In my prior posting on the financial meltdown I mentioned that just about anybody by now has their own theory on what caused the financial meltdown of 2008. Mine may be a little different: The financial meltdown occurred because nobody believed that all the bankers had gone insane.
I remember the first time I heard a radio commercial advertizing home loans for people with bad credit ratings that had a one percent interest rate, the ability to pay whatever you feel like that month, and no need to verify your income. The announcer reminded me of Crazy Eddie. Too young to remember Crazy Eddie?
The biggest difference was that instead of ending with “….prices are insaaaaane” it ended with ‘It’s the biggest no-brainer in the history of mankind!”
I remember my reaction was there had to be something that they weren’t telling, or that I was missing. Otherwise it was just too insane to be real. The concept of these loans not only went against common sense, but the entire notion of what a banker was. I remembered worrying about being approved by the bank when I first bought a house. I also remember my parents being relieved each time that they passed the hurdle of being approved by the bank. We all had seen old movies where the hard luck merchant or farmer had to go to the unsympathetic banker. The scene definitely did not go like this:
Farmer: Please we really need this loan.
Banker: Of course! Everybody’s approved!
Farmer: The last two years’ crops failed.
Banker: No credit history? Personal Bankruptcy? No problem!
Farmer: We can’t pay much.
Banker: Pay whatever you choose each month. It is fine with us. How much did you make last year?
Banker: We’ll just say two hundred thousand, nobody is going to check.
I imagine that I was not the only one who heard these commercials advertizing stated-income, one percent, flexible payment loans and figured that there must be something I was missing. The people taking them up on “the biggest no-brainer in the history of mankind” must have felt that the terms couldn’t be that nuts or the bank would not be offering it. The notion that the roles had been reversed and the borrower now had to protect the banker from irresponsible finances, was beyond comprehension. The banking regulators and members of Congress must have also reached the same conclusion that the banks could not really have gone that insane. The credit rating agencies who rated as AAA the bonds filled with these loans must have concluded the same thing. And so on throughout the entire financial industry. Nobody really thought these loans and the bankers making them could be as insane as they seemed to be.
But the bankers really had gone Crazy Eddie. They had hit upon a pair of bright and not at all insane ideas, at least from a personal standpoint.
- The first bright idea was that things like verifying income and dealing with rejections took time. So if instead they pushed everyone, even those who might qualify for more stringent loans, into the most easy-to-qualify and quickest-to-process loan, they could write way more business.
- The second bright idea was that if they could structure a loan that would not default in the first year (and with one percent for the first year and choose-your-own-payment that certainly would be the case) then (i) the annual bonus checks from that business would be safely cashed before any trouble arrived, and (ii) the loan itself would have already been collateralized multiple times, credit default swaps sold, and derivatives marketed. By the time the second year rolled around, the danger from those insane loans would be far, far away.
When the invisible hand of the marketplace finally did show up to give AIG, Bear Stearns, Lehman Brothers and the others the spanking that they deserved, it turned out that the invisible hand was holding a trillion-pound sledge hammer that would crush anybody else nearby too. And so a new idiom was added to the English language: “too big to fail”.
I am not saying this was the whole cause of the financial collapse. But it does put other factors, like the credit rating agencies providing AAA ratings on the mortgage backed securities, in a clearer light. Had they just believed their own eyes and ears, rating agencies, regulators, Congress, investment bankers could have seen this coming, and were in a position to change the course.