Reading this book will help you understand how the housing crash happened and make intelligent judgments about our government’s policy responses to the Great Recession.
Finance is dry stuff and most people hate reading about it, but this book has a lot going for it. Most importantly, it’s easy to read. Written in simple layman’s language, it’s only 192 pages, and is divided into short sections of a few paragraphs each. It’s up to date, with a publication date of May 2014, which means it was written in 2013. The authors aren’t famous Nobel laureates (yet), but they have impressive credentials: One is a professor of economics at Princeton, the other a professor of finance at the University of Chicago. And it bears the imprint of a reputable publishing house: University of Chicago Press.
I won’t keep you in suspense about who we should blame: The bankers. It’s just as you suspected; this debacle was their fault.
Conservatives with a political agenda, namely letting people like them rob people like you, will dispute this. They’ve strived mightily to blame the mortgage meltdown that triggered the worst economic disaster since the Great Depression on ordinary people who dreamed of owning a nice home. You see, they weren’t supposed to bite on the loans dangled before them by crooked lenders who not only knew the borrowers couldn’t afford the payments but contrived ingenious loan products (such as interest-only mortgages) to make it appear they could.
They preach about “individual responsibility,” which makes a compelling sound bite, but this rationale falls apart under the barest scrutiny. We live a world so complex most of us can master only one tiny set of its nuances, usually the one we’re paid to know more about than our clients and customers do. The banker, not his customer, is responsible for figuring out whether the customer can afford the loan. That’s what bankers are paid to do. When bankers put customers into loans they know shouldn’t be approved, with the intent of selling the inevitable losses to unsuspecting investors, that’s fraud. And when the entire banking industry does it, and Wall Street joins in by knowingly selling high-risk loans as triple-A rated securities, it’s systemic fraud.
It’s an idea the financial crisis blew out of the water. Trying to shift responsibility to the victims of the fraud is itself fraudulent. Fundamentally, conservatives want you to believe that when banks bundle high-risk mortgages into packages they call “tranches,” and ratings agencies like Moody’s and Standard and Poor’s give these things triple-A ratings, the investors who buy them are supposed to figure out the bankers and ratings agencies are defrauding them and these “mortgage backed securities” aren’t worth the paper they’re written on. Please.
This book clearly explains this. A “neglected risk” is a weakness in a security that could cause an investor to lose his money, which the banker knows exists, but the investor overlooks. The banker knows exactly what he’s doing when he sells that security to the investor:
“The key insight is that bankers will create securities that are vulnerable only to these neglected risks. In other words, the securities sold to investors will load heavily on the neglected risk itself. For example, if investors convince themselves that house prices throughout the country cannot fall by 10 percent or more, then bankers will create securities that retain their value in every scenario except when house prices throughout the country fall by 10 percent or more. Because these securities look riskless to investors, they will be produced in abundance. …
“What is the best kind of security to sell to investors who neglect certain risks? Debt. Debt has the unique feature that it convinces investors they will be paid back in almost every future scenario. An investor buying debt believes what they are holding is safe, independent of the underlying asset they are financing. The financial sector convinces investors that they are holding ‘super-safe’ debt even in the clear presence of an asset bubble. … Debt instruments lead investors to focus on a very small part of the potential set of outcomes. As a result, they tend to ignore relevant information; they may even miss blatant fraud.” (pp. 114-115)
That’s exactly what happened when all those subprime mortgages went bad, and it was a banker’s dream come true. Make no mistake about it, the housing disaster was intentional, the bankers and Wall Street financiers knew exactly what they were doing, and it worked exactly the way it was supposed to: They made huge profits and didn’t have to disgorge them when the house of cards collapsed. The general public got stuck with the bill. And the general public is totally justified in feeling madder’n hell at the banks and financiers, none of whom went to jail (because they’re the people who pay for political campaigns, which unsurprisingly buys them “Get Out Of Jail Free” cards).
Here’s another factor that blows the conservative “individual responsibility” argument out of the water: Those subprime borrowers didn’t go to the banks, the bankers came to them. More precisely, the bankers hired people to go into poor neighborhoods, knock on doors, and offer people what looked a lot like free money. It wasn’t just the elderly who lost their homes; some pretty smart and well educated people, including middle-aged professionals, got caught up in this too. That doesn’t prove how stupid people are; it shows how clever and sophisticated the con was.
This book does a lot more. It also explains why the mortgage crisis morphed into a general economic disaster. Basically, consumer spending collapsed under the weight of unpayable debts, and the depressing effect of debt on consumer spending hit hardest in the lower income and net worth brackets. The leveraging nature of debt also multiplied these effects. It’s a shame these individuals and corporations didn’t have a substantial group of options to choose from with their mortgages, such as wholesale mortgage where loans can be reasonably paid back in relative time.
One of the great ideological clashes of our time is supply side vs. demand side doctrines. The main “schools” of economic thought split along these lines (e.g., Austrians vs. Keynesians), as do policy preferences (austerity vs. stimulus) and political philosophies (conservative vs. liberal). While it begins as competing economic theories, it spills over into politics and public policies. Both sides agree on a struggling economy’s need for increased aggregate demand, but differ over how to achieve it.
Supply siders argue that stimulating investment creates demand, i.e., if you build a factory, people will buy its products. This is a very powerful argument because it says, “If you want jobs, you must encourage investment” with concessions to investors. This argument has won considerable traction in U.S. politics and explains, for example, why capital gains and dividends are taxed at a much lower rate than workers’ wages.
