When financial historians look back at the last six months, they'll be hard-pressed to explain precisely why our advanced financial system suffered such a catastrophic failure. So many of the developments—a $1.2 trillion subprime-mortgage market, a $62 trillion unregulated, nontransparent credit-default-swap market, $50 billion private-equity buyouts of cyclical companies, hedge funds going public—seem, on their face, to be irrational, silly nonstarters. And yet the players pulling off these deals were lionized as geniuses, as transformational business figures. They were the Smart Money. They turned out to be the Dumb Money. How did the crown jewel of American capitalism—our financial-services industry—transform into cubic zirconia? How did a nation shift seamlessly from the dotcom bubble into a more-inclusive housing and credit bubble? And, most important, how can we stop it from happening again?
There's plenty of blame to go around: poor regulation, eight years of a failed Republican economic philosophy, Wall Street–friendly Democrats who helped stymie reform, misguided bipartisan efforts to promote home ownership, Wall Street greed, corrupt CEOs, a botched rescue effort, painfully fallible central bankers. But while there was plenty of alleged criminal activity—ahem, Mr. Madoff—law-abiding, respectable citizens who were operating well within the confines of laws and regulations racked up the overwhelming majority of losses. Everybody—individuals, companies, institutions, and governments—got caught up in the stupidity.
Which is part of the problem. In the first decade of the 21st century we had a bubble, just as we did in the 1990s. The bubble was not just in housing. It was in debt, in speculation, in gambling. "At the center of this crisis was a bubble of risk-taking," said money manager Jeremy Grantham. And as was the case during the dotcom bubble, too many elements of our financial system and money culture were procyclical. Which is to say that built-in features of our economic operating system—government policy, private companies, the media, popular culture—functioned as accelerators rather than brakes. Once a hot money trend gets going, everybody wants in.
Government policies often play a role in kicking off bubbles. Congress commissioned the first telegraph line in the 1840s and made huge land grants to railroad builders. That was the case in the housing bubble, too. The cost of the mortgage interest deduction, which subsidized big loans (the more you borrowed, the more you could deduct) grew sharply as housing prices rose, from $55 billion in 2000 to $66 billion in 2003.
Fannie Mae and Freddie Mac similarly acted as amplifiers. Their loan limits were tied to average home prices. The more house prices rose, the more debt they would offer and insure. And the more they lent, the more prices rose. Between 2000 and 2004, the so-called conforming loan limit rose by nearly one third, from $252,700 to $333,700. (Lather. Rinse. Repeat.) The Federal Deposit Insurance Corporation stopped collecting insurance premiums when times were good, so long as its rainy-day fund amounted to 1.25 percent of insured deposits—no matter how much banks expanded their balance sheets. It's as if companies stopped selling flood insurance after three years without a hurricane, and shore residents started building really expensive high-rises instead of cottages.
For a few years there, thanks to the pervasive extension of cheap credit by the Federal Reserve and by global investors, there were no hurricanes. After the tiny Utah-based Bank of Ephraim went under in June 2004, 952 days passed without a bank failure, breaking the 609-day record from the mid-1940s. The lack of failure gave bankers an enormous amount of self-confidence. The financial system reversed Shakespeare's admonition. Everybody a borrower or a lender wanted to be. Established banks carpet-bombed downtowns with outlets. The number of new banks formed rose from 91 in 2002 to 178 in 2006. Between 2004 and 2007, 630 banks were started. Banks extended home-related credit to anyone who asked for it. And as default rates on corporate debt plummeted, huge investment banks like Citigroup and Merrill Lynch extended hundreds of billions of dollars in credit to private-equity firms for leveraged buyouts.
On Wall Street—and in the culture at large—those who embraced the mentality of the bubble with the most fervor were richly rewarded. In the 1990s, the investment bankers who brought in hot technology IPOs were the new Big Swinging Dicks. In the Dumb Money decade, the more you borrowed to make bets on stocks and bonds, the more capital—social and financial—you acquired. Like real-estate brokers who realized they could make more money flipping condos than collecting commissions, large investment banks decided they would rather be principals than mere agents. Executives who preached caution were ritually shunned.
