After the Music Stopped

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Alan S. Blinder. After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York: Penguin Press, 2013.

The title of Blinder’s book refers to a quote from Chuck Prince, Citigroup CEO, in 2007: “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Dancing meant making as much money as you could in the overheated markets for housing and mortgage-backed securities before the bubble burst, which it did shortly thereafter.

Economist Alan Blinder has written an exceptionally lucid and readable account of the financial crisis and its aftermath. He has a knack for taking complicated financial concepts like collateralized debt obligations and explaining them simply. His book is a good place to start for non-economists trying to make sense of it all. He addresses three key questions:

  • How did we ever get into such a mess?
  • What was done to mitigate the problems and ameliorate the damages–and why?
  • Did we “waste” the financial crisis of 2007-2009…or did we put it to good use [that is, did we learn to do things any better]?

Having recently discussed The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It, by Peter Temin and David Vines, I did not feel that Blinder did as good a job as they did putting the financial crisis in a larger macroeconomic context, especially a global context. Although Blinder does discuss some global fallout from the crisis, his account of both its causes and its solutions focuses primarily on problems within the American financial system and its regulation. He doesn’t explore the connections between those problems and the competitive position of the United States in the world. As a result, his solutions may not be fundamental enough to cure what really ails the American economy. I’ll return to that issue after summarizing Blinder’s account of how the crisis occurred.

In Part II: “Finance Goes Mad,” Blinder identifies seven key weaknesses in the US financial system before 2008, which he also calls seven “villains”:

  1. Inflated Asset Prices: Bubbles often occur when buyers overreact to some trend that increases the value of an asset. After the tech-stock crash of 2000, housing seemed a relatively safe investment, and the Federal Reserve’s efforts to stimulate the economy by lowering interest rates made it more affordable. Once home values were rising and interest rates falling, owning was much more profitable than renting, and owners could pocket some of the benefits by borrowing against equity or refinancing at lower rates. A boom also occurred in mortgage-backed securities (pools of mortgages sold to investors), which paid higher interest than Treasury bonds but seemed almost as safe as long as the risk of default was believed to be low. Low interest rates on the safest government and corporate bonds encouraged investors to “reach for yield,” accepting what they hoped were reasonable risks for the sake of a higher return.
  2. Leverage: Consider a house that appreciates 10%, from $100,000 to $110,000. If you paid cash for it, your gain is 10%. But if you leveraged your investment by putting down $20,000 and borrowing the rest, the gain on your investment is 50%. The flip side is that if the house depreciates by $10,000, your loss is also 50%. During the housing boom, many home purchases were more heavily leveraged, often with only 5% down. Between 2000 and 2008, total household debt rose from about 100% of GDP to about 140%. Banks and investment firms also acquired assets using more leverage, often by using accounting gimmicks to circumvent financial regulations.
  3. Lax Financial Regulation: The major regulatory agencies mostly looked the other way as banks and mortgage brokers became increasingly aggressive, pushing riskier loans to borrowers with shaky credit. The expanding market for “derivatives” largely fell through the regulatory cracks, partly because of an explicit Congressional exemption. A derivative is a security whose value depends upon the value of an underlying asset, like a stock option whose value depends upon the price of the stock when the option is exercised. Derivatives can protect against risk, as when a manufacturer purchases the right to buy a commodity at a given price, to protect against a future price increase. But derivatives can also be used to make speculative bets on assets one doesn’t own. Insurance companies like AIG made huge bets that housing defaults would remain low when they agreed to protect financial firms from losses on mortgage-backed securities. But because the contracts were classified as derivatives rather than insurance policies, the regulations that would have set cash reserves to back the policy didn’t apply.
  4. Banking Practices: Within this climate of lax regulation, lenders lowered their lending standards and increased their subprime lending. Many of these loans were traps for unwary borrowers: “Many subprime mortgages were ‘designed to default.’ The most popular such example was the ‘2/28 ARM.’ These were 30-year adjustable-rate mortgages (ARMS) with, say, a barely affordable “teaser rate” like 8 percent for the first two years that would reset to a presumably higher rate…after that.”
  5. Securities Complexity: Why didn’t lenders seem to care as much whether borrowers could make their payments or not? Because of mortgage securitization. Lenders sold their mortgages to financial firms that packaged them for sale to other investors. These mortgage-backed securities became increasingly complicated and difficult to value. Collateralized Debt Obligations were pools of mortgages that had been divided into slices called “tranches,” which carried different degrees of risk. Buyers of the riskiest tranches had to absorb more of the losses from any defaults in the pool, while buyers of the safest tranches would only be hurt if the rate of default reached a very high level. Sometimes the tranches were repackaged and divided into their own tranches, creating a so-called CDO². “The Wall Street financial engineers who created the CDOs and CDO²s were performing mathematical exercises with complex securities; they had no clue about–and little interest in–what was inside. And the ultimate investors, ranging from sophisticated managers to treasurers of small towns in Norway, were essentially clueless.” Blinder characterizes this complicated edifice as a house of cards, ready to collapse once the word got out that the underlying mortgages were shaky.
  6. Rating Agencies: The companies responsible for rating securities did a terrible job, often giving AAA ratings to securities with substantial risks. “To put the rampant grade inflation into perspective, on the eve of the crisis only six blue-chip American corporations–names like GE, Johnson & Johnson, and Exxon Mobile–and only six of the fifty states merited the coveted Triple-A credit rating.” Rather than being truly independent, the rating agencies were paid by the firms whose securities they rated, and those firms could take their business elsewhere if they didn’t like the ratings they got.
  7. Compensation Systems: Financial firms often had compensation schemes that rewarded employees for making big bets with other people’s money. They got paid even if the bets went bad, and they got paid much more if the bets paid off. Merrill Lynch CEO Stan O’Neal led the company into make heavy bets on mortgage-backed securities, which ultimately resulted in huge losses for shareholders. When he was forced out, he received a “colossal golden parachute package worth over $160 million.”

