Reining In Bubbles So They Won’t Pop

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.