Skip to content

The Great Recession

On September 15, 2008 Lehman Brothers filed for bankruptcy – the largest bankruptcy in history.  What followed was a predictable reaction in the financial markets and an even more intense reaction among the consumer market.  Before we knew it, an economic slowdown had turned into the worst recession since the Great Depression.

Honestly, I had paid little attention to events leading up to Lehman’s collapse.  I was consumed with work and of course, the ’08 presidential election.  But I knew something was wrong going back to 2006.  A process that should have taken a couple of months took almost a year and by the time my condo in Iowa finally sold, the purchase price had fallen by close to 10% after rising steadily over the prior ten.  It was still worth twenty grand more than the purchase price but a year before it had been worth so much more.

But it was not until I was personally effected by the recession that I started researching.  I was incredibly fortunate, by the time I was laid off from ING and hired by ServiceNow, that the recession had neared its end and some segments of the economy had started hiring.  Technically, I was unemployed for 3 weeks when my now dear friend Samantha Smith hired me.   Once I started receiving a steady paycheck, I began to research and of course, read.  Fortunately, a lot of experts were publishing their accounts so I quickly accumulated a library of fascinating accounts by a number of authors with varying political proclivities (that is – both sides of the political spectrum).

This post has been ruminating in my brain for a while now.  It’s a complicated subject and frankly, I’ve wanted to write it primarily to prove to myself that I understand what happened.  What follows in my interpretation of not only WHAT but also WHY it happened.  While long, I hope you find it informative enough to go research yourself.  I can recommend several books and if you do not like to read, several movies that do an excellent job of explanation.

I have mentioned in a few previous posts about the modern conservative movement’s reaction to the Soviet Union and its successes and capitalism’s failures.  I will not repeat myself here.  But what I have not spent much time describing is the US economic situation in the 1970s – a period of inflation and recession brought on by overconsumption and underproduction.  For conservatives and some moderates, increased government spending during Vietnam and the Great Society had led to double digit inflation while other economic factors resulted in a decline in production and GDP.  This combined with OPECs self-induced oil shortage had created a horrible economic situation for Americans – long gas lines, higher prices and job losses dubbed the situation “stagflation.’  In current events, there was the embarrassing loss in Vietnam, Nixon’s opening of China (seen by conservatives as a betrayal of capitalist values), Watergate, hostages in Iran and the Soviet invasion of Afghanistan.  But it was the domestic economy that gave the “deregulation” movement the extra push it needed to undo most of the New Deal’s economic reforms and regulations.

There are many books, websites, and articles that will detail each roll back but suffice it to say, these regulations were rolled back in the light of day and under multiple presidencies – both Democrat and Republican.  The intent, of course, was to “get the economy moving again” and so each reversal was completed, I believe, with altruistic intents.  But there were warning signs that were ignored or at best – not acted upon in any legislative way to prevent future catastrophe.   Republicans were firmly under the spell of the Conservative Movement (anti- government, strict interpretation of the constitution, low taxes and limited regulation) and Democrats were practicing “the Third Way” doctrine – an attempt, starting with the Clinton candidacy and then administration, to move the party from its 60s radicalism to center left policy.  In fact, it was President Clinton who really put the nail in the regulatory coffin by reversing Glass-Steagall, effectively allowing investment and commercial banks to live under the same umbrella.  In effect, this allows investment banks (the riskier of the 2 entities) to use depositor funds as leverage in risky investments.

But all of this just set the stage.  What really led to the financial crisis was the housing market and here is where I prove to myself that I understood and retained everything I learned from all of those books and movies.

Before I get to mortgages, it is important to understand a few things about our financial markets.  Perhaps most importantly is this:  our economy runs on leverage.  Yes – our capital and financial markets are based on debt.   Without easy access to money, and reasonable interest rates, small and large business would cease to exist.  Many companies cannot make payroll and pay basic invoices without access to credit markets or without selling short term commercial bonds.   Credit crunches, which originate on Wall Street, can have devastating effects on Main Street and so it is critical that banks continue to lend.

Debt is not a bad thing – in fact using debt financing to grow your business is the back bone of the modern capitalist economy.  But over leveraging your assets or not knowing how much you have outstanding on margin can get you into a lot of trouble – and that is what happened in 2008.