Demand siders, on the other hand, argue that demand must exist before investment will occur, i.e., customers wanting products have to come before building a factory to make the products, thus consumers not investors should be the target of stimulus efforts. The demand side argument says giving tax breaks to businesses and investors will not create jobs in a demand-starved economy, and argues for government deficit spending (the Keynesian solution) to overcome recessions.
This book takes sides, and sharply refutes the supply side argument, as does evidence I see from other sources. These authors argue the debt burden imposed on consumers during the credit binge that preceded the Great Recession led to contraction of demand, and the economy now needs demand-oriented remedies rather than supply-side remedies. This is of enormous importance in terms of policy choices, and I agree with the authors on this point. Fortunately, after the economy went into crisis, U.S. voters opted for leaders who generally favored demand-side policies, and I believe most of the policy choices made in the aftermath of the financial crisis were the right ones. But I also believe we had a very close call and barely missed living through another Great Depression reminiscent of the 1930s. Conservative policy choices might well have taken us there.
I can’t write an article capable of serving as a substitute for reading the book. You really need to read the book to get all the material in it. At 192 pages, it isn’t very long, and it’s fast reading; it’s not a book you’ll have to wade through. Reading it goes quickly. There’s a tremendous amount of stuff written on this topic and nobody could read it all in one lifetime. A fair amount of it is useless or worse, in terms of contributing to your knowledge and understanding. I read a lot of stuff about economics, and I think this book is sound, and worth your time.
So far, I’ve been discussing macroeconomics, i.e. economics on a societal scale, because that’s what this book discusses. Shifting gears for a moment to personal finance, I have strong feelings about debt and think that anyone should seek debt relief support if they need to by visiting National Debt Relief agencies, but I’ll be brief, as I don’t want to turn this article into a sermon on that subject. When I was young, I was constantly in debt, and hated it. Consequently, I devoted my adult life to getting out of debt someday. That day came in December 2008 when I made my final mortgage payment; and since then, I haven’t owed a penny to anyone. I’ll never go back to being in debt, if I can possibly help it. Debt is your worst enemy.
This book also makes that clear. Spain’s horrible mortgage system provides the perfect laboratory for testing what debt is capable of doing to individuals, economies, and nations:
“[I]n Spain a law from 1909 stipulated that most Spanish home owners remain responsible for mortgage payments even after handing over the keys to the bank. If a Spaniard was evicted from his home because he missed his mortgage payments, he could not discharge his mortgage debt in bankruptcy. He was still liable for the entire principal. Further, accrued penalties and the liabilities followed him for the rest of his life. … As a result of these laws, mortgage-debt burdens continued to squeeze Spanish households even after they were forced out of their homes.” (pp. 119-120)
Sounds a lot like our student loan system, doesn’t it? The result is Spain’s economy is in the worst shape of any economy in Europe. They have 25% unemployment, on a par with the worst months of the Great Depression. In America, student loan debt is preventing young people from buying homes, starting families, and becoming consumers. In short, it’s a drag on the economy. But conservatives argue that all debts must be repaid, no matter what, no exceptions. That’s false, too. Their argument against student debt relief boils down to a “moral” contention that debts ought to be repaid because it’s immoral to borrow money and not repay it. (Let’s not get bogged down here in the immorality of predatory and reckless lending that crashes the entire economy. The hypocrisy of the conservative position on student debt is so self-evident we don’t need to dwell on it.) What’s moral about a social policy that makes a sick economy sicker? It’s like making a sick child swallow radiator fluid.
Student debt, though, isn’t the problem that bank-created mortgage fraud was. Here, let’s look at the Big Picture: Total U.S. debt is something like $54 trillion, roughly evenly dividend between households, business, and government. (Government is actually a bit less if you take out the portion of debt the government owes to itself.) The U.S. economy is two-thirds consumer spending driven, so the ability of households to spend is what matters to the economy’s health more than anything else. When consumer spending dries up, so do jobs, and that’s why the squeeze that subprime mortgages put on consumer spending led to the Great Recession.
When you look at total household debt, about 80% of it is mortgage debt. Student loans and credits cards are each about 6% to 8% of household debt. This is why credit cards or student loans can’t create a financial crisis on the scale that mortgage debt did — there simply isn’t enough of those kinds of debt to have such a big impact, even if all of it went bad for some reason. This, by the way, also refutes the argument that student loan relief — especially the very modest relief being proposed by Senator Warren and others — would cause another 2007-2008-scale financial crisis. That’s also false. In reality, student debt reform is one of the things our political system needs to do if we want our economy to get healthier.
I’m not saying all debt is bad, or you should never use credit, even constructively. Most of us have to borrow at times in our lives. I took out student loans, a car loan when I was offered a job that required a car, and eventually a mortgage when I started a family. I repaid all of these loans in a timely manner which is the only proof needed of responsible borrowing. This book doesn’t condemn sensible and productive borrowing. It makes clear the financial crisis and Great Recession were caused by reckless lending practices.
I really feel I could just keep going on and on with this book review, because there’s so much interesting stuff — yes, interesting! — to talk about, and so much more ground that could be covered. But I’ll stop here. Just read the book. Maybe I’ll post an article sometime about achieving and living a debt-free lifestyle, but I’m not going to do that here.