by Nate Silver
Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.
The alchemy that the ratings agencies performed was to spin uncertainty into what looked and felt like risk. They took highly novel securities, subject to an enormous amount of systemic uncertainty, and claimed the ability to quantify just how risky they were. Not only that, but of all possible conclusions, they came to the astounding one that these investments were almost risk-free.
Too many investors mistook these confident conclusions for accurate ones, and too few made backup plans in case things went wrong.
And yet, while the ratings agencies bear substantial responsibility for the financial crisis, they were not alone in making mistakes. The story of the financial crisis as a failure of prediction can be told in three acts.
Act I: The Housing Bubble
An American home has not, historically speaking, been a lucrative investment. In fact, according to an index developed by Robert Shiller and his colleague Karl Case, the market price of an American home has barely increased at all over the long run. After adjusting for inflation, a $10,000 investment made in a home in 1896 would be worth just $10,600 in 1996. The rate of return had been less in a century than the stock market typically produces in a single year.47
But if a home was not a profitable investment it had at least been a safe one. Prior to the 2000s, the most significant shift in American housing prices had come in the years immediately following World War II, when they increased by about 60 percent relative to their nadir in 1942.
The housing boom of the 1950s, however, had almost nothing in common with the housing bubble of the 2000s. The comparison helps to reveal why the 2000s became such a mess.
The postwar years were associated with a substantial shift in living patterns. Americans had emerged from the war with a glut of savings48 and into an age of prosperity. There was a great demand for larger living spaces. Between 1940 and 1960, the homeownership rate surged to 62 percent from 44 percent,49 with most of the growth concentrated in the suburbs.50 Furthermore, the housing boom was accompanied by the baby boom: the U.S. population was growing at a rate of about 20 percent per decade after the war, about twice its rate of growth during the 2000s. This meant that the number of homeowners increased by about 80 percent during the decade—meeting or exceeding the increase in housing prices.
In the 2000s, by contrast, homeownership rates increased only modestly: to a peak of about 69 percent in 2005 from 65 percent a decade earlier.51 Few Americans who hadn’t already bought a home were in a position to afford one. The 40th percentile of household incomes increased by a nominal 15 percent between 2000 and 200652—not enough to cover inflation, let alone a new home.
Instead, the housing boom had been artificially enhanced—through speculators looking to flip homes and through ever more dubious loans to ever less creditworthy consumers. The 2000s were associated with record-low rates of savings: barely above 1 percent in some years. But a mortgage was easier to obtain than ever.53 Prices had become untethered from supply and demand, as lenders, brokers, and the ratings agencies—all of whom profited in one way or another from every home sale—strove to keep the party going.
If the United States had never experienced such a housing bubble before, however, other countries had—and results had been uniformly disastrous. Shiller, studying data going back hundreds of years in countries from the Netherlands to Norway, found that as real estate grew to unaffordable levels a crash almost inevitably followed.54 The infamous Japanese real estate bubble of the early 1990s forms a particularly eerie precedent to the recent U.S. housing bubble, for instance. The price of commercial real estate in Japan increased by about 76 percent over the ten-year period between 1981 and 1991 but then declined by 31 percent over the next five years, a close fit for the trajectory that American home prices took during and after the bubble55 (figure 1-4).
Shiller uncovered another key piece of evidence for the bubble: the people buying the homes had completely unrealistic assumptions about what their investments might return. A survey commissioned by Case and Schiller in 2003 found that homeowners expected their properties to appreciate at a rate of about 13 percent per year.56 In practice, over that one-hundred-year period from 1896 through 199657 to which I referred earlier, sale prices of houses had increased by just 6 percent total after inflation, or about 0.06 percent annually.
These homeowners can perhaps be excused for their overconfidence in the housing market. The housing bubble had seeped into the culture to the point where two separate TV programs—one named Flip This House and the other named Flip That House—were launched within ten days of each other in 2005. Even home buyers who weren’t counting on a huge return on investment may have been concerned about keeping up with the Joneses. “I can remember twenty years ago, on the road to Sacramento, there were no traffic jams,” I was told by George Akerlof, a frequent colleague of Shiller’s, whose office at the University of California at Berkeley sits at the epicenter of some of the worst declines in housing prices. “Now there tend to be traffic stoppages a good share of the way. That’s what people were thinking—if I don’t buy now then I’m gonna pay the same price in five years for a house that’s ten miles up the road.”
