21 October 2008

The Bubble: Part 2

An interesting excerpt from a piece at RealClearMarkets:
The market responded to the price signals given by the Fed and loaned money that the Fed deemed nearly worthless. When the price of anything is held artificially low the logical result is a future shortage. Thus we now have a shortage of credit just as one would predict based on past experiences with price controls.

At first reading I completely disagree with this statement. "Easy money" no doubt contributed to the current debacle, but it was not the primary reason. Government policies that encourage excessive levels of home-ownership (and thus artificially high demand for mortgages) and the absence of anything else profitable to invest in are a much bigger cause of this mess.

During the tech boom of the late 1990's the big investment banks like BearStearns and Lehman Bros were making profits on the deals they brokered to bring ".com" ventures online. After the bust of that bubble they were caught sitting on their hands with not many ways to generate the large level of profits they had during the boom, so they got into a new market: mortgages. The only way to make big profits is to take big risks. But nobody wants too much risk, so enter the MBS (mortgage backed security). Let's bundle mortgages together and issue bonds that pay from the interest stream of the mortgages. The risk gets spread around to everybody; the risk is mitigated now, so let's keep demanding more mortgages to securitize, encouraging the banks originating mortgages to increase their risk tolerance (really not even tolerance, since they didn't hold the loans on their portfolio's anyway---they were sold off for fat premiums). Hello subprime! Banks will originate mortgages to nearly anyone, because they're not holding the loan for it's life. Brokerage houses package them up and "distribute" the risk and collect a hefty fee for the securitization services. And the ultimate investors buy the bonds backed by the mortgages because house prices never decline!--the interest will keep on coming because any mortgage borrower in trouble can simply refinance.

The point of my ramble is that "easy money" wasn't the sole issue. There were artificially high levels of demand too, leading to the inflation of a bubble that how now burst.

Investor's were used to the excessive profits of the tech boom and demanded that Wall Street continue to perform; and Wall Street delivered, by finding new ways to make boatloads of money without ever creating any real value. It was a repeat of the tech boom, with mortgage assest substituting for tech stocks.

The rest of the article is good though; I actually agree with the idea of letting the market work everything out on it's own, even though Keynes is probably surely looking at me incredulously for saying that.

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