David P. Goldman has an excellent post, which makes it crystal clear why we saw a housing bubble and the explosion dicey AAA-rated CDOs that caused so much hurt when it all went bust.
No, it wasn’t Wall Street greed. As we’ve seen others put it, blaming greed for Wall Street’s collapse is like blaming gravity for a plane crash. It’s not an answer.:
Every sort of idiotic expanation is offered by academic economists for the financial crisis. Explaining the crisis has become a major industry. The academics by and large haven’t a clue. Grass might as well grow where their classrooms now stand. Wall Street greed and absence of risk management was the usual answer. That’s silly. The investors who bought subprime assets in 2006 weren’t any greedier than when they bought prime assets in 2004. The difference is that monstrous demand crushed the returns on prime assets.
Uh-oh. This sounds a lot like Alan Greenspan’s “Savings Glut” idea. And since we all know that Alan Greenspan must be a total idiot eager to unload any blame for the crisis, it just can’t correct.
But let’s carry on. Here’s a research note he wrote for Cantor Fitzgerald in 2006.
In C.S. Lewis’s “Screwtape Letters,” an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialise, absolute yield levels remain low, and investors enhance returns through leverage.
Investors are not piling into levered synthetic BBB structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth. Investment banks are selling AAA-rated synthetic CDO principal with coupon indexed to the performance of the equity tranche, like the old range accrual notes that brought down Orange County in 1996. Trust Preferreds, REITs, Chinese loans, home equity and a wide variety of other assets have entered the lists of CDO collateral.
That phenomenon, combined with excess savings from Asia — again, with the same mission of finding yield — spurred the insane creation of all these structured products.
This chart shows the inverse relationship between foreign purchases and spreads on agency debt. The greater the demand from Asia, the cheaper funding became, and the more mortgages they could write.
He has other charts showing a similer phenomenon. Cash coming in from overseas depressed rates on everything.
The financial crisis may have calmed down, but the sources of the crisis remain unchanged: the industrial world is unable to fund the greatest retirement wave in history at current returns. Everything that seems to offer yield turns almost instantly into a mini-bubble. This time, as I’ve argued, it’s the “troubled assets” that TARP was supposed to take off banks’ books. They have doubled in price during the past three to four months, just as losses are starting to creep up.
This is all see-able now. Demand for junk, as we’ve noted several times, is off the charts. And the toxic assets held by the banks, as he notes, have soared. It’s hard to imagine a solid, compelling investment not immediately soaring to the moon (followed by a crash) in this environment.
This is also a reminder of how silly and counterproductive the Washington theatrics, and the outrage about bonuses and greed are. They’re not the issue, and limiting them won’t accomplish jack.