During bubbles, the views of bulls are ratified, and so they get even bigger megaphones and more credibility. Meanwhile, the bears, doomsayers, and buzzkills who warned that the economy had too many eggs in one basket were marginalized. For much of the decade, David Lereah, chief economist at the National Association of Realtors, had the task of going on CNBC and crowing about rising home prices each month. In February 2005, Lereah published a book entitled "Are You Missing the Real Estate Boom?" in which he argued that home values were now in the midst of a permanent boom, fueled by demographics and the changes in the marketing and financing of homes. Never mind the impressive recent increases. Homes now represented a "once-in-every-other-generation opportunity."
Consumers internalized Lereah's message. During bubbles, we always conclude that Something Fundamental Has Changed, and that the recent party is a mere prelude to even greater revels. I call it Pro Forma disease. (Pro forma calculations, projections that rest on certain assumptions, are a staple of MBA classes and business plans.) The main symptom is a compulsive tendency to extrapolate results of recent fat years endlessly into the future. Just as people who came of financial age in the 1990s believed that stocks moved in only one direction, those who matured financially in the early part of this decade believed that interest rates and housing prices each moved in only one direction (down, and up, respectively). You could overpay for that five-bedroom Toll Brothers McMansion in Totowa, New Jersey, secure in the knowledge that you could (1) sell it rapidly at a higher price, or (2) refinance your way out of trouble at the drop of a hat.
Wall Street's aristocrats fell prey to the same blinkered procyclical thinking. Private-equity players borrowed to do ever-bigger deals. Dumb Money had elevated stock slingers and merchants of debts into Wise Men, new archetypes of success. Stephen Schwarzman, cofounder of the Blackstone Group, wanted to be seen as un homme sérieux, in the image of W. Averell Harriman; he acquired the trappings of a Rockefeller Republican—including an apartment on Park Avenue once owned by John D. Rockefeller Jr.
In the dangerous late stages of the bubble, financial engineers came to believe that because they had made a lot of money flipping assets with cheap credit, they could apply their genius to industries in which they had little expertise. In 2003, the brilliant hedge-fund manager Edward Lampert acquired Kmart out of bankruptcy and used it as a platform to buy Sears in 2005, creating a 3,800-store behemoth that occupied a dubious place in the retail firmament. In February 2007, Sam Zell, the Chicago-based real-estate investor, sold Equity Office Properties, a collection of high-end office buildings, to the Blackstone Group in a deal valued at about $38 billion. Zell decided that good timing in flipping real estate made him an expert on the ailing newspaper industry, so he spent $8.2 billion to acquire the Tribune Company, which owned the Los Angeles Times, the Chicago Tribune and the Chicago Cubs. Zell put down a mere 4 percent of the purchase price—$315 million—and borrowed much of the rest, loading up the company with nearly $13 billion in debt. Zell didn't have many good ideas about how to revive ailing newspapers; the Tribune Company filed for bankruptcy in December 2008.
Leverage was like an elaborate pulley system that allowed us all—from the humblest consumer to the most exalted private-equity baron—to hoist a mammoth weight. Then, in 2008, the rigging broke. The large weight plummeted, propelled by the twin forces of mass and gravity. And it turned that the Dumb Money forces were as procyclical during a bust as they were during a boom. Just as pervasive overconfidence inspired reckless lending, sudden pervasive lack of confidence inspired a hesitancy to lend. The system shifted, seemingly overnight, from a posture of trusting everyone to a posture of trusting nobody. A bubble breaks, former Federal Reserve chairman Alan Greenspan said, when it becomes clear that long-term expectations are patently unrealistic. "The result of this is a dramatic 180-degree switch that goes from exuberance to fear." We go from an environment where anybody will lend any amount of money to anybody (2006) to one in which nobody will lend to any amount of money to anybody (2009).
The implosion of the dumb money economy—housing, insurance, real estate, the auto industry—has erased much of the economic progress of the decade. By the end of 2008, stocks had fallen back to where they were in 1997. The foreclosure epidemic took the home-ownership rate in the third quarter of 2008 back to its 2002 level. Stripped of their easy access to financing, the royalty of the Dumb Money era have been reduced to commoners.
