treasuries, investors began to worry less about safety and more about returns. On the surface, Wall Street’s new designer mortgage securities were an attractive alternative. Investors were told they were safe—at most, a step or two riskier than a U.S. Treasury bond, but with significantly higher returns—which itself should have served as a warning signal to investors. But with more U.S. dollars to invest, the quest for higher returns became more concerted, and investors warmed to increasingly sophisticated and complex mortgage and corporate securities, indifferent to the risks they were taking.
The financial world was stunned when U.S. homeowners began defaulting on their mortgages in record numbers. Some likened it to the mid-1980s, when a boom in loans to Latin American nations (financed largely with Middle Eastern oil wealth) went bust. That financial crisis had taken more than a decade to sort through. Few thought that subprime mortgages from across the United States could have so much in common with those third-world loans of yesteryear.
Still more disconcerting was the notion that the subprime mortgage losses meant investors had badly misjudged the level of risk in all their investments. The mortgage crisis crystallized what had long been troubling many in the financial markets: Assets of all types were overvalued, from Chinese stocks to Las Vegas condominiums. The subprime meltdown began a top-to-bottom reevaluation of the risks inherent in financial markets and, thus, a repricing of all investments, from stocks to insurance. That process would affect every aspect of economic life, from the cost of starting a business to the value of retirees’ pensions, for years to come.
Policymakers and regulators had an unappreciated sense of the flaws in the financial system, and those few who felt something was amiss lacked the authority to do anything about it. A deregulatory zeal had overtaken the federal government, including the Federal Reserve, the nation’s key regulator. The legal and regulatory fetters that had been placed on financial institutions since the Great Depression had broken. There was a new faith that market forces would impose discipline; lenders didn’t need regulators telling them what loans to make or not make. Newly designed global capital standards and the credit rating agencies would substitute for the discipline of the regulators.
Even after mortgage loans started going bad en masse, the confusing mix of federal and state agencies that made up the nation’s regulatory structure had difficulty responding. When regulators finally began to speak up about subprime and the other types of mortgage loans that had spun out of control, such lending was already on its way to extinction. What regulators had to say was all but irrelevant.
Yet even the combination of a flawed financial system, cash-flush global investors, and lax regulators could not itself have created the subprime financial shock. The essential final ingredient was hubris: a belief that the ordinary rules of economics and finance no longer applied. Everyone involved—home buyers, mortgage lenders, builders, regulators, ratings agencies, investment bankers, central bankers—believed they had a better formula, used a more accurate model, or would just be luckier than their predecessors. Even the bursting tech stock bubble just a few years earlier seemed to hold no particular lessons for the soaring housing market. This time, the thinking went, things were truly different. Though house prices shot up far faster than household incomes or rents—just as dotcom-era stock prices had left corporate earnings far behind—markets were convinced that, for a variety of reasons, houses weren’t like stocks, so they could skyrocket in price without later falling back to Earth, as the Dow and NASDAQ had.
Skyrocketing house prices fed many dreams and papered over many ills. Households long locked out of the American dream finally saw a way in. Although most were forthright and prudent, too many weren’t. Borrowers and lenders implicitly or explicitly conspired to fudge or lie on loan applications, dismissing any moral qualms with the thought that appreciating property values would make it all right in the end. Rising house prices would allow homeowners to refinance again and again, freeing cash while keeping mortgage payments low. That meant more fees for lenders as well. Empowered by surging home values, investment bankers invented increasingly sophisticated and complex securities that kept the money flowing into ever-hotter and faster-growing housing markets.
In the end, there was far less difference between houses and stocks than the markets thought. In many communities, houses were being traded like stocks, bought and sold purely on speculation that they would continue to go up. Builders also got the arithmetic wrong as they calculated the number of potential buyers for their new homes. Most of the mistakes made in the tech-stock bubble were repeated in the housing bubble and became painfully obvious in the subsequent bust and crash. The housing market fell into a self-reinforcing vicious cycle as house price declines begat defaults and foreclosures, which begat more house price declines.
It’s probably no coincidence that financial crises occur about every ten years. It takes about that long for the collective memory of the previous crisis to fade and confidence to become all-pervasive again. It’s human nature. Future financial shocks are assured.
A few naysayers popped up along the way. Some on Wall Street and in banks became visibly uncomfortable as the housing boom and bubble intensified. But it was hard to stand against the tide: Too much money was being made, and if you wanted to keep doing business, you had little choice but to hold your nose. As another Wall Street CEO famously said just before the bust, “As long as the music was playing, you had to get up and dance.” A few government officials did some public hand-wringing, but their complaints lacked much force. Perhaps they were hamstrung by their own self-doubts, or perhaps their timing was off. Perhaps history demanded the dramatic and inevitable arrival of the subprime financial shock to finally make the point that it wasn’t different this time.
I take some pride in being one of those who warned of the problems developing in the housing and mortgage markets and financial system more broadly, but I was early in expressing my doubts and had lost some credibility by the time the housing market unraveled and the financial shock hit. I certainly also misjudged the scale of what eventually happened. I expected house prices to decline and for Wall Street and investors to take losses, but I never expected the financial system to effectively collapse and precipitate the worst global economic downturn since the 1930s’ Great Depression. Indeed, as I was finishing the first version of this book in July 2008, I penned this sentence: “As this is being written, about a year after the subprime financial shock hit, the worst of the crisis appears to be over.” This was after the Bear Stearns collapse but before a string of fatal policy errors beginning with the government takeover of Fannie Mae and Freddie Mac, and the collective decision by the Bush Administration and the Federal Reserve to allow Lehman Brothers to go bankrupt. These mistakes and a few others turned a serious yet manageable financial crisis into an out-of-control financial panic.
Any full assessment of the subprime fiasco must also consider the role of the credit rating agencies. Critics argue that the methods and practices of these firms contributed to the crisis by making exotic mortgage securities seem much safer than they ultimately proved to be. Others see a fatal flaw in the agencies’ business model, under which the issues of securities pay the agencies to rate these securities. Three firms dominate the global business of rating credit securities: Moody’s, Standard & Poor’s, and Fitch. In 2005, Moody’s purchased the company I cofounded, and I have been an employee of that firm since then. To avoid any appearance of a conflict of interest, I have no choice but to leave discussion of this facet of the subprime shock to others. The views expressed in this book are mine alone and do not represent those held or endorsed by Moody’s. It is also important for you, the reader, to know that I am donating my royalties from the book to a Philadelphia-based nonprofit, The Reinvestment Fund (TRF). TRF invests in inner-city projects in the Northeast United States.
Understanding the roots of the subprime financial shock is necessary to better prepare for the next financial crisis. Policymakers must use its lessons to reevaluate the regulatory framework that oversees the financial system. The Federal Reserve should consider whether its hands-off policy toward asset-price bubbles is appropriate. Bankers must build better systems for assessing and managing risk. Investors must prepare for the wild swings in asset prices that are sure to come, and households must relearn the basic financial principles of thrift and portfolio diversification.
The next financial crisis, however, won’t likely involve mortgage loans, credit cards, junk bonds, or even those odd-sounding financial securities. The next crisis will be related to our own federal government’s daunting fiscal challenges. The United States is headed inexorably toward record budget deficits, measured both in total dollars and in proportion to the economy. Global investors are already growing disaffected with U.S. debt, and even the Treasury will have a difficult time finding buyers for all the bonds it will be trying to sell if nothing changes soon. Hopefully, the lessons learned from the subprime financial shock will be the catalyst for making better choices regarding taxes and government spending that we collectively will have to make in the not-too-distant future.
This book isn’t filled with juicy financial secrets; it might not even spin a terribly dramatic yarn. Instead, it is an attempt to make sense of what has been a complex and confusing period, even for a professional economist with 25 years at his craft. I hope you find it organized well enough to come away with a better understanding of what has happened. Although nearly every event feels like the most important ever when you are close to it, I’m confident that the subprime financial shock will be judged the most significant financial event in our nation’s economic history.
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