In the boom years, the financial world, which we still call Wall Street, reaped rewards to satisfy King Midas. In just one recent year, 2006, its firms paid out an astonishing $62 billion in bonuses (no, this is not a typo).This was a manifestation of a trend in which the financial services industry's share of total American business profits grew from approximately 10 percent in the early 1980s to an incredible 40 percent at its peak last year. These were years of astonishing, almost obscene, multimillion-dollar salaries and bonuses to the denizens of finance.
The public came to think of these firms and markets as the brains of our economy. There's some truth in that. Wall Street allocated both cash and credit more productively than any central planner ever could, and the credit enabled people to invest in the future, to run businesses, and to buy homes. The prestige—and rewards—of finance attracted elites from our best universities and, indeed, the rest of the world.
But the financiers were too clever by half. The "masters of the universe" created not one bubble but two—a housing bubble and then a credit bubble. Now that both have burst, we face a growing danger of a global financial panic. Every day that passes without a remedy multiplies the risk that we might see a complete freeze-up of the financial and credit markets. This would cause a flight from the system that finances all our activities into safe but less productive havens like U.S. Treasury securities. Such a move could cause an economic crash of horrible consequences.
That's why the administration and Congress have no choice but to try to fix things. Unfortunately, they fumbled the first time round. The idea that greed and carelessness might be condoned, much less rewarded, rightly brought an explosion of public anger. Now they're trying again. But the insistent question in the public mind, one to answer before looking for an exit strategy, is how we got into this potentially lethal maze in the first place.
First, housing. People with no credit history and insufficient income were enabled to buy homes with no money down—often at ridiculously high prices. How come? The immediate cause was as much political as financial. In the early days of the housing boom, members of Congress won votes by pressing for "affordable housing" for everyone. Community organizers were eager to get on the bandwagon and round up likely buyers. The money often came from Fannie Mae and Freddie Mac, which both parties protected by allowing them to run with artificially loose rules. Of course, everyone assumed houses would go on appreciating way beyond the value of any collateral, so that somehow it would all work out. These mortgages, and others like them, became the straw out of which the Wall Street money wizards could spin gold by bundling them into bonds and securities to be sold to institutions like banks around the world. The banks bought them because they were highly rated by credit agencies that didn't actually know what they were rating.
Money everywhere. The result was the greatest housing boom in the country's history. Home values appreciated from 2002 to 2006 at the extraordinary rate of 16 percent a year, compared with 3 percent annually in the prior 55 years. But at a point, it became impossible for the typical American family to buy an average-price house using a conventional 30-year mortgage. Those who used so-called teaser mortgages found their payments ballooning. People defaulted, lenders foreclosed, and house prices started falling. Prices are still 60 percent above their value in the year 2000, when they began to go crazy. If they continue to fall, there will be more defaults on mortgages and mortgage securities—and increased personal bankruptcies and credit card defaults.
No one knows what the mortgage securities and the fancy derivatives that emerged out of them are worth, and which firms might fail, since so much was based on the assumption that housing prices would not go down. Nobody knows who owes what to whom and whether borrowers at any level have the ability to pay. Investors have lost the confidence to trade with one another. And confidence is the essential ingredient in the world of finance. Without confidence, the markets stop functioning. We saw that when stock prices of financial firms, especially those that were massively leveraged with excessive debt, plummeted.