So...How Did We Get Here?

Housing wise, it's been a good four years. Let's review:

• Housing prices are down about 25% where we used to live, more so in less fortunate parts of the country.
• The economy is on its ass, with high unemployment and poor growth.
• Interest rates for consumers are very low - if you have money in the bank, you're not getting much for it.
• Credit for businesses is hard to get, see also poor growth.
• The Federal Bailout Agency^H^H^H^H^H^H^H^H^H^HFederal Government has spent all kinds of money on the crisis* so when we come out of all of this, our national total national debt is going to look at lot more like Italy's than it used to.

You might ask yourself: how did I get here?

Let's trace backward. The problems we have today come from two sources:

1. The results of a housing bubble. The housing bubble represents a massive mis-allocation of resources. Simply put, we spent the Bush years (I don't want to call them the "oughts") building houses we didn't need; this hasn't set us up for future growth, rather it was squandered investment.
2. The bursting of a credit bubble. There's a lot less credit than their used to be, which makes it hard to invest in new growth.

These bubbles are actually interlinked; since most people finance their houses, house prices are tied to housing credit (that is, cheap mortgages). So really we had a mortgage bubble that is now hitting us twice: it hurt our real economy by misdirecting investment into houses, and it hurt our banking system by creating a lot of bad debt.

How did we end up with a mortgage bubble? The answer to that is: financial alchemy.

Simply put: Wall Street banks discovered that they could turn lead (sub-prime mortgages and other low quality debt) into gold (AAA-rated CDOs) because the credit rating process wasn't very good. Banks could stuff their securities with "thin file" borrowers (borrowers with a good credit score but short credit history) and low-score borrowers and the average was good enough for the pool to be acceptable.

Wall Street made money on these transactions from the difference in the cost of raw materials (crappy mortgages) and the price of the finished product (high-grade AAA debt). This explains the strong pressures for lower lending standards: the worse your mortgage, the less the bank has to pay to buy it; if they can still manage to turn it into a CDO, they make more money by lowering their cost of supplies.

You can think of this as painting lead bars in gold paint because the gold inspector only looks at the bars, rather than testing them more carefully. Get the cheapest lead you can to make the most money when you resell your fools-gold.

The banks building these CDOs would have done quite well by this strategy except for one problem: they kept their own defective product. In trying to answer the question: were they malicious or were they incompetent, this pushes me to suspect gross incompetence; if you know you are making a truly defective product, the last thing you want to do is keep it. If nothing else, I think the CDO losses being eaten by the major banks indicate that they didn't realize the scope of the mess they were making.**

So to summarize: Wall Street discovered they could make money by financial alchemy, and the raw material was housing debt; this demand for housing debt as raw material drove down the cost of financing and thus drove up the price of houses, which caused a building boom. (You gotta love how commodities markets react to prices.) When the whole thing fell apart, we're left with too many houses, too much bad debt, and not a whole lot of money. Not a whole lot of money unless, of course, you received bonus payments for creating CDOs.

* I am very critical of the Fed and Treasury's handling of the crisis, which I think has created moral hazard and burned fiscal and monetary resources without either fixing real problems for "main street" or addressing any kind of long term problems. This approach has been consistent under both Bush and Obama.

** This doesn't make their actions even remotely acceptable; but I think the issue is important when we consider how to prevent this from happening next time. Regulations to stop "bad guys" aren't going to help; we need regulations that stop the amount of damage that can be done by "dumb guys who have our money".