The Economy

The Economy

The stock market had rapidly fluctuated during the last three decades, producing record bull and bear markets alike, but generally rising higher at a rate that seemed unnatural to some economists. The value of homes in many urban markets had risen by 10 to 20 percent each year, which caused a boom in real-estate speculation. As had occurred during the 1920s, few Americans were saving money, while others used leverage in dangerous ways. Some families took out multiple mortgages, leveraging their homes to purchase stock on margin or invest in more real estate. Unlike the 1920s, however, consumers were also using credit cards to borrow for everyday purchases, while most college students and their families financed a large portion of their educational expenses with federally backed loans. Other modern financial products, such as second mortgages and home-equity loans, also increased the risk of going into debt.

Perhaps the most remarkable new finance mechanism was the zero-equity home loan. These were loans that did not require a down payment and were increasingly paired with adjustable-rate mortgages (ARMs). These risky types of loans were marketed to those who had dreamed of purchasing a home but had been turned away by traditional lenders. These individuals often did not have a very sophisticated idea of finance and were happy to accept any home loan. They were especially happy to find that they had been approved to buy a brand-new home with no money down. The terms of most ARMs were seldom fully explained by salespeople who were paid on commission. Many of the companies that offered these high-risk loans later sold these loans to other financial companies. The banks that purchased these loans failed to investigate each individual loan or simply believed that any investment backed by a mortgage was safe. Even if home owners defaulted, they reasoned, the bank would get to keep the house, which would have likely increased in value. In some cases, loans were designed to force home buyers to default after a certain number of years, thereby giving the banks ownership of the real estate while keeping all of the payments the family had made up to that time.

It was a fail-proof system for the banks and mortgage companies so long as home prices continued to increase. But in 2005, housing prices stagnated as fewer and fewer buyers entered the market, and by 2007, these prices began tumbling. A family who had purchased a $250,000 home with no money down found they were $250,000 (or more) in debt for a house that was now valued at $150,000. Many chose bankruptcy to this upside-down situation, which left the banks with homes that were worth much less than the money they had originally loaned.

Other home owners tried to fulfill their obligations but found their zero-down adjustable-rate mortgage contained some unpleasant surprises. Although they should have realized at the time, most ARMs came with loan-repayment rates that jumped from a low introductory rate of 4 percent to 6 or even 8 percent. For example, the interest alone on a monthly mortgage payment for a $250,000 home would jump from $833 at 4 percent to $1,458 at 7 percent. Banks that had purchased these risky loans had done so believing that if the family in question could no longer pay their mortgage, the bank would at least be able to take possession of a house that was worth $250,000 or more. Instead, those that defaulted were often abandoning both a bad loan and a home that was worth only a fraction of what they owed.

In the past, home loans were made by local banks that faced the prospect of losing money or even going out of business if they loaned money to families who could not pay. By the early twenty-first century, home loans were made by a variety of financial institutions, but usually ended up in the hands of only a few firms. The government was supposed to regulate the health of this system, but had increasingly reduced the restrictions on lenders due to political pressure and the historic gains of the stock market and real-estate prices.

Critics warned that the health of the nation’s economy was directly related to the stability of a handful of banks and investment firms, but until 2007, those firms were making record profits, which masked the symptoms of disaster from all but a few economists no one wanted to hear. Warnings that America’s leading financial firms had unwittingly purchased billions of dollars in loans they knew very little about were ignored, while government regulations were regarded as restraints that prevented the economy from reaching its full potential. As a result, the news that venerable New York investment bank Bear Stearns faced bankruptcy sent a wave of panic throughout the system in 2008.

All of a sudden, the United States awoke to the very disturbing reality that nearly all of its leading banks were at risk of default, which threatened to cause the failure of the entire banking system. Because these banks were insured by the federal government, the failure of one major institution like Bank of America might cost taxpayers hundreds of billions of dollars and begin a tidal wave of other banks to fail. The federal government stepped in and negotiated the takeover of Bear Sterns by JPMorgan Chase. IndyMac Bank, the nation’s largest mortgage lender soon failed, which was followed by federal bailouts of Freddie Mac and Freddie Mae—two government regulated corporations that bought and sold mortgages from banks. Dozens of other leading institutions were nearing insolvency. AIG was the largest insurance firm in the country and had invested heavily in mortgage-backed investments. Facing the prospect that AIG would no longer be able to pay insurance claims, the Federal Reserve took over AIG’s financial obligations by essentially purchasing the heavily indebted company.

