Part 1 - Credit bubble was root of problem

Part 1 - Credit bubble was root of problem

Note: Today begins a nine-part series of blog posts that offer my take on the credit and housing bubbles, why solutions to-date will fail, what we should do and what we can do to prevent it from happening again.

Historians will argue for years to come about the causes of the credit bubble that artificially inflated housing prices, commodities and other asset classes in the U.S. But for me, three factors rise above the rest: the Financial Services Modernization Act (also known as the Gramm Leach Bliley Act), the Commodity Futures Modernization Act and artificially low interest rates after the dot-com bubble popped.

The Financial Services Modernization Act repealed a portion of the Glass-Steagall Act of 1933 that had prohibited banks from owning other financial companies, a protection that had been put in place to prevent a second Great Depression. The repeal not only enabled financial innovation, but also allowed banks to gamble on mortgage-backed securities, collateralized debt obligations and structured investment vehicles, the three legs of the stool that enabled the current global financial crisis. Banks are built on deposits backed by the Federal Deposit Insurance Corp. (FDIC), which equates to the full faith and credit of the U.S. government. Thus, the Financial Services Modernization Act allowed banks to become "too big" to fail and to gamble with what amounted to taxpayer backing. Banks' excessive growth and high-risk behavior put taxpayers in great jeopardy.

The Commodity Futures Modernization Act of 2000 essentially exempted financial derivatives and credit default swaps from regulation. These financial instruments, called "financial weapons of mass destruction" by investor Warren Buffett, allowed banks to make increasingly risky bets by providing the illusion that those bets were insured. While the concept of taking insurance against potential losses seemed simple, the lack of regulation naturally concentrated losses on those least likely to be able to bear them. Consequently, these financial instruments introduced significant risk into the financial system as evidenced by subsequent events. This legalized form of unregulated financial gambling triggered the bankruptcy of Lehman Brothers and the Federal Reserve's loans to cover AIG's growing losses.

Technology companies lost $5 trillion in market value when the dot-com bubble popped. In the aftermath of that, the Federal Reserve, led by Alan Greenspan, lowered the federal funds rate to 1 percent to encourage banks to borrow and invest more freely. Since banks could borrow so cheaply from one another, the interest rates they were willing to pay depositors dropped. Those low rates forced depositors, who included retirees, pension plans, municipalities and other typically conservative investors, to use riskier strategies to seek higher returns. This happened at a time when millions of investors were already reeling from dot-com bubble losses they were desperate to recoup.

Together, these three factors combined to create a massive credit bubble in which banks rapidly expanded offerings of innovative financial products. These products were sold to unwitting investors, who were desperately seeking the reasonable returns that the Federal Reserve had stolen from them and who relied on the banks' promises of minimal risk due to the illusion of insurance. All the banks still needed was a vehicle for these investment products. And, as I’ll explain in the next post, housing was primed and ready to go.

Next: Credit bubble finds home in housing

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