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The last main ingredients to the crash, mortgage backed securities and financial deregulation, are some of the major ingredients which lead to the Great Recession of 2008. However, let's quickly recap the series of events that led us to the meltdown:
As previously stated in my blog, the Federal Reserve lowered interest rates and inflated the dollar, driving the housing market up and creating a bubble. Additionally, the low interest rates caused foreign nations to buy US debt (US Treasuries) in the trillions. Lastly, an inflated dollar and deflated yuan caused US importers to buy less while simultaneously decreasing the purchasing of US goods in foreign nations (a dramatic increase in the trade deficit was inevitably the result).
In 1933, the Glass-Steagall Act, or the Banking Act of 1933, was enacted to control speculation, or the lending of money, purchasing of assets, equity or debt in a manner that has not been given throrough analysis or has high risk of default. In other words, the government wanted to control the loose buying and selling of assets/credit and enforce increased analysis to ensure that safe investments are in play. However, in 1999, a provision that prohibited a bank-holding company from owning (buying stock, for example) other companies was repealed under Bill Clinton.
In 1987, those that were against the repealing wrote the following argument:
"1. Conflicts of interest characterize the granting of credit (that is to say, lending) and the use of credit (that is to say, investing) by the same entity, which led to abuses that originally produced the Act.
2. Depository institutions possess enormous financial power, by virtue of their control of other people’s money; its extent must be limited to ensure soundness and competition in the market for funds, whether loans or investments.
3. Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.
4. Depository institutions are supposed to be managed to limit risk. Their managers thus may not be conditioned to operate prudently in more speculative securities businesses. An example is the crash of real estate investment trusts sponsored by bank holding companies (in the 1970s and 1980s)."
Mortgage Backed Securities:
Anywho, the Glass-Steagall Act was, for the most part, nonexistant because of this one repeal. It enabled companies like CitiGroup to build and sell investments called mortgage backed securities. Mortgage Backed Securities are essentially a group of mortgages that are combined into one security (like a stock symbol) and sold in the marketplace. So, say for example we're all eating pie in our respective houses that have mortgages. The money owed on our house goes to the bank who provided the mortgage. Well, a couple companies by the name of Fannie Mae and Freddie Mac take all of our mortgages and buy them from the bank. They then pool these mortgages together (say, 10,000 mortgages) and then establish a single value on all of the mortgages based on how much we owe on our homes, everyone's credit, the likelyhood that we'll pay our mortgage (plus interest) in a timely manner, etc.
In other words, mortgage backed securities are like stocks, but instead their value is derived from home owner's debt obligations to banks. They are divided between various classes, including subprime loans, prime loans, high risk, low risk, etc. Fannie Mae and Freddie Mac were the two major issuers of MBS's, but private banking institutions like CitiGroup, Bear Stearns, Wells Fargo, Washington Mutual, Goldman Sachs, etc. were allowed to buy the mortgages from other banks to create and sell MBS's. Because of the repeal of the Glass-Steagall Act, (financial deregulation) the amount of speculation (or analysis) in these MBS's was VERY limited. No one really knew how risky they were unless you had an idea of what was going on behind the scenes (as described in this blog). Therefore, the rating agencies like Moody's, Standard & Poor's, Fitch, etc. were giving these sub-prime, high risk mortgage backed securities great investment ratings.
Many bank holding companies, eager to get their hands on the surging house-market, invested heavily in mortgage backed securities. They even took loans out on their cash reserves to invest as much as possible in MBS's. Now, consider this: before the repeal of Glass-Steagall, only 5% of all mortgage loans were subprime (high risk, low credit scores, high likelyhood of defaulting, etc.). During the 2008 meltdown, that percentage nearly hit 30. 30% of all mortgage loans in the US were subprime! And the repeal of the Glass-Steagall Act was the reason why.
When interest rates rose, the dollar deflated, the housing bubble popped and prices started decreasing (deflation), the mortgage backed securites started tanking in value, and the investors and major institutions that were heavily invested in them started to fall fast.
It doesn't take much to see why our economy is in its current state. Overbetting on risky investments without proper diversification and speculation is almost asking for failure. Additionally, poor monetary policy and volatile interest rate fluxuations, along with financial deregulation and tempting access to credit is bound for failure.
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