Photo credit: (c) Can Stock Photo
Hindsight is 20/20, the saying goes. It’s much easier to see what went wrong after events have played out and we’re able to scrutinize the facts. This is one reason last year’s film The Big Short was such a critical favorite, nominated for five Academy Awards among an array of other accolades. It explained the dynamics of economic boom and bust in housing markets, which seemed like a stable and growing invesment to most people in the financial sector until hedge fund manager Dr. Michael Burry, portrayed by Christian Bale, looked past the conventional wisdom to find the market’s crumbling foundation and made an enormous bet against it.
Although it’s much easier to see how the housing market crashed in retrospect, a degree of foresight is also possible once we recognize the economic principles at work. Creating a bubble with supply and demand is sort of like baking a cake. It takes a recipe, with both ingredients and an oven.
A truly excellent bubble cake is prepared with large quantities of hubris. Fortunately, this grows in the wild on a place called Capitol Hill and can be harvested for free. On the same hill, one can find a supermarket that specializes in unintended consequences with an eager staff that has long experience in good intentions gone terribly wrong.
Staff for the bakery can be found at the Political School of Baking, where current and former congressmen and presidential aides gain experience in working closely with feel-good activists to set the standards for the baking industry, introduce new products, direct baking activity and provide uplifting speeches about the good work of bakers. Naturally, it is wise to donate generously to the baking school’s senior political action committees (PACs), and expect to pay substantial consultation fees to graduates of the school.
Experience has shown that the really good senior bakers are found among the top management of large financial institutions, especially banks. They can be relied upon to be adventurous and excited about doing something new, especially with potential for personal fame, although clueless about the recipes of Bubble Cakes. They will recruit a fine staff of wonder bakers to do the work, but never come close to the kitchen where the actual baking occurs.
Bubble cakes require a special kind of baking soda to make them grow to great size. Although the actual composition of this is a mystery, if not a national secret, we will simply use a short-hand label: expansionary monetary policy (EMP). One can still bake without EMP, but the result will not be an enormous and long-lasting bubble cake to be enjoyed by all.
The ingredients of a bubble cake are provided for free by the government. Without going into great explanation, they consist of:
- first congressional, then regulatory, mandated lowering of credit standards for home mortgages;
- with careful kneading, these become “no-down-payment loans,” better known as “no-skin-in-the-game” loans;
- it also helps to have “low-income down payment” subsidies (these can usually be found in the “American Dream” section of the political marketplace);
- once credit reports are strained from the mix we have “liar loans” that can be ignored;
- we can sometimes use a dash of NINJA loans (no income, no job or assets) to thicken the batter;
- next, we need a healthy dose of adjustable rate mortgages (ARMs), which start with a low interest rate that anyone can afford and makes “owning” cheaper than renting and must be frequently refinanced in order to hide the true cost of ownership;
- if there are not enough ARMs for the size of bubble cake we plan, we can use “interest-only” loans or even “interest-differed” loans to make sure that even the poorest among us get a slice.
To ensure a successful bubble cake, the above ingredients need to be mixed with a substantial amount of “refinancing”:
- this is important to make sure the ARMs do not prematurely set off “pop-up rates” that would damage the bubble cake while it is still in the oven;
- refinancing is best when it includes “no-cost” provisions, with fees simply added to principal;
- refinancing is essential to enable mortgage equity withdrawals (MEWs), the active ingredient that allows people to eat slices of the cake even as it remains in the oven growing ever-larger;
- MEWs allow people to treat their homes like an ATM, withdrawing without ever having made a deposit and trading slices for cars, furnishings, appliances, and countless other things.
The oven we use for our bubble cake determines how large and how long we can bake it:
- a large Community Reinvestment Act (CRA), which requires that homes be sold to people who cannot afford them, provides the foundation for the oven;
- on this we can build quotas for “low- and moderate-income” loans, “inner-city” loans, and loans made to satisfy community reinvestment examiners and activists;
- the oven needs to be big enough, so we use government-sponsored enterprises (GSEs) like Fannie Mae (FNMA) and Freddie Mac (FHLMC), which enjoy the provilege of borrowing at government interest rates and make taxpayers suffer all the losses from bad decisions;
- it also helps maintain a hot oven if we have long obsolete institutions like federal home loan banks (FHLBs) to provide additional fuel to Fannie and Freddie;
- next, our oven requires mortgage-backed securities (MBS), which allows the new loans created by the refinancing ingredient of our bubble cake to be combined with other loans and then sold to investors who have no idea what is in them — and make the nastiest of ingredients smell and taste like sweet frosting;
- once we have MBS in place, we can blend in some collateralized debt obligations (CDOs) and some CDSs, which serve as a kind of lottery for betting that the bubble cake will collapse;
- these last two components of the oven work best if we have rating agencies stamp them as AAA grade stainless steel, even if all we have is pig iron;
- finally, the oven is complete if we have “capital inflows,” funds exchanged by foreigners for MBSs and CDOs that we use for new refinancings to fuel and sustain the growth of the bubble cake.
It is essential to understand that some of the ingredients we have used require that the bubble cake grow continuously, or it will collapse. One might think that if it stops growing, it can be removed from the oven and enjoyed by all. Unfortunately, because we used refinancings, MEWs, ARMs, and NINJA loans, much of it has been consumed as it was baking. If we stop baking it, we will find that the MEWs supported a tremendous amount of consumption of other things. Our bubble cake is actually hollow, sharing many characteristics of a soufflé, and no matter how carefully we remove it we cannot prevent it from collapsing in on itself once the oven has been turned off.
If the worst happens, and our bubble cake implodes, we will find that we have tremendous excess capacity in producing the things that people enjoyed because of their refinancings and MEWs — but no longer any demand for that capacity. Also, we will see travel and tourism drop sharply and remission of funds by immigrants to the “old country” contract. Our own industries will feel a desperate need to bring back to our country — and to their balance sheets — vast amounts of money they had invested and earned in other countries. This will give the false impression that our currency is strong, but others will not catch on very quickly.
Regrettably, we get an opportunity to build a truly giant bubble cake only once in a lifetime, so we must enjoy it while it lasts. Once it is gone, we will have neither the ingredients nor the oven to bake another for a long time. A collapsing bubble cake causes simultaneous financial earthquakes, hurricanes, tornados, volcano eruptions, tsunamis, and outbreaks of foundation-eating termites. Governmental policies become helpless, and only years of hard work by ordinary people can repair the damage.
The Big Short shows us some of the immediate devastation that people felt after the housing bubble crashed, but doesn’t delve into the long, drawn-out, agonizing aftermath that continues to be felt throughout the economy all these years later. Left hungry and maybe homeless after a bubble collapses, people need to replant the garden, pool resources with family and neighbors, and begin the long, slow process of cleaning up the mess, making repairs to the foundations of democratic market economies, and restoring the primacy of “We the People” over the government.