INTRODUCTION
Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors.
Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.1
How did this happen? Whose fault was it?
A 2009 study by the Congressional Research Service identified 26 causes of the crisis.2 The Financial Crisis Inquiry Commission is studying 22 different potential causes of the crisis.3 In the face of such complexity, it is tempting to view the housing crisis and subsequent financial crisis as a once-in-a-century coincidental conjunction of destructive forces. As Alan Schwartz, Bear Stearns’s last CEO, put it, “We all [messed] up. Government. Rating agencies. Wall Street. Commercial banks. Regulators. Investors. Everybody.”4
In this commonly held view, the housing market collapse and the subsequent financial crisis were a perfect storm of private and public mistakes. People bought houses they couldn’t afford. Firms bundled the mortgages for these houses into complex securities. Investors and financial institutions bought these securities thinking they were less risky than they actually were. Regulators who might have prevented the mess were asleep on the job. Greed and hubris ran amok. Capitalism ran amok.
To those who accept this narrative, the lesson is clear. As Paul Samuelson put it,
And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.5
The implication is that we need to reject unfettered capitalism and embrace regulation. But Wall Street and the housing market are hardly unfettered. Yes, deregulation and mis-regulation contributed to the crisis, but mainly because public policy over the last three decades has distorted the natural feedback loops of profit and loss. As Milton Friedman liked to point out, capitalism is a profit and loss system. The profits encourage risk-taking. The losses encourage prudence. When taxpayers absorb the losses, the distorted result is reckless and imprudent risk-taking.
A different mistake is to hold Wall Street and the financial sector blameless, for after all, investment bankers and other financial players were just doing what they are supposed to—maximizing profits and responding to the incentives and the rules of the game. But Wall Street helps write the rules of the game. Wall Street staffs the Treasury Department. Washington staffs Fannie Mae and Freddie Mac. In the week before the AIG bailout that put $14.9 billion into the coffers of Goldman Sachs, Treasury secretary and former Goldman Sachs CEO Hank Paulson called Goldman Sachs CEO Lloyd Blankfein at least 24 times.6 I don’t think they were talking about how their kids were doing.
This book explores how changes in the rules of the game—some made for purely financial motives, some made for more altruistic reasons—created the mess we are in.
The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor.7 Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives to both borrow and lend recklessly.
When large financial institutions get in trouble, equity holders (stockholders) are typically wiped out or made to suffer significant losses when share values plummet. The punishment of equity holders is usually thought to mitigate the potential for moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk-taking.
The expectation by creditors that they might be rescued allows financial institutions to substitute borrowed money for their own capital even as they make riskier and riskier investments. Because of the large amounts of leverage—the use of debt rather than equity—executives can more easily generate short-term profits that justify large compensation. While executives endure some of the pain if short-term gains become losses in the long run, the downside risk to the decision makers turns out to be surprisingly small, while the upside gains can be enormous. Taxpayers ultimately bear much of the downside risk. Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.
Almost all of the lenders who financed bad bets in the housing market paid little or no cost for their recklessness. Their expectations of rescue were confirmed. But the expectation of creditor rescue was not the only factor in the crisis. As I will show, housing policy, tax policy, and monetary policy all contributed, particularly in their interaction. Though other factors—the repeal of the Glass-Steagall Act, predatory lending, changes in capital requirements, and so on—made things worse, I focus on creditor rescue, housing policy, tax policy, and monetary policy because without these policies and their interaction, the crisis would not have occurred at all. And among causes, I focus on creditor rescue and housing policy because they are the most misunderstood.
In the United States, we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets their money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives.
NOTES
1. Two very useful overviews of the crisis include Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson, The Origins of the Financial Crisis, Fixing Finance Series Paper 3 (Washington, DC: Brookings Institution, November 2008), http://www.brookings.edu/~/media/Files/rc/papers/2008/11_origins_crisis_baily_litan/11_origins_crisis_baily_litan.pdf; and Arnold Kling, Not What They Had in Mind: A History of Policies That Produced the Financial Crisis of 2008 (Arlington, VA: Mercatus Center, September 2008), http://mercatus.org/publication/not-what-they-had-mind-history-policies-produced-financial-crisis-2008. See also James R. Barth et al., The Rise and Fall of the U.S. Mortgage and Credit Markets (Santa Monica, CA: Milken Institute, 2009), http://www.milkeninstitute.org/pdf/Riseandfallexcerpt.pdf. Two prescient analyses that were written without the benefit of hindsight and that influenced my thinking are Gary Stern and Ron Feldman, Too Big to Fail: The Hazards of Bank Bailouts (Washington, DC: Brookings Institution, 2004); and Joshua Rosner, “Housing in the New Millennium: A Home Without Equity Is Just a Rental with Debt,” working paper, June 29, 2001, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456.
2. Mark Jickling, Causes of the Financial Crisis (Washington, DC: US Congressional Research Service, 2009), http://assets.opencrs.com/rpts/R40173_20090129.pdf.
3. The Financial Crisis Inquiry Commission is a bipartisan commission created in May 2009 to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.” See Financial Crisis Inquiry Commission, “About the Commission,” http://www.fcic.gov/about/, for a description of the 22 areas the commission is charged with examining.
4. Quoted in William Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (New York: Doubleday, 2009), p. 450. The bracketed edit is my own substitution for family consumption.
5. Paul Samuelson, “Don’t Expect Recovery Before 2012—With 8% Inflation,” interview by Nathan Gardels, New Perspectives Quarterly 27 (Spring 2009), http://www.digitalnpq.org/articles/economic/331/01-16-2009/paul_samuelson.
6. Gretchen Morgenson and Don Van Natta Jr., “Paulson’s Calls to Goldman Tested Ethics,” New York Times, August 8, 2009, http://www.nytimes.com/2009/08/09/business/09paulson.html?_r=3&hpw.
7. Here is one tally of Goldman Sachs’s revolving door with the government: “A Revolving Door,” http://media.mcclatchydc.com/static/images/goldman/20091028_Jobs_GOLDMAN.pdf. See also Kate Kelly and Jon Hilsenrath, “New York Chairman’s Ties to Goldman Raise Questions,” Wall Street Journal, May 4, 2009, http://online.wsj.com/article/SB124139546243981801.html. And one look at the money flows from Wall Street to Washington is “Among Bailout Supporters, Wall St. Donations Ran High,” New York Times, September 30, 2008, http://dealbook.blogs.nytimes.com/2008/09/30/among-bailout-supporters-wall-st-donations-ran-high.