What to do? More regulation is certainly in the offing. But Congress tends to regulate with hindsight. After a slew of accounting scandals, Congress in 2002 passed the Sarbanes-Oxley Act, which correctly forced CEOs to sign off on the accuracy of financial statements. Markets already have started doing much of the heavy lifting of retroactive regulations. Rules that prohibit houses being bought with no money down and no-documentation mortgages? All the lenders who provided such loans are out of business.
It's also impossible at some level to regulate speculation. Bubbles speak to something innate in the American psyche. They're fun. They make a lot of people feel rich. If one business idea works, 500 other people will try it. Regardless of the regulatory regime in place, somebody is always willing to fund the eighth online pet store, the 7,567th hedge fund, the 137th condo tower in Miami, and the 52nd ethanol plant.
Since we can't stop ourselves from pressing the pedal to the metal when we get excited by a hot new trend, perhaps we need some automatic brakes. In other words, we need to figure out ways to make our system and our money culture less procyclical. We need a sort of fiscal lithium, an agent that smoothes out things. It might take away some of our personality and make us a little less fun to be around, but it will also make us less destructive and easier to live with.
For example, the inadequacy of banks' capital levels–especially those of banks, like Citi, which grew too large to fail—is one of the main factors hindering a recovery. Of course, the best time to tell banks to boost their reserves is during a boom, when their balance sheets are expanding and they have easy access to capital, not during a bust, when they have effectively collapsed. To prevent a repeat, the FDIC might consider tying the level of deposit insurance premiums to a bank's size, so that, for example, Citi, or any other institution whose failure would swamp the entire system, would pay at a higher rate than a small bank with six branches.
Or what if the asset-management industry, which profited so mightily during the boom and set the stage for the debacle, effectively insured itself against meltdowns? Dean Baker, codirector of the Washington-based Economic Policy Institute, is advocating a tiny tax on trades of stocks—say one quarter of one percent of the transaction's value—and other assets. Doing so would discourage speculation for the sake of speculation, and, Baker notes, "a tax like that could easily raise $100 billion per year." We could use the funds raised from hedge funds and other manic traders to pay for the bailout.
University of Chicago economist Richard Thaler suggests that Fannie Mae and Freddie Mac, who play a larger-than-ever role in housing finance, could also become less procyclical. "One of the problems with the housing market was that as prices were going up, lending standards were going down," he says. Houses, like stocks, have price-to-earnings ratios. For homes, it's the market price of a house divided by the amount of rent it can produce. What if Fannie and Freddie were to require higher down payments as the ratio of prices to rents rose and required lower down payment as they shrank. "It would have been harder to get a mortgage at the height of the bubble, and it would be relatively easier to get one now, particularly in areas where housing prices have fallen sharply," Thaler said.
Finally, we have to be a little more willing to be stupid during Dumb Money eras, to leave money on the table, to forgo the easy returns our friends and neighbors are making. Of course, that's difficult. "When we see other people around us making money, flipping houses and tech stocks, we feel that we need to go into it as well," said Dan Ariely, author of "Predictably Irrational." "To minimize the regret, you join the bandwagon." To avoid this, we have to recognize the patterns of bubbles. We have to learn not to conflate a few random occurrences with a streak that can be extended into the future.
The End of Dumb Money has been like a death—of dozens of institutions, thousands of careers, millions of dreams and billions in value. As we grapple with the aftermath, we seem to be proceeding through the five stages of grief. First came denial, which was rampant throughout the system. Next came anger at the size and manner of the bailouts. Third, bargaining: last fall, it was common to hear arguments that taxpayers might actually make money on the bailout. And around December, the fourth stage, depression, set in. It still lingers. I hope that is where it stops. For it would be a shame if we moved on quickly to the final stage, acceptance. There is nothing acceptable about what happened. This crisis was not a random, once-in-a-lifetime thing that fell out of the sky. It was a manmade product that turned out to be immensely toxic and damaging. And we'll be paying for the cleanup for a long time. We can and should get angry. We should also get smarter.