Blinder explains these points well, and together they give readers a good idea of what was wrong with the American financial system before the crisis. But other analysts of the US economy before 2008 have convinced me that larger macroeconomic factors were involved. I would summarize these factors by saying that economic growth was proceeding in ways that were very unbalanced and unsustainable. One imbalance was the trade deficit that had turned the United States into the world’s largest debtor nation. Some foreign countries, especially in East Asia, based their economic growth heavily on exports. They exported to us far more than they imported from us, maintaining this pattern partly by keeping their currencies weak relative to the dollar. The demand for dollars remained high not so much because foreigners used them to buy our products, but because they used them to invest in American securities they considered safe. The availability of all that foreign capital was one reason why Americans could take on more debt. Foreigners were building for the future by selling, saving and lending, while Americans were living on borrowed time by buying, borrowing and spending.

A second imbalance was the widening income gap in the United States. Most of the gains in income were going to the top, while wages in the middle or below stagnated or even declined, especially for men. In part, this was because technological change was raising the skill requirements of jobs, and globalization was putting more workers in competition with inexpensive foreign labor. Some authors, however (see my posts on Kalleberg and Stiglitz, for example), see US inequality as too extreme to be attributable just to the same forces affecting economies everywhere. The US made inequality worse than it had to be by relying so heavily on cost-cutting as a competitive strategy, underinvesting in human capital, attacking labor unions, and so forth. The expansion of wealth at the top, aided and abetted by generous tax cuts, provided still more capital that went in search of lending opportunities. Meanwhile households with stagnating wages could at least buy cheap imported products, but they went more into debt to obtain the things that weren’t getting cheaper–housing, education and health care. Government under the George W. Bush administration also became more indebted by cutting its tax revenue and then borrowing to finance its rising expenditures, primarily the wars in Iraq and Afghanistan. Government debt was heavily enabled by foreigners willing to buy safe US Treasury bonds.

The large supply of domestic and foreign capital available for lending made it hard for lenders to command a high-interest return. It was in that context that lenders started to “reach for yield,” and financial firms found it profitable to offer securities with higher returns but disguised risks. Subprime housing loans that could be repackaged as safe-looking investments thrived in that environment. The bubbles in housing and mortgage-backed securities developed in a situation where some people were unusually eager to lend, while others were unusually willing to borrow. In retrospect, we can see how tricky it is to sustain economic growth on the assumption that one part of humanity will become increasingly indebted to another.

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