It’s common knowledge that greed on Wall Street is the cause of the 2008 Recession. Both Republicans and Democrats will confirm this when pressed. All of my economically-savvy friends will echo this sentiment and recommend that the government regulate to remove these deleterious excesses of capitalism.
In the 1990’s banks began to expand their mortgage business and started lending to individuals with poor credit and potentially insufficient income to cover their mortgage payments in the long term. Banks offset this poor business practice by bundling mortgages together and selling them as mortgage bonds and mortgage-backed securities, mitigating the risk for the bank and so if one or two mortgages failed, the 1000 other mortgages in the bond would offset those losses.
Given that mortgages are generally a secure investment these products attracted pension fund managers. Given that it’s important to not lose someone’s pension money, the investors, the fund managers would buy insurance on these bonds. What happens if the payments stop, or the credit defaults? They can then offload that risk onto an insurance company in the form of a credit default swap – a derivative product of a mortgage.
On top of mortgage-backed securities, Wall Street began to collect debt and package it into a single instrument: the CDO. Investors could choose what level of risk they wished to invest in, and since it was a collection of various debt instruments it was considered diversified.
Not only was debt collected as an investment vehicle, the insurance on the debt (the credit default swaps) were also collected into an investment vehicle called the Synthetic CDO.
Somewhat horrifyingly, it was possible to go deeply into debt to invest in CDOs and Synthetic CDOs. It was possible to go into debt and then insure that debt. Thus there was an enormous financial bubble on top of the housing bubble.
There was an entire phantom economy based on the mortgage industry, which was itself in a major bubble. If the mortgage bonds failed, the insurers had to cover those losses and the bubble would burst. When houses began to foreclose, this increased the supply of houses for sale, and via the laws of supply and demand, this decreased the price of houses.
The value of the mortgage bonds was nothing near what pension funds had initially paid for them. Calling for the insurers to step in didn’t help because they didn’t have assets as they were based on debt. Quite rapidly, the phantom economy collapsed.
The question then becomes: What caused the housing bubble? I seldom hear it mentioned by the late night comedians, Hollywood depictions of the collapse, or politicians preaching their ideology.
The housing bubble was itself caused the Community Reinvestment Act – a U.S. Federal law that encouraged subprime lending. This artificially increased the demand for houses (creating a demand among low-income individuals), which artificially increased the price of houses giving us the housing bubble.
Whenever the pundits explain the problem as derivative trading rather than governmental intervention it’s akin to asking where water comes from on this planet and receiving the answer that water is caused by two hydrogen molecules coming together. This is materially what water is but it doesn’t answer the historical question of where water originally comes from. When a statist tells us that Wall Street derivative trading caused the collapse they’re only telling us materially what it was, they aren’t telling us what caused it.
It was caused by government intervention, under a flawed ideal that everyone should be a homeowner. The U.S. government specifically pressured Fannie Mae into the subprime market during the 1990s and as a result financial instruments arose in response to the insanity and the underwhelming economic expertise of the U.S. government. There are serious consequences to economic nescience.
2008 didn’t serve to call us toward regulation against the deleterious excess of capitalism, and we must be vigilant against the dangerous excess of governance.
Featured image: CNN.com
Brandon Kirby
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