Pursuing an idea provided by a frequent commenter, I believe I may have stumbled on the “smoking gun” in the financial crisis we find ourselves in.
The commenter pointed out that housing prices began rising sharply in 1996. That would seem to rule out the Bush fiscal policy, the Greenspan monetary policy, subprime mortgages or any of the other things that came about as a reaction to rising housing prices as the culprit.
However, it wasn’t just housing prices that were rising. Asset prices generally started rising sharply at just about that time. The DOW closed above 4,000 for the first time in February, 2005. By October of 1996 it had closed above 6,000. In 1996 Alan Greenspan made his well-known “irrational exuberance” speech.
I believe the smoking gun is the pegging of the yuan to the dollar which took place in 1994. I’m going to try to put a post together that explains how all of these things relate to each other.
Suggestions gratefully accepted.
Well, pegging the yuan to the dollar when China has a large continuous trade surplus with the US (and with most of the rest of the world) requires a counterveiling flow of Chinese investment into the US — China sells goods for dollars, doesn’t spend these dollars on goods and services, and can’t sell them on currency markets without bidding up the yuan and down the dollar, so they must burn or bury those dollars or invest them in the US.
China did in fact invest large amounts of dollars in the US, mostly in the form of buying up oodles of treasury bonds. This bid the risk-free interest rate way down, which had two major effects. It spurred small, casual investors away from safe investments (savings accounts and the like, which now had pitifully low interest rates) towards risky investments, which fed the equities bubble. It also affected institutional investors (banks, insurance companies, etc) who are forced by regulatory requirements to invest in AAA securities, moving them away from truly safe investments (treasuries and corporate bonds in very financially secure companies) to higher-yielding investments that were treated as safe by regulatory agencies and which were widely believed by the financial industry to be safe (mortgage-backed securities and CBO-insured high-risk bonds).
This inflow of capital into the MBS market made buying a house much cheaper, and it made it much easier for banks to issue loans to bad credit risks without bearing the true cost of the risk of default (by checking the right boxes on the forms and selling off the loans early while they’re still performing). This kicked off the housing bubble.
In the late 90s, the housing bubble was fed in certain regions (particularly the San Francisco Bay Area) by people getting rich as a consequence of the equities bubble (both in salary from overfunded companies and from incentive stock options).
When the equities bubble popped in 2000, many individual investors concluded that stocks were unsafe, but looked at the unpopped real estate bubble and incorrectly concluded that real estate was a safe investment, which fed further into the real estate bubble.
As the real estate bubble continued, risk models based on historical analysis got more and more broken, and the assumption of bubble-level growth of housing prices got baked into the risk models as if they were the real growth rate, so the apparent risk and the true risk of MBSs and CBOs got further and further apart, further feeding the real estate bubble and the derivitives bubbles built on top of it.
I hadn’t made the Yuan-pegging connection before, but now that you mention it it makes a remarkable amount of sense. There was a great deal of contributory negligance, though, which should be noted:
The financial industry was overly reliant on risk analysis models which break in a sustained bubble.
A great many individual investors and homebuyers made bad assessments of the market and of their own financial situations.
Regulators incorrectly treated MBSs and CBO-insured bonds as if they were as safe as treasuries. Combined with the regulatory requirement to investing AAA securities, this encouraged companies to buy into the bubble when they would have been better off buying AA+ corporate bonds.
Federal policies (particularly Fanny Mae and Freddie Mac) actively encouraged the securitization of mortgages and by some accounts (I’ve heard it most often from Arnold Kling) are responsible for the existence of the mortgage-backed securities market in the first place.
The beauty of this explanation, Eric, is that every single step in the chain is easy to document. It’s all right there.
However, it does place Wen Jiabao’s comments of today into context: this cycle must change and I’m not sure there’s any way to make the change so that it comes out in China’s favor. If they allow the yuan to rise, it will further depress the exports on which their economic growth depends. If the dollar falls, a huge chunk of their national wealth collapses with it.
Here’s a link that makes two points to consider. One is that China’s currency policies multiply the effects from East Asia. The other point, that derives from this, is that China could revalue the yuan modestly in a way that has multiple impacts across East Asia without China taking the brunt.
The paper is five years old though.
http://www.iie.com/publications/papers/paper.cfm?researchid=268
Well, whoever that commenator was, he’s full of…..oh, wait.
I like Eric’s comprehensive view. A couple things I have to ponder a bit more:
1. Just because investors got burned in equities did they necessarily turn to real estate? That’s irrational (although perhaps true). If so, in the US anyway, the real estate bubble was almost a pop cultural issue. And it would make John Q Public’s greed even more of a culprit than banker’s greed. I doubt we will hear a politician say that, though.
2. This is perhaps a nuance, or quibble: “it (Chinese capital inflows into MBS) made it much easier for banks to issue loans to bad credit risks without bearing the true cost of the risk of default” As oft noted, I’m a prisoner of personal experiences. Bad underwriting is still bad underwriting, whether you have plenty of funding or not. And I’ve seen it in either environment. But why the bad underwriting standard? You know my view. In any event, the general MBS market, and Freddie, as Eric points out, certainly made loan syndication an easy way to dump those badly underwritten mortgages from originator’s balance sheets.
Finally, yes, I see no near term change possible in China’s export/savings driven economy.
So what bubble will they fund next!!
Drew:
WRT point 1. We have a policy in place (deductibility of home mortgage interest) that effectively raises the profitability of buying and selling homes relative to other investments and another policy in place that taxes dividends and capital gains which effectively lowers the profitability of buying and holding equities.
When equities began looking riskier after the dot-com bubble deflated, like the boll weevil, the money was lookin’ for a home.
Dave: True. Although no change in that policy occurred in 1996 that might explain housing. But speaking of tax policy. I have never posted this before because it would probably just be dismissed as “pertisan,” and because I’ve never seen an economist take up the argument and attempt to quantify the policy’s impact. However……….
“Tonight, I propose a new tax cut for homeownership that says to every middle-income working family in this country, if you sell your home, you will not have to pay a capital gains tax on it ever — not ever.â€
— President Bill Clinton, at the 1996 Democratic National Convention
This tax break proposed by President Bill Clinton was approved by Congress in 1997. One wonders if when his re-election looked certain and/or when it became clear the following Congress would pass this that the housing game wasn’t on.
Combined with the rise of bad credit / sub-prime in the 90’s, Clinton legacy protectors ain’t gonna like this at all once historians can look back years from now without the haze of politics.