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Subprime

The Economy

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This post is the first of my attempts to make sense for myself of the current financial crisis. In this post I ask the question: How did we get into this mess?

The simplest explanation is that encouraging people to take mortgages was the easiest way to create investment opportunities for surplus capital:

The result was that the wealthy—the investment class—had more money to invest, or lend, than there were people and businesses looking to borrow.

The easiest way to bring more borrowers into the system—and to create more of a market for money—was to promote homeownership in America. This is precisely what the Bush administration did, touting home ownership as an American right. Of course, they weren’t talking about home ownership at all, but rather pushing people to borrow money tied to the value of a house.If people could be persuaded to take mortgages on homes, real estate values would go up for those already invested (like land trusts and real estate funds) and banks would have a market for the excess money they had accumulated.

Even before Bush, regulation had been pushed through eliminating New Deal era restrictions on finance capital:

in 1999, Congress dismantled the Glass- Steagall Act, a pillar of the New Deal, which separated commercial and investment banking. That enormous change was undertaken with no thought or effort — or desire — to regulate the world that it would help to create. Now we know that an entire shadow banking system” has grown up, without rules or transparency, but with the ability to topple the financial system itself.

But perhaps no deregulatory effort had more catastrophic effect than the 2000 law that explicitly excluded derivatives, including those credit default swaps, from regulation under the Commodity Exchange Act of 1936.

It was in this climate that some very inventive” schemes were developed to repackage bad loans as AAA quality securities. The people doing this knew it was a bad thing to do, but a culture was created in which everyone was profiting and nobody seemed to be getting hurt, so it continued unabated. The best accounts of this I’ve come across are both in narrative form and both focus on the issue of subprime” loans. Obviously the current crisis has evolved beyond the subprime loan issue into an international credit crunch, but subprime lending is still at the heart of the story. First there is this amazing episode of This American Life, The Giant Pool of Money (they deserve lots of awards for this), and second this roughly drawn but well written cartoon slideshow.

I’m still a little unsure as to exactly how this untenable system came unraveled at the very end — resulting in the international credit crisis we now have, but it seems the whole thing simply fell apart like the house of cards that it was, bringing down the rest of the financial system with it. [For more information, see my

next post on the bailout.]

UPDATE: Here is a map of the foreclosures the NY Times published back in April:

The New York Times

UPDATE: Also see this excellent piece by Robert Kuttner in The American Prospect. It adds some important details about the role of hedge funds as well as how deregulation has changed the role of the Federal Reserve.

Indeed, until Congress dismantled financial regulation, the Fed was not called upon to mount these heroic rescues, which have become so common in recent years. Until the 1960s, the central bank could keep interest rates low, confident that they would underwrite the growth of the real economy rather than risky financial speculation, for the simple reason that entire categories of speculation did not exist.

But during the past quarter-century, as deregulation has turned the economy into a casino, the Federal Reserve has had to mount major rescues at least six times.

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