The Magical Market Savings theory only made sense as a national strategy if asset prices moved in just one direction. Here, too, the elites provided justification. In February 2005, David Lereah, chief economist of the National Association of Realtors, published Are You Missing the Real Estate Boom?: The Boom Will Not Bust and Why Property Values Will Continue To Climb Through the End of the Decade—and How To Profit From Them. Real estate, he argued, was now in the midst of a permanent boom, fueled by demographics and changes in the marketing and financing of homes. In 2005, Robert Toll, CEO of McMansion giant Toll Bros., argued, cogently, that America stood on the precipice of a brave new world in which yuppies would devote half their incomes to mortgage payments.
Wall Street bought into the same mentality, adding a new twist. Wall Street CEOs had an unshakable faith in the ability of hot new technologies—securitization and derivatives—to control and spread risk. If any risk could be managed, then any risk could be assumed—no-money-down mortgages, payment-in-kind corporate bonds, covenant-lite loans, $50 billion private-equity buyouts of cyclical companies. Whatever. Technology—zippy computer models and credit agencies—could gauge the riskiness and value of the new types of securities and derivatives. Since the firms could quantify precisely how much they could lose if things went wrong, there was little need to maintain large reserves. VAR—value at risk, the amount of money firms had at risk on any given day—became a staple of quarterly and annual reports. Lehman Bros. assured investors in 2006 that the firm, which had hundreds of billions of dollars in mostly short-term debt outstanding, could lose no more than $42 million in an off day. Whoops!
In 2007 and 2008, each of the pillars of Dumb Money began to crumble. The rules of physics still applied to finance. Interest rates, it turned out, could rise. Asset prices could, indeed, fall. Borrowers, having seen no income growth in a decade, fell behind on their debts. All of which helped cause the markets for securitizing debt and derivatives to break down.
There's a lot more to the story, of course: the rapid rise and slow-motion humbling of the hedge fund community, the smartest of the smart money; the absurd deals pulled off by private-equity titans, who, egos swollen with cheap money, fancied themselves experts on all sorts of industries, ranging from newspapers to cars; the feckless regulators; the botched rescue plans; Wall Street's continuing, inexplicable arrogance in the face of massive failure; and the refusal of those who started the fire to take any responsibility for the inferno.
Last October, when Alan Greenspan appeared before Congress, he offered something of a mea culpa. Greenspan had been the chief proselytizer for the holy trinity of the Dumb Money creed: low interest rates, deregulated markets, and the ability of financial innovation to insulate markets from calamities. But Greenspan was experiencing a dark night of the soul. "I found a flaw," in the theories, he said. "I was shocked because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well." A flaw? The persistence of low interest rates, which, he assured us, made all the sense in the world, sparked a speculative orgy in securities and derivatives. These instruments, he had assured us, would help people manage risk; instead, they created systemic risk. And deregulated, free and open markets had gone so haywire they required massive government intervention. In short, pretty much everything Greenspan said about how this system was supposed to work turned out to be wrong. And yet he's still around, offering cures to treat the disease he failed to diagnose. Maybe the Era of Dumb Money isn't over just yet.
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Smash and Grab
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