Between 2000 and 2005 I found myself spending an increasing amount of time scratching my head. I had been researching and investing in financial-services stocks since 1992, but what I saw during that five-year span confounded me. Banks offered “ninja” mortgages—no income, no job, no assets—to any borrower brazen enough to walk into a branch and request one. I would ask bank management teams during my research meetings how they could justify such imprudent loans. “Housing prices are going straight up!” the executives retorted. Lenders saw no need to worry about a real-estate buyer’s ability to repay his loan when the value of the underlying collateral kept rising.
“But what if prices stop rising, or even fall?” I countered. Before they could answer, I continued with the inevitable conclusion, “If house prices decline you will be stuck with an insolvent borrower and an underlying asset not sufficient to cover the loan balance.”
Bank managers, without fail, brusquely dismissed my hypothetical concern with the bubble-era logic of the early 2000’s: “You just don’t get it.”
They had a point. I didn’t get it. At least I didn’t get it while real-estate prices shot to the moon on their early millennium tear. To our nation’s misfortune we now know that the bankers didn’t get it, either. More precisely, the banks didn’t get it until after those reckless house buyers took up their pitchforks and torches, phoned their congressmen in populist revolt, and demanded both forbearance from foreclosure and loan-balance reductions for borrowing more than they could have repaid if they had won the lottery. Luckily, political economists Nolan McCarty, Keith T. Poole, and Howard Rosenthal, the three authors of Political Bubbles: Financial Crises and the Failure of American Democracy, do get it. Their investigation of the housing crisis identifies all the responsible villains and suggests ways to avoid future recurrences. Unfortunately, their recommendations for averting a replay of the United States’ most recent financial catastrophe get lost in a jumbled text that only a tenured social scientist could love and that conservatives will find grating.
McCarty, Poole, and Rosenthal correctly identify three “pillars” behind the worst financial crisis since the Great Depression: an explosion of loans to unworthy borrowers (i.e., subprime mortgages), a boom in securitization (the bundling and sale of mortgages by the originators to unwitting third parties), and the invention of credit default swaps designed to insure that same worthless paper. As if that weren’t enough to overextend the world’s largest economy, the Federal Reserve’s easy-money policies, combined with mountains of foreign capital in search of a safe haven, pumped in the helium that eventually popped the American real-estate balloon.
These five factors acted in concert to reinforce their most negative effects. Banks eschewed credit-underwriting standards during the go-go years. They took every opportunity to securitize and offload their bad loans to lazy investors who relied on meaningless ratings from credit agencies paid by the lending banks and beholden to their demands. These easy-to-get loans empowered delirious buyers to push real-estate prices skyward. By disconnecting risk from reward through securitization and derivative contracts masquerading as insurance, the system deluded borrowers, lenders, and investors into abrogating their moral and ethical duty to behave like responsible market participants. Adult behavior went the way of your grandfather’s 25-percent down payment. As the authors point out, the sowers of this disastrous global whirlwind were many and diffuse.
Astute students of financial bubbles notice a consistent pattern across time. Easy credit begets excess. Political Bubbles takes the analysis a step further than the typical historical recounting of such phenomena. By analyzing the wreckage of the 2008 real- estate crash through the book’s “Three I’s” framework—ideology, interests, and institutions—the authors show that behind every financial bubble lies a political bubble distended by the same “irrational exuberance,” untamed passions, and flights from economic reality. They rightly blame both political parties’ unthinking acceptance of “free market conservatism” for providing cover for an “anything goes” mentality in American financial markets over the last several decades. However, their objectivity falters when they cite the Tea Party’s “fundamentalist free market capitalism” as an even more insidious manifestation of ideological blindness. Thus begins their crusade against all positions to the right of Barney Frank. Readers with a healthy skepticism of academia will find this unsurprising, even though the authors declare themselves “nonideologues” in the book’s Acknowledgements.
In order to bolster these politicized charges aimed straight at conservatives, the writers ignore the Marxist impulses behind many U.S. banking regulations and government financial policies. The Community Reinvestment Act, a 1977 federal law that forced banks to bend to the “needs” of low- and moderate-income borrowers as a quid pro quo for regulatory approval of pending mergers and acquisitions, reeks of statist meddling and bears no resemblance to capitalism. But the book hardly discusses the legislation’s harmful impact on mortgage lenders’ subsequent credit decisions. Likewise, the Fed and its Soviet-style practice of propounding one interest rate for the entire economy—arguably the prime cause of the real-estate bubble—fails every free-market test and finds its most ardent opposition from conservative goldbugs. Yet, again, this paramount factor merits little attention in the book. But just to confuse things, the authors cite President George W. Bush’s inane remarks at the signing of the American Dream Downpayment Act of 2003—“The rate of homeownership amongst minorities is below 50 percent. And that’s not right, and the country needs to do something about it”—as evidence of the “egalitarian ideology” underpinning the Republican’s ownership society. Huh?
The remaining two of the “Three I’s”—interests and institutions—work better. While illegal behavior often exacerbates financial bubbles, here we learn that “the honest graft of special interest politics” played an even bigger role in causing the American financial crisis. Wealthy campaign contributors stuffed money into the pockets of politicians willing to vote their way, regardless of party affiliation. Rent-seekers, as Tocqueville warned in 1835 when he wrote about the evils of factions, we will always have with us. Short of constitutional change, venal mercenaries will continue to manipulate the U.S. political apparatus to their own advantage. Until enough Americans start to ridicule and shame their fellow citizens for treating the federal treasury as a feeding trough that only fools don’t abuse, we can expect more honest graft to pollute our political economy. The authors deserve special credit for bringing this twisted version of the Emperor’s New Clothes up for national discussion.
It would be hard to identify a practice more detrimental to the nation’s long-term financial viability than biennial congressional elections, which McCarty, Poole, and Rosenthal correctly charge with putting “a premium on short-run fixes over long-term solutions.” Just think of how much larger Wells Fargo, BankAmerica, and JPMorgan Chase are now, thanks to the government prodding of these three megabanks to buy their struggling competitors during the darkest days of September 2008. Consensus opinion deemed this trio of behemoths “too big to fail” at the onset of the crisis; now, mergers complete, they are “too big to bail.” Additionally the courts, infected by the same ideological taint and beholden to special interests like their legislative counterparts, come in for scrutiny for overstepping their constitutional bounds. To society’s detriment, rogue jurists too often rule based on policy concerns and not legal reasoning. Finally, chronic gridlock prevents legislators and regulators from improving rules and laws that history may have shown to be ineffective or outmoded. Instead of calling for the heads of Wall Street executives or demanding the abolition of all derivative securities, Americans should reflect on the authors’ observation that nowhere in the world are the “institutional impediments to financial regulation . . . more severe [than] in the United States.” This insight into our ruling structure’s defective design applies doubly to the think-tank crusaders still set on spreading American-style mobocracy to every unenlightened outpost worldwide.
Those curious as to the sequence of events surrounding the 2008 financial collapse will benefit from the brief history presented in Political Bubbles. The book’s “Three I’s” framework provides a blunt tool to understand an historical event beset by causal density. Yet caution is in order. Perhaps we can forgive these three social scientists for their closing hope that a replay of the government’s policies spanning the period from FDR to Ike will lead to another “period of more than sixty years without a major financial crisis.” Readers with a better grasp of history will remember that era as one in which the United States benefited as the sole functioning economy after World War II. Meanwhile, conservative readers will wonder why, with all the book’s talk of predatory lenders, the authors refuse to indict predatory borrowers, such as those who took out ninja mortgages or borrowed more than the value of their house.
[Political Bubbles: Financial Crises and the Failure of American Democracy, by Nolan McCarty, Keith T. Poole, and Howard Rosenthal (Princeton University Press) 296 pp., $28.95]
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