This week marks the 10th anniversary of one of the most dramatic series of events in human history, when raw, unmitigated greed was allowed to leverage itself, virtually unchecked, to a disastrous end. I’m talking about the Financial Crisis of 2008.
On January 6, nine months before the collapse, part of my 2008 Predictions included this: “There will not be a national crisis of mortgage foreclosures.”
As noted above, there was a financial crisis that year. A devastating one. But my prediction was correct, because unlike what you may have heard, that crisis was not caused by mortgage foreclosures, sub-prime or otherwise.
The Financial Crisis of 2008 was caused by how Wall Street banks packaged and sold bundles of home mortgages – called tranches – as securities. Creating these securities wasn’t the problem. Mortgage-backed securities have long been an essential funding source of the home-ownership pillar of the American dream. This crisis was caused by that unmitigated greed.
In the first decade of the 21st century, Wall Street banks were allowed to leverage mortgage securities beyond the 1:1 ratio. That’s the one dollar of credit for one dollar of market value standard you and I are bound by when we get mortgage money to buy a home. Unfortunately, criminally lax oversight by management, regulators and credit rating firms, allowed some mortgage-backed securities to be sold, repackaged and sold again. The result was that some securities were leveraged 70:1. That’s right: $70 of credit for $1 of real value. Again, unmitigated – and illegal –greed.
There were early warning signs. In March 2008, the 85-year-old Wall Street titan, Bear Stearns, collapsed in a liquidity crisis due to its mortgage practices, and was sold off in parts. On September 6, Fannie Mae and Freddie Mac were put into federal conservatorship. These two quasi-government entities were created so investors would capitalize the mortgage industry, which investments came with an implicit guarantee by the Federal government, which is the definition of “moral hazard.”
Then, one week later, the crisis was officially born when the “shadow banking system” balked at accepting mortgage-backed securities as collateral for overnight loans. It finally became apparent that these over-leveraged securities weren’t adequate to justify the loan requests. This is like your mortgage holder calling the loan on your home because they found out you’d gotten more money from other mortgages using the same home as collateral each time.
The shadow banking system is an unregulated group of organizations that facilitate short-term credit across the globe. Most people have never heard of it, but the shadow system is bigger than the regular, regulated banking sector. Consequently, because of its size and global counter-parties, when the shadow bankers started rejecting those mortgages as collateral, it essentially plugged the liquidity pipeline of not just U.S. financial markets, but around the world. The dominos started falling when these rejections caused the September 15 collapse of both Lehman Brothers – which had a major stake in the over-leveraged mortgage-backed securities sector, and AIG – which was complicit in the financial collapse as an insurer of the poor quality mortgage securities.
In the near-term following the Financial Crisis of 2008, the U.S. Wall Street was set back for about a year. But by 2010, bank bonuses were back into record territory and, as you know, the markets have been on a bull market tear ever since.
Meanwhile, out here on Main Street, the combination of the Great Recession and the Financial Crisis devastated millions of families of Americans who lost their jobs. Plus hundreds of thousands of small business that had to close, and the sustained damage to those small firms that survived is incalculable. A decade later, as small businesses are just now getting back to where they were in 2007, the memory is still keen. When we polled small business owners about the possibility of another financial crisis caused by Wall Street, over 90% said they were somewhat or extremely concerned.
It’s true that steps have been taken to make the financial sector operate more responsibly and with more reserves. But we have to remember that from 16th century Tulipomania to the Financial Crisis of 2008, history is replete with examples of what Charles Mackay called, “Extraordinary popular delusions and the madness of crowds.” But here’s what’s different today: the next madness example will have the awesome and instantaneous power of digital leverage.
The problem with humanity is the humans. Therefore, regarding another global financial crisis – not if, but when. Forewarned is forearmed. Prepare yourself and your business.
Write this on a rock …
What about the humans who ran the “too big to fail” banks that created the crisis? Apparently, they were all too big to jail.