But let’s start with mortgages.  They used to be really easy.  Thirty to forty years ago, a would be home owner would walk into their local bank with twenty percent down and apply for a loan.  The banker would carefully assess the risk because his name and his bank would be on the hook should the borrower not pay back the loan (and yes, ‘he’ is the appropriate pronoun as banking was a predominately male occupation – as it is today).  The local bank held the loan until the mortgage was paid off and thus, lenders were limited in the number of mortgages it could extend.

This started to change in the late 60s and 70s with the creation of Freddie Mac and Fannie Mae – two government sponsored enterprises that were set up to expand the secondary mortgage market.  You see – the government wanted to expand home ownership because of the housing market like automobile manufacturing is a catalyst industry:  to build a house, you have to employ a lot of people in a lot of industries – thus creating increased demand for everything from lumber to furniture.  And it was not just the government.  As banking regulations were relaxed, financial markets saw opportunities to increase the number of financial transactions processed and thus, the number of fees banks could charge.  It was a win-win.

The secondary mortgage market is both easy and complex.  The easy part is this:  lenders bundle multiple mortgages into a single security and then sell it on the open market to investors.  Hedge funds, money markets, institutional investors and even 401k’s likely own “mortgage backed securities” in their portfolio.  When the MBS’s are filled with prime mortgages (loans that are highly likely to be paid back), then the investment should provide an almost guaranteed income stream.  In the unlikely event that a home owner fails to repay their loan, the mortgage lender can foreclose on the property and sell it on the open market, thus recouping the outstanding debt.

But most mortgage backed securities became increasingly complex – to the extent that no one, not even the actuaries that priced the investments truly understood them.  To make it worse, investment banks (Lehman Brothers, Goldman Sachs, JP Morgan Chase, Citibank, etc) made them even more complicated by creating a derivative of MBS’s in the form of “collateralized debt obligations.”  These CDO’s contained pieces of multiple MBS’s sliced into “tranches” – each tranche representing dozens, if not hundreds of individual mortgages from all over the country, individually rated by independent (I’ll get back to this) rating agencies as AAA, AA, A-, etc.  CDO’s were then put on the secondary mortgage market and sold to investors.

Of course, investment banks had to hedge their bets and so they sought credit insurance against MBSs and CDO’s.  Enter “credit default swaps.”  CDS’s were even more complicated investment vehicles that investment banks purchased in case their CDO’s were downgraded OR in case insurers faced underlying asset depreciation (aka – housing prices declined or there were unexpected losses).  CDS’s were then sold on the derivatives market to anyone and everyone.

Let’s pause for a second and restate a few assumptions on which this entire system was based.    First – the underlying asset is the American housing market.  It was assumed that housing prices would remain stable or increase over time.  Second, even if the housing market did suffer a bit of a slow-down, it would certainly not be universal.  While housing starts may decline in one part of the country, they would not decline across the country and thus, the overall risk was mitigated.

Next – the rating agencies.  Rating agencies were independent and evaluated funds based on the risk of the underlying investment.  If Moody’s found a hedge fund to be rated AAA, then that you could almost be guaranteed a positive and long term return because it was a safe risk.

Finally – and this one is my favorite – the Federal Reserve lobbied against regulating the secondary mortgage and derivatives market.  Alan Greenspan, Chairman of the Federal Reserve from 1987 – 2006, was adamantly opposed to federal regulations of these markets and testified multiple times before Congress against them.  He was an ardent proponent of free market economics and ultimately believed that the derivative market was small enough to be self- regulating.  You’ve heard this before:  markets can regulate themselves.  And Congress listened.

You know where this is going but we need to understand the motive.  All of these market transactions produced massive fees for brokers, dealers, and banks.  Making money is not bad – not bad at all.  In fact, I am a big fan of making a lot of money.  However, those fees – and the ease at which they were generated, led to a bit of a stampede in the market place.  Wall Street investment banks, including Lehman Brothers, demanded more and more mortgages that they could then package into MBS’s and CDO’s, sell and generate fees.  Wall Street traders became one of the top occupations for college graduates.

