More Financial Editorializing of the TL;DR Variety

It's been the lead story for weeks, if not months, sometimes knocking the presidential election off the top of the fold. Recently, someone asked, "wasn't it poorly conceived legislation which lead to this whole subprime snafu? What bit(s) of policy exactly was that?" The roots go way deep, but here's one way of looking at it:

First, America has been spending more money than it takes in for a long time, and has been buying more goods from abroad than it sells. In concert, these two facts mean that other countries have been trading the dollars they get for their goods from us for IOUs from our government, as well as other investments, stocks, bonds, what have you. They have a lot of money to invest, and America despite its faults has had a lovely and vibrant market for investing in, with unequalled liquidity and transparency and fairly low overhead. Unlike in America, the burgeoning middle classes of eastern and southern Asia have been socking their money away, and their banks have been searching for ways to put it to good use, and one of the biggest ways has been to invest in American securities, bidding their prices up and their interest rates down. So, we've been awash in cheap capital looking for an outlet.

Second, the explicit policy of American government for the past couple of decades has been to expand homeownership and participation in the securities markets. That was part of the rationale for Fannie Mae and Freddy Mac, and for the rise of the IRA and the 401k plan. Ever more people invested in their homes and in the stock market would lead to greater social stability and community participation, or so went the theory. All of that capital available to lend and government policies toward expanding homeownership led to the gradual decline in the amount of equity required to purchase a house, until for a while it actually could be negative. This flood of money into housing inflated prices, making real estate look like an even better investment. And as prices rose, people refinanced and took out some of their equity and spent it, heating up the economy and the stock markets some more.

Third, we saw the rise of relatively unregulated mortgage companies after the contraction of the thrifts in the last real estate bubble bust twenty years ago. These companies would take investor capital and sell mortgages to people with gradually more lax qualifications as they tried to expand their markets. Then they'd turn around the mortgages and sell them off to Fannie Mae and Freddy Mac, and increasingly, to investment banks. The mortgage companies would then lend the money out again, and the cycle would repeat, keeping the housing market on an expanding tear.

Fourth, the loosely-regulated investment banks would take their piles of mortgages and slice and dice them into new synthetic securities with various aspects that they could sell, chief among them some especially enticing bits that looked like a AAA-rated bond. It was the new fashion craze, everybody had to have some - as long as they could also get some insurance to go with them, to cover their butts if the securities went into default. And where there's demand, someone will supply, in the form of investment bankers and insurance companies willing to take your money in return for a guarantee that they'd relieve you of your defaulted bond at its pre-default value. Best of all, the insurance wasn't called insurance, and it fell outside the regulatory eyes of both insurance commisioners and the SEC. Hooray! Let's buy more!

Fifth, we found the investment bankers were leveraged to their eyeballs, imprudent bankers and insurers had been selling bond insurance to people who didn't even own the bonds, and people were buying houses who had no business doing so even when times were good, with sub-prime mortgages that featured teaser rates and interest-only payments that were guaranteed to get more expensive later. The last sucker was in on the deal.

Then the housing bubble popped, and people started getting in trouble with their mortgages. The investors who were holding the synthetic bonds made out of those mortgages started feeling the hurt, too, and they started a dash for the exits. The insurers of those bonds discovered that insurance only works with risks that are localized, not with risks that can affect everyone at once. With every passing month the revelations about just how big the house of cards the mortgage-derived securities had been holding up got wider, and the worse the holders of those securities were taking it in the shorts. When the market in them finally ground to a bloody halt, holders were in terrible shape, because of accounting rules that forced the securities to be valued on the books at whatever they had last sold for. That meant that the assets of many financial companies that held these now toxic securities were worth less than their obligations, a condition commonly referred to as bankruptcy. Lenders started sitting on their cash, rather than risk handing it over to some firm that might be bankrupted and seized by the government, even if the possibility was remote. Some colossal failures and equally dramatic rescues truly put the fear into people, and the mattress-stuffing began in earnest. We're watching it play out right now.

So, there's policy blame a-plenty to go 'round, but it isn't necessarily the right (or should I say wrong) policies that are getting the bad press. It's policies that have every liberal sentiment going for them that are at least partly responsible for the mess. We want to encourage investment, we want to expand home ownership in the name of community and wealth building, we want to shop the world for the best deals for consumers, and we want to spend now and pay later. We like businesses to have minimal regulation, because it lowers costs and encourages innovation in products and services. We don't like paying taxes. We're all free to take a flyer on any expanding market bubble that comes along. Blaming deregulation for our woes is missing at least ninety percent of the story. Only a couple of clear cases of deregulation, expanding the leverage investment banks can use and ending some of the Glass-Steagal restrictions, have played a real role, and these were not root causes of the situation, just multipliers.

So, how do we fix it? Trillion dollar band-aids? In some ways we've got a crisis in confidence, and that confidence is shaken at least as much as it's reassured by the size of the measures being taken. And I trust the legislatures to deal with the underlying issues appropriately about as much as I trust them to do theoretical physics. I'd rather not think about how my net worth has gone down over the last year, or worse, my retired relatives' net worth. Over the long run, I remain optimistic. I'm still maxing out my retirement funding, directing it into various domestic and foreign index funds; someday this will probably be considered an excellent time to buy. I just wish I felt better about it.