15 September 2009

Opportunism and Credulity

This article is excerpted from the book Outline of the U.S. Economy, published by the Bureau of International Information Programs. View the entire book (PDF, 3.26 MB).

The dot-com boom was a characteristically opportunistic expression of American economic optimism and credulity. Americans’ fascination with potential stock market windfalls was not a new phenomenon. America’s Founding Fathers had relied on lotteries to raise money for the Continental Army, and today Americans wager more than $50 billion annually in state-run lotteries whose proceeds help fund education and other programs. Investment manias sprouted in every generation, from colonial-era land speculation, to railroads in the 19th century, to biotech and computers in the late 20th century.

In March 2000, the dot-com bubble burst. The immediate cause is debated, although rising interest rates and a downturn in technology investments by major companies hurt the investing climate. Investor confidence was battered by investigations showing that some prominent Wall Street securities experts had misled the investing public about the prospects for some of the Internet stocks. The NASDAQ Index fell close to 1,000 in 2002, wiping out $5 trillion in investors’ “paper” profits. The value of Pets.com fell from $11 per share in February 2000 to $0.19 the day it closed its doors at the end of that year.

The fallout claimed two of the highest-flying companies of the time. One was WorldCom, which had used an aggressive acquisitions strategy funded by stock issues to claim a leading position in telecommunications, taking over competitors such as MCI. The other was Enron, originally a provider of natural gas and electricity, but later an online trader of energy services and commodities. Government investigations led to indictments and convictions of top executives of both companies for defrauding investors through the release of false financial information.

The dot-com bust was followed by another massive flood of speculative investment into U.S. real estate and the home mortgage market. Two-thirds of American families own their homes, which are by far their most important investment, absorbing one-third of their spending and supplying an average $75,000 in homeowner equity, a significant retirement cushion. Home ownership was a crucial part of the American dream, promoted by government leaders across the political spectrum.

Lower interest rates early in the 2000s decade encouraged a surge in lending by banks and nonbank mortgage companies and in borrowing by home buyers. The U.S. government urged banks to make more mortgages available to lower-income families, increasing financial risks for both borrowers and lenders. Mortgages sold to these families with lower-than-average incomes or shaky financial histories were called subprime mortgages (contrasted with standard, or prime, loans to families with average or better financial positions). In the quarter century before 2007, Americans’ household debt including mortgages rose from 45 percent of U.S. gross domestic product to 98 percent.

But the federal government took no serious actions to regulate the surge in mortgage lending that followed. Nor did regulators move to restrain abusive sales tactics by lenders that left unsophisticated home buyers with home loans they could not afford. Home loans were sold by brokers, whose fees rose with each sale, motivating them to push lower-income families into home purchases that strained their finances to the limit. Often, low, “teaser” interest rates were offered for the first years of a mortgage, but the rates would increase dramatically in later years. Studies later showed that many new home buyers did not understand the financial risks they were taking on.

The mortgage industry sought to manage these risks through a process called securitization. Riskier loans were bundled with conventional home loans into packages and divided into units that were sold to investors, like bonds. These mortgage-backed securities paid higher than standard interest because they entailed more risk, and they were eagerly snapped up by investors in the United States and, later, around the world. In 2005, for example, sales of mortgage-backed securities exceeded $1 trillion. Wall Street financial “engineers” developed a series of increasingly more complex and speculative investments linked to the mortgage-backed securities. These also sold well with investors. The result was a sharp global expansion of speculative investments financed heavily by debt.

As long as housing values kept growing, the process continued apace, and housing sales flourished not only in the United States, but also in Britain, Spain, and other nations. But when the overbuilt U.S. housing market crashed in 2007, many individual homeowners found themselves owing more money on their mortgage than their home was worth. As teaser-rate periods expired, borrowers were faced with sharply higher monthly payments, higher in many cases than they could afford. When home prices seemed as if they would continue to rise without limit, borrowers willingly assumed these debts, secure in the belief that they could always sell the home at a profit or refinance against the home’s increased value. Once home prices began their decline, however, these calculations were exposed as gambles gone bad.

These individual mortgage debts had been packaged into increasingly exotic securities and sold worldwide, causing the mortgage crisis to become a global epidemic. The United States and major European and Asian nations committed trillions of dollars to rescue impacted banks and investment funds. As fearful, capital-short lenders stopped making even the short-term and overnight loans woven deeply into the everyday workings of the world economy, government treasuries and central banks became the lenders of last resort on a massive scale, pouring tax dollars into the fractured financial sector and taking direct control or major ownership positions of banks and funds in a stunning reversal of decades of deregulation and reliance on markets.

To some experts, the devastating turn of events was a familiar one in the American economic chronicle. “Booms and busts play a prominent role” throughout U.S. history, the late Federal Reserve Board member Edward M. Gramlich had observed. “In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and a financial boom. The 20th century saw another financial boom, a stock market boom, a postwar boom, and a dot-com boom.

“The details differ, but each of these cases feature initial discoveries of breakthroughs, widespread adoption, widespread investment, then a collapse where prices cannot keep up and many investors lost a lot of money,” Gramlich said. “When the dust clears, there is financial carnage, [but] the canals and railroads are still there and functional, the minerals are discovered and in use, the financing innovations stay, and we will have the Internet and all its capabilities.”

The carnage from the 2008 financial crisis has reached staggering proportions and has fueled widespread demands for closer government regulation of lending and securities markets and far more accountable disclosure of investment risk. European and Asian leaders have insisted that oversight of U.S. and other banking and financial sectors be a global responsibility. It is impossible at this writing to determine how the United States and other nations will resolve these issues. But American history chronicles an ongoing debate over regulation. Today’s Americans and tomorrow’s must determine how best to balance dynamism and order, growth and safety, innovation and stability.