Now here’s the snag – the supply of mortgagees with excellent credit and thus the ability to repay their loans was limited.  As a result, the supply of “prime” mortgages was also limited.  Given the demand and the enormous money it generated, the finance community had to get creative in order to maintain their supply.   By no means is this a complete list, but it gives you an idea of what went on:

  • A shadow banking system – outside of the normal banking channels and thus, not subject to regulation emerged offering mortgages to individuals with questionable credit.
  • Creative products like “interest only loans,” ARMs (where the interest rate adjusted on a yearly basis) provided borrowers with the means to borrow more than what they could afford, including a reduction in the down payment required.
  • Low or no documentation loans. Mortgages were given to people without verification of income, jobs or assets.
  • Fraudulent appraisals. As anyone who has a mortgage knows, banks will traditionally loan a borrower no more than the appraised value of the home.  If the appraiser is on the take – and gets a kick back on each successful and closed mortgage – there is a great deal of incentive to ‘over-estimate’ the value of the asset.
  • Independent rating agencies were not really independent. As it turns out, investment banks PAY the rating agencies a fee to evaluate and rate their product risk.  The top 3 agencies (S&P, Moody’s and Fitch Group) are in competition with one another.  If JP Morgan does not like Moody’s rating, they simply go to Fitch or S&P.  Hard to be independent, if you need your customer’s business.
  • Risk management was non-existent.

All of the above, coupled with decades of deregulation and a seemingly humming economy produced a housing bubble just waiting to burst.  Remember – the underlying asset was the home itself.   If the value of housing, in multiple regions of the country, saw a significant reduction in price then all of the investments based on those assets could come tumbling down.

And of course, that is what happened.  When you loan money to people who cannot pay it back in significant numbers you are just asking for trouble.  In the year to eighteen months ahead of the Lehman’s collapse, the housing market declined and ultimately crashed.  Borrowers who had taken out some of the more creative loans with the assumption that they could refinance their mortgage before their huge balloon payments were due found themselves in a real financial pickle when the value of their home was less than what they owed on their original mortgage.  In that situation, home owners found themselves under-water in a home that was over-valued and over-leveraged in second and third mortgages.

At that point, the value of the investments built on mortgages also crashed which invoked collateral and margin calls that banks never expected to have to pay.  AIG, the primary supplier of CDS (credit insurance) discovered that they held insurance policies on all the major investment banks – including its own investment arm, thus owing billions of dollars to external sources.  Oh – and the “experts” had really no idea how much these products were worth so they could not dispute the fall in value.
I forgot one thing:  it was not just American investors at risk.  As it turns out, in perhaps our most infamous export – the entire world had invested in our financial markets.  The entire world.  Think about that for a second.  The value of these investments were careening and this small number of investment banks were hemorrhaging cash.  Lehman was driven to insolvency and the stock market raced towards a cliff not seen in our lifetimes.   The entire world economy was at risk of the “crash and burn.”

Colossal fubar folks – “fucked up beyond all recognition.”  That is perhaps the best description of 2008.  The entire capitalist world functioned on credit and the major suppliers of credit were bleeding from their femoral and carotid arteries.  They could not prove their solvency and investors were demanding their money.  Small business could not get loans to pay their employees or their bills.  Workers were being laid off, increasing the foreclosure rate on assets embroiled in the faulty investments.   And this was just the beginning of the spiraling effects from poor decisions and lack of oversight.

It was at this point that the Federal Reserve and the Treasury Department stepped in.  Congress passed a $700 billion-dollar rescue bill called the “Troubled Asset Relief Program” or TARP.  At this point, I’ll be honest….I’m tired of typing.  If you have made it this far, I implore you to Google “Financial Crisis.”   The “bank bailout” led to the rise of the Tea Party and Occupy Movement.  The Wall Street implosion led to a Main Street recession, second only to the Great Depression.

People were outraged and understandably so.  Banks were bailed out but borrowers losing their homes were not.  Prime mortgages were also defaulting because their borrowers lost their jobs.  How is that fair?  Companies like my own at the time (ING) evaluated their portfolio and found Alt-A and sub-prime mortgages on their books.  Not knowing their risk, they quickly moved to offload their assets and reduce their expenses.  Layoffs ensued.  Individual investors found their 401ks significantly depleted – again, through no fault of their own.  And yet – CEOs at the helm of these banks continued to receive eight digit bonuses, despite running their companies into the ground.

The anger and backlash against government resulted in the populist movement supporting Bernie Sanders and Donald Trump (or so says the mainstream media).
All of this is history and by ‘history’ I mean – events based on facts.  You really cannot dispute that deregulation and turning a blind eye to financial product innovation led to the colossal failure of our financial and capital markets.  And here is the kicker:  this has happened before.  Even as a history major, I had never truly understood what caused the Great Depression.

