On Jan. 27 the Financial Crisis Inquiry Commission completed its work with the issuance of a 633-page report. It actually made for pretty great reading. Among my favorite parts is former Citigroup CEO Chuck Prince telling the commission that "I did not know" about the stupendous amounts Citi lent to companies that originated mortgages—which at any one time totaled as much as $7 billion—until "the end of my tenure," and that he wouldn't have approved the loans if he had. Another jewel is former Bear Stearns CEO Jimmy Cayne saying that the rating agencies' downgrade of Bear's debt was "like having a beautiful child and they have a disease of some sort that you never expect to happen."
Evidence of CEO stupidity aside, what most struck me was this statistic: From 1978 to 2007, the amount of debt held by the financial sector increased twelvefold, from $3 trillion to $36 trillion. Maybe underneath all the idiocy, deception and delusion, and all the complexity of financial instruments like mortgage-backed securities and collateralized debt obligations—maybe under all that, the real lesson of the financial crisis is really quite simple: Steeply rising debt isn't healthy for people, and it isn't healthy for banks.
The end of the housing market's era of financial sobriety came, by one plausible reckoning, with passage of the Tax Reform Act of 1986. That much-praised legislation ended the tax deductibility of interest on credit cards and other consumer debt but left in place the mortgage interest deduction. It probably isn't a coincidence that around that time the financial industry began to aggressively market home equity loans and cash-out refinancings (which entailed increasing the amount of your mortgage so that you could put the extra cash in your pocket). A typical ad slogan was this one, courtesy of Citibank: "Now, when the value of your home goes up, you can take credit for it." A year after the 2008 bust, I was driving down a Chicago street littered with abandoned buildings when I saw, affixed to one broken window, a tattered Chase banner. It said: "Let your home take you on vacation." It was a Walker Evans landscape transported seven decades into the future.
The numbers in the commission's report chart the surge in housing-related debt: "By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996." Of course, all of this came at a cost: "Overall mortgage indebtedness in the United States climbed from $5.3 trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years from 2001 to 2007—more than 63%, or from $91,500 to $149,500—as it had over the course of the country's more than 200 year history." This was during a period when overall wages were stagnant. To cut the figures a different way, as the commission helpfully does: Household debt rose from 80 percent of disposable personal income in 1993 to almost 130 percent by mid-2006. More than three-quarters of this increase was mortgage debt. Did all this debt hurt economic growth? On the contrary, it supplied it: "[B]etween 1998 and 2005, increased consumer spending accounted for between 67% and 168% of GDP growth in any given year. …"
The financial industry didn't just aid and abet this buildup of debt. It got caught up in the easy-money mania too. Indeed, it did the rest of us one better by not only taking on debt but actively lobbying to weaken the rules so that it could do so. The commission notes that by 2007 the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Bros., Merrill Lynch, and Morgan Stanley—were "operating with extremely thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning that for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm." Commercial banks were no better. The commission reports that Citigroup's leverage increased from 18-to-1 in 2000 to 32-to-1 by the end of 2007. If Citi had been forced to consolidate various debts that it had moved off its balance sheet, its leverage in 2007 would have been a stunning 48-to-1.
As the commission also reports, "the kings of leverage" were the government-sponsored entities, Fannie and Freddie. By the end of 2007, they either owned or guaranteed $5.3 trillion of mortgage related assets, against which they held just $70.7 billion of capital, for a leverage ratio of 75 to 1.
There are two ways to make debt overload even riskier. One is to make it short-term (thereby allowing the lender to demand abrupt repayment). The other is to use risky, hard-to-sell assets as collateral (which may leave you no way to pay if the lender starts to worry about the value of the collateral and demands cash payment). Wall Street, in its wisdom, did both. The commission notes that Bear Stearns, by the end of 2007, had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing between $50 billion and $70 billion overnight in what's known as the repo market, where a firm uses securities it owns as collateral for a loan. Does it surprise you that Bear had no clue about the risk it was taking? According to the commission, Robert Upton, who was Bear's treasurer, said that until the week Bear was sold to JPMorgan he never worried about the disappearance of repo lending.
As for Lehman, the commission reports that by the end of 2007 Lehman had amassed $111 billion in commercial and residential real estate holdings—almost twice what it held just two years before and more than four times its total equity. Lehman used debt to acquire this pile of assets, and these real estate holdings were illiquid, meaning that unlike, say, a share of IBM, Lehman couldn't sell them at a moment's notice. This real estate turned out to be worth far less than it was valued at on Lehman's books, which is one of the reasons the government gives for not bailing out Lehman.
In 1978, financial companies borrowed $13 in the credit markets for every $100 borrowed by nonfinancial companies, the commission says. By 2007, financial companies were borrowing $51 for every $100. "We have a lot more debt than we used to have, which means we have a much bigger financial sector,' John Snow, the former railroad executive who served as treasury secretary from 2003 to 2006, told the commission. "I think we overdid finance versus the real economy and got it a little lopsided as a result." That's the understatement of the year.
For homeowners, the orgy of debt ended with an epidemic of bankruptcies and foreclosures. According to the report, nearly $11 trillion in household wealth has vanished, and as many as 13 million households in the United States may lose their homes to foreclosure. But for Wall Street—Lehman aside—everything worked out just fine, thanks to the government bailout. Within a year, average taxable bonuses were up 17 percent, to $123,850, and Wall Street profits reached a record $61 billion. When we talk about the importance of personal responsibility, it turns out we literally mean personal responsibility, because Wall Street banks don't seem to bear any.
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