Capitalism Gone Wild – Wall Street's Mortgage Mess

Government regulation is often viewed as a costly impediment to business.  Companies are best able to determine the most efficient allocation of their resources.  The genius of this system has led to the United States' growth over the last two centuries.

The problem arises when certain business practices harm the public at large.  When the writer Upton Sinclair exposed the horrors of meat packing plants in "The Jungle" in the early 1900s, regulating the industry seemed a reasonable response—we all want wholesome food produced in sanitary conditions. 

The trick is to determine the appropriate level of regulation in order to let business prosper while leaving the public protected.  Finding the appropriate amount of regulation of our financial industry has proved to be particularly difficult.

We are slowly recovering from the repercussions of the Wild West activities engaged in by Wall Street, otherwise known as the mortgage-backed bond market.  Unfettered capitalism fueled by greed and a lack of self-control helped cause the biggest economic downturn since the Great Depression.

We can easily blame many parties for the drunken excess that became the housing bubble—mistaken government policies, incredibly low interest rates set by the Federal Reserve, individuals buying houses they absolutely could not afford, and mortgage brokers who provided loans to anyone who could fog a mirror.  However, pointing the finger at other bad actors does not absolve anyone of their misdeeds.

In his book "The Big Short," Michael Lewis brilliantly indicts the "geniuses" of Wall Street for exacerbating the situation by issuing shaky mortgage-backed bonds and then creating ways to bet on these bonds that increased the risk to our financial system.

The main thing to realize about mortgage-backed debt is that Wall Street pooled groups of home loans—often risky sub-prime loans—into bonds.  The bonds were rated by Standard & Poors and Moody's, but Wall Street leaned on them to make the bonds seem more attractive than they really were.  The bonds were then sold to institutions that relied solely on the ratings without investigating the actual underlying investment. 

But it gets worse.  The supply of sub-prime loans was limited and Wall Street desired to make even more money.  So they started selling bets on the mortgage pools without having any ownership interest in the actual bonds themselves.  These bets, known as derivatives, constituted billions of dollars more than the actual underlying mortgages.  Institutions like AIG and investment companies like Merrill Lynch leveraged their capital by 30 and 40 times.  This insane amount of speculation exacerbated the problem of the risky loans that existed. 

Here's the final piece—only a handful of people really understood how these derivatives worked.  For the most part, the geniuses on Wall Street, the ratings agencies who blessed these instruments and the ultimate buyers were mostly clueless as to the intricacies of these deals.

Eventually, the music stopped and the whole house of cards collapsed.  Those holding the dubious bonds and the bets made on them lost billions of dollars.  The resulting crisis was so bad that it threatened the functioning of our financial system such that the federal government stepped in to insure its solvency.

How could Wall Street have been so stupid, even if blinded by greed?  The answer is that they were playing with other people's money.  The big investment firms used to be partnerships whose partners were concerned about their personal status and liability.  But then the firms went public and started playing with their shareholders money.  The Wall Street elite were paid huge bonuses by taking huge risks.  When the bets failed, the investment bankers kept their bonuses and the shareholders and bond owners suffered the consequences.  It was a classic case of "heads I win, tails you lose."

"The Big Short" causes us to question how Wall Street can argue against stricter regulations after its actions resulted in a major financial disaster.  If Wall Street can jeopardize the global economy without taking any responsibility, it seems to deserve to be regulated more closely. 

We can only hope that the government correctly determines the appropriate type and level of regulation.   After all, we still rely on our financial institutions as part of a healthy business environment.  Excessive restrictions on Wall Street can hamper the recovery or our economy.

Words of Wisdom

I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence. -- Paul Volcker, Former Federal Reserve Chairman [who also said that the biggest innovation in the financial industry in the last 20 years was the ATM.]