In high school, text books devoted a few paragraphs to the lead up to the October 1929 stock market crash but the focus was on the Roaring Twenties, Flappers, and the “Charleston.”  The crash itself was blamed on “speculation.”  After feeling fairly informed about 2008, I decided to read up on 1929 and surprisingly, I found incredible parallels.  No regulation, no oversight and investments in products with questionable underlying value.  The major difference in the 20s was that overt fraud and manipulation of the markets was legal.  So I guess that’s an outlier.

And now I’m going to get partisan.  Given these facts – and yes folks – they are facts, I continue to be amazed at Republican obstinacy and denial.  The GOP opposed every attempt to reform post-Great Recession and even Democrats – including the Obama Administration – were afraid to impose penalties on the very bankers who almost destroyed the world.  (That’s actually a variation of a book title =)).

The GOP plans a repeal of Dodd – Frank, legislation passed after the Crash that attempted to curtail Wall Street abuses and make it easier to ‘wind down’ firms that were too big to fail.  And they want to repeal it out of principle and the apparent belief that any regulation impedes capital investment.  In a future post, I will explain my understanding of “financialization” and how banks, since the Recession, are bigger and more profitable than ever and yet they are not re-investing in the economy – rather profits are being offshored to avoid taxation AND utilized in stock buy-back programs that benefit the few at the top of the economic strata (aka – not you and not me).

I will also explain why lower taxes do not historically result in increased capitalization, investment and job growth.  Interesting.

It is barely 10 years post financial collapse and yet the GOP, and until recently the Democratic Party, have adhered to absolute laissez-faire principles as described in conservative think tanks financed by the very industries that benefit from these laissez-faire principles.  It is amazing to me that Paul Ryan – a smart guy – simply refuses to acknowledge that unrestricted and unchecked capitalism is NOT and never has been self-correcting and self-regulating.

Donald Trump, partisan of the people and enemy of Wall Street have placed Wall Street at the helm of the government; Steve Mnuchin is our new Treasury Secretary.  Steve Mnuchin is a millionaire who made his fortune in the unregulated credit markets.  “Let’s give him a chance” or so go his advocates but so far, given what I have read about his philosophy, he tows the tried and proven failed line of “low taxes and de-regulation.”  That’ll fix everything.

These policies have failed before and will fail again.  And every time they fail, the middle and working classes lose.  Not only do our investments suffer, but holistically, so does our capitalist system.  No one wants to speak of it, but these systemic failures were predicted by Marx and other famous socialists back in the 19th century.  These failures, Marx predicted, would lead to the proletariat and communist revolution because it would be clear that capitalism was unsustainable.  Now before you get your panties in a bunch – I am not advocating a communist revolution.  Frankly, conservatives have destroyed and liberals have allowed the complete destruction of the socialist movement in the United States starting in the 1950s.  There is simply no foundation – not yet anyway – for a socialist uprising.

But I can tell you that personally, I am no longer a moderate just left of center.  While I have been fortunate and have benefited from our modern market system, I can tell you that I see its weaknesses.  And prior benefits do not necessarily reflect future ones.  At this very moment, the same house of cards is being built on auto-loans such that it is entirely possible that a new bubble will bring on another financial catastrophe.  The more I study, the closer I slide to that socialist democratic stance of Bernie Sanders and I’ll warn conservatives:  maintain your absolutism and adherence to modern conservativism as defined by the Koch Brothers at your own peril.  I predict a backlash and a “real” fall in American dominance in the next decade if our politics does not self-correct and moderate.  Right now, I have little faith and confidence that it will.

If anything, I hope this post (if you read it in its entirety) will cause you to pursue your own investigation.  In my own, I have concluded that the conservative talking points are just that – talking points.  I have also concluded (perhaps a bit late) that we need a much stronger labor movement and leftist party in America.  While we are stuck with a 2 party system (perhaps another post to explain why our system is inherently set up to support just 2 major parties), I hope the Democrats continue to move in the direction of Bernie Sander and Elizabeth Warren.  This country and the economy needs a little dose of socialist reform (aka – smart regulation) to ensure its continued viability.  There will still be business cycles and recessions, but we simply cannot allow another 2008.  To do so would be to ignore history and demonstrate absolute ignorance of reality.  I really hope we are smarter than that.

Amy – from the Facebook Archive

%d bloggers like this: