A Lesson from Housing Bubble

Before we replace angst about housing, mortgages and credit markets with anxiety about rising oil prices, consider what we’ ve learned in the past several months. We had a housing bubble; that’ s now obvious. But how did it happen? Why was its bursting so painful? Without answers, we can’ t hope to reduce chances of a repeat. 

Boil it down to the three reasons: rocket scientists, regulators, and ratings agencies.

The rocket scientists are the wizards of Wall Street who invented securities that supposedly dispersed risk widely but actually created much more leverage than proved wise. 

In a modern capitalist system, regulators provide guardrails to keep markets from driving the economy off a cliff. The regulators failed. Whether regulators should or could have restrained innovation on Wall Street or prohibited business deals between consenting, sophisticated adults is a tough question.

Among their many failings, the regulators allowed lenders to make a fundamental mistake: To lend not against the borrower’ s cash flow and income, but instead to lend against the seemingly inexorable increase in the value of the collateral. Mortgages were made to people who couldn’ t afford the payments because the lender (or investor) figured that if the borrower defaulted, the house would always be worth more than the loan.

Then there are the rating agencies. The flaws of rating agencies are a melange of conflicts of interest, misleading grading systems that classified complex securities as if they were much like simple corporate bonds and a backward-looking approach that proved particularly useless. They were the enablers. They are atoning and changing their ways, as they should. Their business model will change; government oversight will be strengthened.

But investors who relied on the rating agencies are at fault, too. Rating firms became a crutch for investors who simply didn’ t want to spend the time and money required to be prudent investors at a time when low interest rates had everyone reaching for higher returns without contemplating the higher risks.

A little “back to basics” in banking and investing would go a substantial way toward avoiding a repeat of the Panic of 2008.