The panic spread from banking and insurance to the entire stock market, causing corporations in industries that were already struggling such as auto manufacturing to collapse had it not been for another massive federal bailout. Oil prices skyrocketed, while the latest round of World Trade Organization talks in Doha, Qatar, failed to reduce international trade barriers. A host of states and cities joined California and the former industrial cities of the Rust Belt in reporting that they were in danger of defaulting on the loans they had made to bondholders. Private and public companies responded by downsizing their workforce, while consumers who had money were understandably reluctant to make large purchases, much less invest in stocks or bonds. The Dow Jones average fell from above 14,000 to nearly 8,000 in just over a year. Retirees returned to the labor market, while those who had planned to retire remained at work, resulting in fewer jobs for recent college graduates who lacked the experience of older workers.

The media soon explained that a new and complicated type of investment was partially to blame and had made a handful of speculators and industry insiders very rich. These investments were called derivatives because they derived their value from the occurrence of a certain event—in this case, the failure of thousands of mortgages. These new investments were beyond the understanding of many experts who worked in the financial service industry and beyond the realm of overburdened government officials whose powers to regulate the banking industry had been vastly reduced by both Republicans and Democrats over the past three decades. These derivatives might have reduced risk had they been purchased by the same banks that held the mortgages their value was derived from—a sort of insurance policy that would compensate the banks if the loans they held ever defaulted.

Many derivatives were bought and sold by speculators betting on a market collapse. Given the incredibly shaky foundation upon which the entire housing market had been constructed, it seemed to many as if some in the investment industry had orchestrated the entire debacle. After all, the only way that many of these loans would not default was if home values kept rising at historically unprecedented rates while new home owners could keep paying mortgages that increased each year. As the media and political leaders kept reporting about hedge fund millionaires and bank executives with multimillion-dollar bonuses, the indignation of many Americans who feared the loss of their homes and jobs mixed with fear to form a volatile mixture.

In late September and in the midst of election season, Bush officials in the Treasury Department crafted legislation that would set aside $700 billion to “bail out the nation’s largest banks, investment firms, and insurance companies.” Debate on the Emergency Economic Stabilization ActA controversial bill authorizing the Treasury Department to use as much as $700 billion to “bail out” banks and investment firms it deemed could have an adverse effect on the national economy if they defaulted on their loans or became insolvent. revealed both the panicked sense that failure to provide these funds would lead to a complete collapse of America’s economic system and the fact that few in government really understood that system. Even though many in Congress protested that the bailout bill had never been fully explained, each day the financial headlines grew more dire, and the bill passed with begrudging but bipartisan support.

The bill provided little assistance for smaller banks, and hundreds of these institutions collapsed. Those banks that had acted prudently survived but were not fully rewarded according to free-market principles by the failure of their larger and more irresponsible competitors. Critics pointed out that many aspects of the bailout were Socialistic—by loaning money to some of America’s largest businesses, the government was effectively becoming the owner of these enterprises. Others claimed these extreme measures were temporary and necessary to save the free market and prevent a second Great Depression.

Libertarians believed that the businesses that had made poor investments should face the same fate of millions of families that had taken on more debt than they could afford. As thousands faced foreclosure and bankruptcy each day, it seemed unfair to most Americans that the largest banks were getting federal bailouts because the entire economy was so dependent on their survival. Others turned away from positive explanations and toward populist anger. All they knew was that handful of speculators in the derivative market became rich overnight, while bank executives who were seemingly driving the US financial system over a cliff they helped build were still making millions in bonuses. Meanwhile, the stock market was collapsing each day, and millions of US families were one mortgage payment away from homelessness.