The Bubble Next TimeRegulations that will stop us from acting crazy next time there's an irrational boom.
Posted Saturday, Feb. 28, 2009, at 7:42 AM ETThe following was adapted From Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation by Daniel Gross, published as an e-book by Simon & Schuster. (You can buy a digital version, for the Kindle or Sony Reader, or an audio version. Readers interested in receiving a PDF of the first chapter or learning about a paper version should send an e-mail to: dumbmoneybook@gmail.com.)
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StumbleUponWhen financial historians look back at the last six months, they'll be hard-pressed to explain precisely why our advanced financial system suffered such a catastrophic failure. So many of the developments—a $1.2 trillion subprime-mortgage market, a $62 trillion unregulated, nontransparent credit-default-swap market, $50 billion private-equity buyouts of cyclical companies, hedge funds going public—seem, on their face, to be irrational, silly nonstarters. And yet the players pulling off these deals were lionized as geniuses, as transformational business figures. They were the Smart Money. They turned out to be the Dumb Money. How did the crown jewel of American capitalism—our financial-services industry—transform into cubic zirconia? How did a nation shift seamlessly from the dot-com bubble into a more inclusive housing and credit bubble? And, most important, how can we stop it from happening again
There's plenty of blame to go around: poor regulation, eight years of a failed Republican economic philosophy, Wall Street-friendly Democrats who helped stymie reform, misguided bipartisan efforts to promote home ownership, Wall Street greed, corrupt CEOs, a botched rescue effort, painfully fallible central bankers. But while there was plenty of alleged criminal activity—ahem, Mr. Madoff—law-abiding, respectable citizens who were operating well within the confines of laws and regulations racked up the overwhelming majority of losses. Everybody—individuals, companies, institutions, and governments—got caught up in the stupidity.
Which is part of the problem. In the first decade of the 21st century we had a bubble, just as we did in the 1990s. The bubble was not just in housing. It was in debt, in speculation, in gambling. "At the center of this crisis was a bubble of risk-taking," said money manager Jeremy Grantham. And as was the case during the dot-com bubble, too many elements of our financial system and money culture were procyclical. Which is to say that built-in features of our economic operating system—government policy, private companies, the media, popular culture—functioned as accelerators rather than brakes. Once a hot money trend gets going, everybody wants in.
Government policies often play a role in kicking off bubbles. Congress commissioned the first telegraph line in the 1840s and made huge land grants to railroad builders. That was the case in the housing bubble, too. The cost of the mortgage interest deduction, which subsidized big loans (the more you borrowed, the more you could deduct) grew sharply as housing prices rose, from $55 billion in 2000 to $66 billion in 2003.
Fannie Mae and Freddie Mac similarly acted as amplifiers. Their loan limits were tied to average home prices. The more house prices rose, the more debt they would offer and insure. And the more they lent, the more prices rose. Between 2000 and 2004, the so-called conforming loan limit rose by nearly one third, from $252,700 to $333,700. (Lather. Rinse. Repeat.) The Federal Deposit Insurance Corporation stopped collecting insurance premiums when times were good, so long as its rainy-day fund amounted to 1.25 percent of insured deposits—no matter how much banks expanded their balance sheets. It's as if companies stopped selling flood insurance after three years without a hurricane, and shore residents started building really expensive high-rises instead of cottages.
For a few years there, thanks to the pervasive extension of cheap credit by the Federal Reserve and by global investors, there were no hurricanes. After the tiny Utah-based Bank of Ephraim went under in June 2004, 952 days passed without a bank failure, breaking the 609-day record from the mid-1940s. The lack of failure gave bankers an enormous amount of self-confidence. The financial system reversed Shakespeare's admonition. Everybody a borrower or a lender wanted to be. Established banks carpet-bombed downtowns with outlets. The number of new banks formed rose from 91 in 2002 to 178 in 2006. Between 2004 and 2007, 630 banks were started. Banks extended home-related credit to anyone who asked for it. And as default rates on corporate debt plummeted, huge investment banks like Citigroup and Merrill Lynch extended hundreds of billions of dollars in credit to private-equity firms for leveraged buyouts.
