The Financial Crisis Blame Game

(page 2 of 4)

Related Items

• Forget Adam Smith, Whatever Works
• How to Get Growth Back on Track
• Views on the Bailout, From Harlem to Wall Street
• Stocks Fall, Capping Wild Week
• Paulson's $250 Billion Bank Buy
• Audio: Wall Street Pioneer Dan Lufkin on the Crisis

The idea for "The Financial Crisis Blame Game" came from BusinessWeek reader Joe Lacenere, who works in supply chain management for a leading multinational. Joe has been a loyal reader of BusinessWeek for at least 15 years.

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• suggest a story
• digg this
• save to del.icio.us

A Sign: Soaring Home Price-to-Income Ratio

First, there was a bubble in the U.S. housing market as home prices hit unsustainable levels. We should have recognized a bubble when we saw it: Just a few years before, another market bubble collapsed—in technology stocks. And all the signs were there in housing.

If you ever drove through row after row of new tract homes sprouting from the California desert and wondered, "How can all these people afford $500,000 houses?" the answer was, they couldn't. For the two decades until 2001, the national median home price went up and down, but it remained between 2.9 and 3.1 times the median household income, according to the Harvard Joint Center for Housing Studies. By 2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6. Or consider this statistic: in 2006, at the height of the bubble, more than four in every 10 California households owning a home spent 30% or more of their incomes on housing.

"As a system, we were pressing beyond what the economics were suggesting people could afford," says Michael Strauss, chief economist at Commonfund. Nonetheless, nearly everyone in the system had a "false sense of security that housing prices would always go up."

That included home buyers and real estate and mortgage professionals.

Another Sign: The Securitization Monster

But what turned a nasty housing downturn into an extinction-level event for the whole economy was a Wall Street innovation called securitization.

With interest rates low, investors around the world were eager for places to put their money that offered substantial returns. While the federal funds rate was at 6.5% for much of 2000, by the end of 2001 Federal Reserve Chairman Greenspan had lowered the rate to below 2%. It remained there until late 2004. In 2003, the yield on the one-year Treasury bill dipped well below 2%, its lowest level in the past 40 years. Securitization, and the new investment products it could spawn, seemed to be the answer for a Wall Street seeking a bigger payoff.

Through securitization, Wall Street firms would buy up mortgages, bundle them together, and sell them off to investors. These mortgage-backed securities were highly complex and hard to price accurately. But selling them offered returns for financial firms far above those of safer investments. And with home prices continuing to rise, many, including ratings agencies, assumed that assets backed by U.S. mortgages were safe.

"The development of the securitization pipeline [meant] there was a lot of pressure to create the loans," says University of Kansas finance professor George Bittlingmayer. Mortgages were given to buyers with low credit scores—so-called subprime borrowers—and other high-risk borrowers, with little concern that they wouldn't be able to pay the loans off. The easy money, in turn, contributed to an "upward spiral" of home prices, Bittlingmayer says—"until the bubble collapsed."

Most of the mortgage brokers who originated these loans weren't "bad people," Bittlingmayer adds. "They were doing what the system was asking them to do."

Wall Street was eager to buy up, bundle, and securitize the mortgages. Washington, in turn, had urged the mortgage industry to give more loans to low-income home buyers. During the Clinton and Bush Administrations, "there was a push to try to put homes within reach of everyone," says Larry Tabb, founder and chief executive of the TABB Group, a capital markets research and advisory firm.