Financial Meltdown.
I think the financial meltdown was fundamentally caused by the fact that we did not require those who make loans to shoulder the risk of the loan. The only way to avoid this kind of meltdown again in the future is to fix the system so that anyone who decides to make a loan must be responsible for the quality of that loan.
Here's why.
Our financial system, and in particular our federal banking system, needs to do one basic thing. It needs to make sure there is enough money (currency or its equivalent) to support all the economic activity in (and with?) the country, but no more. Without money, people can't effectively and efficiently buy or sell their goods or services. So we need enough money to cover all the economic activity that happens. And we don't want to have "too much" because that will just lead to inflation, a devaluing of the currency, reducing your buying power by driving up prices. If, somehow, the federal banking system knew exactly how much economic activity there was, they could just make sure that much money is available, and that question would be solved.
How would they know who to give money to? The basic idea is that the fed would be willing to lend money to anyone who could convince the fed that they had, or would soon have, collateral exactly equal in value to the money they wanted to borrow. The fed would know who to give the money to, and how much to give them.
Now the question is, how do we determine the value of the collateral? The housing market is an easy example. Suppose new homes in your city are selling for $200,000. Then if someone came along and decided to make another new home, they could reasonably expect to sell it for $200,000. The fed would be willing to loan that person $200,000, because in the event that that person could not pay back the loan, the fed could take possession of the house and still have something worth $200,000.
This, in principal, is how "new money" is created and how we decide who should get the new money as our economy expands. We give the new money to the people who have the new things/services that someone has created. The borrowers usually have to turn around and pay the people who built the house. (And the builders probably have to pay their employees, and suppliers, etc.) So the government says, yes, indeed, that house (or whatever) is worth $200,000. We will print $200,000 worth of money and loan it to you, because you will either pay it back, or I will be able to take your $200,000 house and sell it to someone else. Whoever built the house created $200,000 worth of economic value, and that value was exactly matched by money the federal government printed. The money was distributed into the economy from the government to the borrower to the builder to the builder's employees and suppliers, and so on.
What if, as with the housing bubble, all of a sudden the collateral is worth less than originally thought, say $100,000 instead of $200,000? If the borrower doesn't default, nothing much happens, at least from the government's point of view. If the borrower defaults, then the government won't be able to recover all the money they loaned. That actually works out just fine. All the government did was print the money anyway. The net effect will be $100,000 worth of inflation. That is, we have $100,000 too much money in circulation.
At its heart, our economic system works that way. Of course, there are many layers of banks between most borrowers and the federal banking system. No one gets a home loan directly from the federal reserve. But in essence, that's it.
And we don't want the fed to have to absorb the losses whenever someone doesn't get the value of some collateral right. We need to require the banks to do their due diligence to make sure the collateral is valued at the right amount and to make sure the borrowers won't default.
In order to make our financial system robust in the face of market bubbles and in the face of defaulted loans we need it to be a system where the banks that make the loans shoulder the risk of those loans. They can keep the profit from the interest on the loans they make, but they also need to absorb the losses on bad loans. That will do three things.
- It will create the proper incentive for banks to be realistic about the value of collateral they accept for a loan.
- It will create the proper incentive for the banks to make loans only to people who won't default.
- It will insulate the federal banking system, and thereby our entire economic system, from the inflationary effects of market bubbles and unsound lending practices.
The meltdown happened because none of those things happened. Banks (and everyone) were unrealistic about the actual value of the houses they were accepting as collateral. That was the housing bubble. Banks were making loans to people who were likely to default. Those were the sub-prime loans. And the federal banking system was not insulated from these negative effects. They were able to percolate all the way to the top, threatening to take down our largest financial institutions, at which point, our only option was to step in and print up more money for these banks.
So, what should have happened when the housing bubble popped?
The people who owned the houses that used to be worth $200,000 but were now worth $100,000 (or whatever), would have just stayed put, continued paying their loans, and everything would have been fine.
Some people might have defaulted on their loans. That's fine. The banks would have been stuck with the losses, because the collateral that should have been worth $200,000 was only worth $100,000. This is the risk the bank takes, and it is why the bank must be good at determining what something is worth, and it is also the reason we let banks profit by charging you more interest that the fed charges them. (It is not officially true, but I do believe it is fair to say that it is the banks' job to monitor and detect housing bubbles.)
Given that the banks had made so many sub-prime loans, many people defaulted on their loans. Still, it is the banks who made the bad loans that should have shouldered that burden, perhaps by being forced out of business. That is the inherent and unavoidable risk they take by making loans. Ultimately, many banks might have gone out of business. The banks that loan to them might have been affected, but in a healthy system, they should not have been affected as much (because they are larger and are not as exposed to one single market). Ultimately, the final effect of the popping of the housing bubble should have been somewhat increased inflation.
The difference between what should have happened and what did happen is that all that risk from the undervalued collateral and sub-prime loans was misplaced.
The risk of falling housing prices should have been borne by the homeowners who borrowed the money. If they had not been sub-prime borrowers, they could have continued to pay back their loan even if their house was worth less than they paid for it.
The risk of sub-prime loans should have been borne by the banks who made the loans. If they hadn't loaned to people who were likely to default, then they wouldn't be faced with all the defaults.
The risk of both those things happening at once should have been borne by a sound financial system in which the risk was localized to the decision makers who were allowing risky loans to be made. After all, the housing market only represents about 6% of our economy (see 1, and 2).
That is, the U.S. financial system should have been able to absorb the effects of all this. Why couldn't it? Because we let people shift the risk from themselves to others, and in particular, to share or amortize that risk over more people. This did three things.
- It exposed more people and institutions to the risk from poor decision making regarding housing prices and home loans.
- It encouraged even more poor decision making because the risk to any particular decision maker was reduced. So we saw more banks willing to give riskier and riskier loans, and because those loans were so easy to get, more people willing to pay more and more for a house, until ulimately people were buying houses they couldn't afford.
- It let even the largest banks expose themselves to a significant amount of risk because of the way that risk was packaged up and shared (as collateralized debt obligations and other inventions of the actuarial types), and because there was so much more risk in the first place.
The meltdown was not caused by the popping of the housing bubble. That may be what triggered it, but it is not what caused it.
The meltdown was not caused by sub-prime loans. Sub-prime loans are the immediate reason for the meltdown (if I can make a distinction between cause and reason), but only because we had spread the risk around so broadly and in such an amount that everyone was exposed to the risk. Without the ability to spread the risk, the effects of the popping of the housing bubble and subsequent defaulting on all the sub-prime loans would have been limited, and would not have spread throughout the financial system.
Put another way, what created the financial meltdown was that banks were able to sell the bad loans to other people, thereby giving the risk of default to someone else. And banks did this on a massive scale with collateralized debt obligations and other concocted financial "products". So, the originators of these bad loans were able to do three things: 1) shift the risk and burden of the bad loan to someone else, and 2) obscure the risk by making it difficult or impossible to evaluate the chances that the borrower would be able to pay the loan back, 3) encourage even more bad loans by making it so easy and profitable to sell them.
Our financial system is founded on the basis of making sound loans as the only practical way to measure economic activity. We allowed financial institutions to create a system in which the incentive to make sound loans disappeared. Those who made the loans were not the ones who had to shoulder the risks. Ultimately, that was the genesis of the financial meltdown.
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