business owners to expand and consumers to spend recklessly. Unfortunately, it also lures the unskilled and unknowledgeable into the game as well. The prospect of easy money makes people and institutions take chances on things they clearly don’t understand.
Our economic disaster started out back in 1994 like a scene from a stereotypical Hollywood movie about greedy bankers. In 1994, a team of JP Morgan bankers was having what they call one of their “Off-Site Weekends.” Typically these are yacht parties, with bikini models, and $1,000 bottles of Cristal; and this trip wasn’t much different at the Boca Raton Resort & Club in Florida. The difference was, as they were holed up for most of the weekend in a conference room at the pink, Spanish-style resort, these JPMorgan bankers were brainstorming how to free up their capital reserves and still be able to lend tens of billions of dollars while skirting the current banking regulations. By the mid 1990s, JPMorgan’s books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. They pondered how they could create a device that would protect them if those loans defaulted, and free up that capital at the same time so they could lend even more – Greed!
What those hard partying bankers came up with was a sort of insurance policy where a third party would assume the risk of the debt going bad, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a “credit default swap,” and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.
The difference between this new concept and what bankers had done in the past was, JPMorgan hired young math and science grads from schools like MIT and Cambridge to create a new market for these complex instruments. In 1997, the credit default swap (CDS) was launched and quickly became the hot financial instrument, and the “safest” way to mitigate risk while maintaining a steady return. There are very few people on the planet that can tell you exactly how a CDS works, yet they were being gobbled up like hot cakes by foreign nations, major US corporations, hedge funds, pension funds and anyone with big money looking for an easy return. By 2007 it is estimated that the CDS market grew to more than $45 trillion – Greed!
When the economy took a downturn and many of the loans that the CDS’s were created to cover went bad, the banks didn’t have the cash reserves to cover them and it started the domino effect of failing financial institutions. AIG became the best known casualty to CDS’s having to be bailed out by US tax dollars after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and dozens of other entities.
The Real Estate Bubble and Crash
The real estate bubble and inevitable crash was fueled by several factors that in retrospect should have been crystal clear. However, greed is a blinding force that allows people to ignore the obvious.
What set the stage for the real estate boom seems so disconnected that most people don’t have a clue about how powerful the effect was. The end of the cold war and fall of communism created hundreds of millions of new capitalists in Eastern Europe and Russia, and billions of Chinese whose own economic revolution was already underway, became productive workers and active savers. They poured their savings into global capital markets. Government defense budgets shrank as the cold war ended which opened up much more available capital. The global savings glut caused a sea of capital to flow into financial institutions that needed to be lent to someone (that’s how banks make their money). Much of the new capital ended up in the United States where its effects were multiplied in new securitization vehicles invented such as mortgage backed securities.
Once an abundance of money was readily available to be lent, President George W. Bush single handedly lit the fire that caused the incredibly rapid climb and equally as rapid crash and burn in the real estate market with his desire to keep his campaign promise of expanding home ownership, especially amongst lower income families and minorities. In June 2002, he unveiled his plan called “Renewing the Dream,” which would give nearly $2.4 billion in tax credits over the next five years to investors and builders who developed affordable single-family housing in distressed areas. Along with this, he created the “American Dream” down payment initiative, which provided down payment assistance to approximately 40,000 low-income families.
President G. W. Bush also issued America’s home ownership challenge to the real estate and mortgage finance industries to encourage them to join the effort to close the gap that exists between the home ownership rates of minorities and non-minorities. Banks were all too happy to expand their market into this new untapped area. This was given incentive with the advent of fractional reserve lending which suddenly allowed banks to lend 10 to 30 times their reserves. The Federal Reserve fell right in line and dramatically lowered interest rates making money less expensive to borrow. The stage was set for disaster.
New buyers flooded the market, now able to get down payment assistance and an inexpensive loan. This sudden demand drove up the prices of properties on the market. Financial institutions responded by creating new loan packages to accommodate the higher prices – 100% financing became the norm. This unfortunately drove prices even higher since it allowed even more buyers in the game as supply diminished. As expected, lenders responded and came up with 106% financing (6% to cover closing costs). Prices continued to climb even higher following the most basic tenant of a free market economy – supply and demand.
Homeowners saw the equity in their homes skyrocket to obscene amounts (in some cases 500%). Homeowners began to pull that equity from their properties refinancing as much as every three to six months. In 2005, homeowners extracted $750 billion of equity from their homes (up from $106 billion in 1996), spending 2/3 of it on personal consumption, home improvements, and credit card debt.
Lenders excited about the money pouring in would lend to almost anyone that “stated” they had money, and a decent credit score, which quickly exhausted the market of qualified borrowers. When the banks ran out of creditworthy borrowers, they had to turn to sub-prime (less qualified) borrowers; and to avoid losses from default, they moved these risky mortgages off their books by bundling them into securities and selling them to investors. To induce investors to buy, these securities they were then insured with credit default swaps.
They also enticed greedy buyers with low teaser interest rates on adjustable rate mortgages (ARMs) offering as little as 2% fixed for the first two years and 28 years adjustable based upon the prime rate. With greed blinding the consumers into thinking the market would continue to grow and they would be able to quickly refinance out of these loans, these poor financing terms were readily accepted.
The growth was simply unsustainable. Some of the cities that had experienced the fastest growth during 2000–2005 began to experience high foreclosure rates as those adjustable rate mortgages adjusted. The sub-prime market fell first followed shortly after by the mainstream market. As refinancing suddenly ground to a halt, the economy saw a sudden loss of the consumption that had been driven by the withdrawal of mortgage equity. As an inevitable result, real estate related industries began to crumble, and consumer retail markets saw an instant drop in sales revenue as well.
The massive defaults on mortgages caused insurers not to be able to cover CDS defaults. Banks and business failures occurred in a dramatic fashion. The credit card industry quickly followed behind the real estate industry and the rest is history – The Great Recession 2007!
Historically, during a recession consumers, financiers, and investors tend to react to the contracting economy by freezing activity and hoarding money. When banks begin to experience high numbers of defaults on business loans, credit lines and mortgages they rapidly restrict lending. Since the life blood of our economy is the banking system that finances business expansion, real estate purchases and major consumer spending,