On Wall Street—and in the culture at large—those who embraced the mentality of the bubble with the most fervor were richly rewarded. In the 1990s, the investment bankers who brought in hot technology IPOs were the new Big Swinging Dicks. In the Dumb Money decade, the more you borrowed to make bets on stocks and bonds, the more capital—social and financial—you acquired. Like real-estate brokers who realized they could make more money flipping condos than collecting commissions, large investment banks decided they would rather be principals than mere agents. Executives who preached caution were ritually shunned.
During bubbles, the views of bulls are ratified, and so they get even bigger megaphones and more credibility. Meanwhile, the bears, doomsayers, and buzzkills who warned that the economy had too many eggs in one basket were marginalized. For much of the decade, David Lereah, chief economist at the National Association of Realtors, had the task of going on CNBC and crowing about rising home prices each month. In February 2005, Lereah published a book titled Are You Missing the Real Estate Boom? in which he argued that home values were now in the midst of a permanent boom, fueled by demographics and the changes in the marketing and financing of homes. Never mind the impressive recent increases. Homes now represented a "once-in-every-other-generation opportunity."
Consumers internalized Lereah's message. During bubbles, we always conclude that Something Fundamental Has Changed, and that the recent party is a mere prelude to even greater revels. The main symptom is a compulsive tendency to extrapolate results of recent fat years endlessly into the future. Just as people who came of financial age in the 1990s believed that stocks moved in only one direction, those who matured financially in the early part of this decade believed that interest rates and housing prices each moved in only one direction (down, and up, respectively). You could overpay for that five-bedroom Toll Brothers McMansion in Totowa, N.J., secure in the knowledge that you could 1) sell it rapidly at a higher price, or 2) refinance your way out of trouble at the drop of a hat.
Wall Street's aristocrats fell prey to the same blinkered procyclical thinking. Private-equity players borrowed to do ever-bigger deals. Dumb Money had elevated stock slingers and merchants of debts into Wise Men, new archetypes of success. Stephen Schwarzman, cofounder of the Blackstone Group, wanted to be seen as un homme sérieux, in the image of W. Averell Harriman; he acquired the trappings of a Rockefeller Republican—including an apartment on Park Avenue once owned by John D. Rockefeller Jr.
In the dangerous late stages of the bubble, financial engineers came to believe that because they had made a lot of money flipping assets with cheap credit, they could apply their genius to industries in which they had little expertise. In 2003, the brilliant hedge fund manager Edward Lampert acquired Kmart out of bankruptcy and used it as a platform to buy Sears in 2005, creating a 3,800-store behemoth that occupied a dubious place in the retail firmament. In February 2007, Sam Zell, the Chicago-based real estate investor, sold Equity Office Properties, a collection of high-end office buildings, to the Blackstone Group in a deal valued at about $38 billion. Zell decided that good timing in flipping real estate made him an expert on the ailing newspaper industry, so he spent $8.2 billion to acquire the Tribune Co., which owned the Los Angeles Times, the Chicago Tribune, and the Chicago Cubs. Zell put down a mere 4 percent of the purchase price—$315 million—and borrowed much of the rest, loading up the company with nearly $13 billion in debt. Zell didn't have many good ideas about how to revive ailing newspapers; tThe Tribune Co. filed for bankruptcy in December 2008.
Leverage was like an elaborate pulley system that allowed us all—from the humblest consumer to the most exalted private-equity baron—to hoist a mammoth weight. Then, in 2008, the rigging broke. The large weight plummeted, propelled by the twin forces of mass and gravity. And it turned that the Dumb Money forces were as procyclical during a bust as they were during a boom. Just as pervasive overconfidence inspired reckless lending, sudden pervasive lack of confidence inspired a hesitancy to lend. The system shifted, seemingly overnight, from a posture of trusting everyone to a posture of trusting nobody. A bubble breaks, former Federal Reserve chairman Alan Greenspan said, when it becomes clear that long-term expectations are patently unrealistic. "The result of this is a dramatic 180-degree switch that goes from exuberance to fear." We go from an environment where anybody will lend any amount of money to anybody (2006) to one in which nobody will lend to any amount of money to anybody (2009).
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