The first thing to understand is that financial crises are not new. They have been around since the beginning of time, and in their modern form, at least since the 1600s. They are built into human psychology and social psychology.
The current crisis, while mostly originating in the U.S., is truly global, and is not limited to one country. Financial crises tend to happen every 10 years, and each time, the reason is different (partly because it takes 10 years for people to forget about “the last one”, and start to buy into the “bubble psychology” again !). The basic hubris was the belief that “the economic rules don’t apply anymore” and that there is a “new economy” or new paradigm that cancels out economic reality. This time, it centered around the idea that housing prices would always rise, and could not fall (and that despite the fact that land, while limited, is not nearly as limited as the promoters of the housing bubble have claimed, because new housing is constantly being built on new land, cities just expand).
At the core of the financial crisis is the hubris surrounding the housing market. The psychology of the real estate bubble is the cause of the crisis. In the U.S., home ownership was over-promoted. Overly aggressive mortgage lenders conspired with buyers to create a bubble in housing prices. Borrowers bought into the notion of ever-increasing housing values, and were lax (to put it mildly). Rating agencies, Fannie Mae and Freddie Mac, all fueled the bubble.
Central banks flooded the markets with cash. After 9/11 and the invasion of Iraq, the central banks slashed interest rates, starting with the U.S. Federal Reserve and Alan Greenspan. This provided the “fuel” for the bubble. Alan Greenspan did not fear inflation, but rather, deflation after 9/11 and the dot.com crash. And he and other central bankers believed that Chinese manufacturing would soak up any inflationary tendency (it did), so they were not afraid to drastically cut interest rates, because they feared deflation, not inflation. Greenspan’s mistake was to think that housing was immune to bubbles.
Capital that had sought the highest returns in the dot.com stock market bubble of the 1990s, now (after the stock market “crash” in 2000) flowed into real estate, and began to create a bubble there.
American consumers bought Chinese (and other countries’) manufactured goods, and the money that paid for those imports to the U.S. went back to China as capital. Instead of investing that capital in Treasury bonds (T-bills), the Chinese now increasingly (as did others) invest in the real estate bubble.
At the same time, banks and other financial institutions created “securitized” (bundled) bonds backed by mortgages, including sub-prime mortgages. These securitized bonds were supposed to spread risk. But what they really did was fog who owned what, and where the real risk was. In effect, they magnified risk, rather than to minimize it. Fannie Mae and Freddie Mac backed sub-prime loans and thus freed up mortgage lenders to pursue even more mortgages. Standards in the banking and mortgage industry became extremely lax (to put it mildly) and borrowers did not even have to show that they were employed to get a sub-prime mortgage. Buyers lied about the real reason for buying a house, that they were using it to “flip”, and as a speculative investment.
The 1990s was a period of intense technological and financial innovation. Wall Street began to meet this with a blizzard of super-complex securities (“structured investment vehicles” [SIVs], etc. and securitized asset-backed bonds). Investors relied ever more on leverage (borrowing) to finance ever more investing (i.e., they went into debt to invest).
Global investors flush with cash from the rising oil price and exports to the U.S. (China, the Arab Gulf States, Russia, etc.) flooded the U.S. housing market with capital. This resulted in mortgage rates dropping, because there was so much capital available. China gained entry into the World Trade Organization in 2001, which led to a massive expansion of Chinese manufacturing and an integration of China into the world economy. Flush with cash from exporting to America, the Chinese got into the real estate bubble.
There was a sea of worldwide liquidity created by rising oil prices, slashed interest rates, and exports to the U.S.. This global cash surplus sought, as it always does, the highest returns, which at that time were to be found in “securitized” bonds, backed by the U.S. government (Fannie Mae) and packaged into new complex securities on Wall Street.
Mortgage originators (those initially lending to people to buy a home) no longer cared about the risk of default. Wall Street did not think much (or care much) about the risks being bundled into securitized assets. And the people in foreign countries buying the new-fangled securities also did not think about how much risk was built into them. Risk was spreading throughout the system, worldwide.
The U.S. government aggressively pushed home ownership as a kind of economic ideology. The government also pressured banks to loan to sub-prime borrowers. The sub-prime crisis was particularly centered in California and Florida, where there were the highest number of sub-prime borrowers (Wisconsin had the least, by the way).
At some point in 2007, people began to question the value of the securities floating around the world, and the real price of them. As in all bubbles that burst, this led to asset prices falling fast. The doubt as to the real price of the assets and securities grew and grew and a panic began as people began to see their assets fall. This is classic social psychology or mass psychology in which people are “infected” by the emotions of others. Suddenly, houses that cost $ 450,000 in San Diego were falling in price and were now only worth $ 300,000 (note: for the first time, people who could not afford a house, now could, so falling prices are not all bad !). This led to a domino effect worldwide.
Banks began to throttle back their buying of assets as they saw their prices fall. The money markets (where billions are loaned and bought overnight in order to keep the “wheels” of the worldwide economy going, and that are based on trust) began to freeze up. At this point, a worldwide meltdown of credit was feared, with people “hoarding their cash”, and banks massively scaling back their lending and borrowing.
At this point, the government stepped in and began a bailout.
The next bubble and crisis probably will hit 10 years from now. All the lessons will most likely again be forgotten and people will maybe talk about a “new paradigm” in which the laws of economics no longer apply. The next crisis will most likely not be related to housing, but probably will be related to the governmental debt now being taken on to bail out the current mess (which will increase interest rates, by the way).
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