Whether homeowners believed that they couldn’t lose on a home or couldn’t choose to defer the purchase, conditions were growing grimmer by the month. By late 2007 there were clear signs of trouble: home prices had declined over the year in seventeen of the twenty largest markets.58 More ominous was the sharp decline in housing permits, a leading indicator of housing demand, which had fallen by 50 percent from their peak.59 Creditors, meanwhile—finally seeing the consequences of their lax standards in the subprime lending market—were becoming less willing to make loans. Foreclosures had doubled by the end of 2007.60
Policy makers’ first instinct was to reinflate the bubble. Governor Charlie Crist of Florida, one of the worst-hit states, proposed a $10,000 credit for new home buyers.61 A bill passed by the U.S. Congress in February 2008 went further, substantially expanding the lending capacity of Fannie Mae and Freddie Mac in that hope that more home sales might be spurred.62 Instead, housing prices continued their inexorable decline, falling a further 20 percent during 2008.
Act II: Leverage, Leverage, Leverage
While quite a few economists identified the housing bubble as it occurred, fewer grasped the consequences of a housing-price collapse for the broader economy. In December 2007, economists in the Wall Street Journal forecasting panel predicted only a 38 percent likelihood of a recession over the next year. This was remarkable because, the data would later reveal, the economy was already in recession at the time. The economists in another panel, the Survey of Professional Forecasters, thought there was less than a 1 in 500 chance that the economy would crash as badly as it did.63
There were two major factors that the economists missed. The first was simply the effect that a drop in housing prices might have on the finances of the average American. As of 2007, middle-class Americans64 had more than 65 percent of their wealth tied up in their homes.65 Otherwise they had been getting poorer—they had been using their household equity as ATMs.66 Nonhousehold wealth—meaning the sum total of things like savings, stocks, pensions, cash, and equity in small businesses—declined by 14 percent67 for the median family between 2001 and 2007.68 When the collapse of the housing bubble wiped essentially all their housing equity off the books, middle-class Americans found they were considerably worse off than they had been a few years earlier.
The decline in consumer spending that resulted as consumers came to take a more realistic v
iew of their finances—what economists call a “wealth effect”—is variously estimated at between about 1.5 percent69 and 3.5 percent70 of GDP per year, potentially enough to turn average growth into a recession. But a garden-variety recession is one thing. A global financial crisis is another, and the wealth effect does not suffice to explain how the housing bubble triggered one.
In fact, the housing market is a fairly small part of the financial system. In 2007, the total volume of home sales in the United States was about $1.7 trillion—paltry when compared with the $40 trillion in stocks that are traded every year. But in contrast to the activity that was taking place on Main Street, Wall Street was making bets on housing at furious rates. In 2007, the total volume of trades in mortgage-backed securities was about $80 trillion.71 That meant that for every dollar that someone was willing to put in a mortgage, Wall Street was making almost $50 worth of bets on the side.72
Now we have the makings of a financial crisis: home buyers’ bets were multiplied fifty times over. The problem can be summed up in a single word: leverage.
If you borrow $20 to wager on the Redskins to beat the Cowboys, that is a leveraged bet.* Likewise, it’s leverage when you borrow money to take out a mortgage—or when you borrow money to bet on a mortgage-backed security.
Lehman Brothers, in 2007, had a leverage ratio of about 33 to 1,73 meaning that it had about $1 in capital for every $33 in financial positions that it held. This meant that if there was just a 3 to 4 percent decline in the value of its portfolio, Lehman Brothers would have negative equity and would potentially face bankruptcy.74
Lehman was not alone in being highly levered: the leverage ratio for other major U.S. banks was about 30 and had been increasing steadily in the run-up to the financial crisis.75 Although historical data on leverage ratios for U.S. banks is spotty, an analysis by the Bank of England on United Kingdom banks suggests that the overall degree of leverage in the system was either near its historical highs in 2007 or was perhaps altogether unprecedented.76
What particularly distinguished Lehman Brothers, however, was its voracious appetite for mortgage-backed securities. The $85 billion it held in mortgage-backed securities in 2007 was about four times more than the underlying value of its capital, meaning that a 25 percent decline in their value would likely be enough to bankrupt the company.77
Ordinarily, investors would have been extremely reluctant to purchase assets like these—or at least they would have hedged their bets very carefully.
“If you’re in a market and someone’s trying to sell you something which you don’t understand,” George Akerlof told me, “you should think that they’re selling you a lemon.”
Akerlof wrote a famous paper on this subject called “The Market for Lemons”78—it won him a Nobel Prize. In the paper, he demonstrated that in a market plagued by asymmetries of information, the quality of goods will decrease and the market will come to be dominated by crooked sellers and gullible or desperate buyers.
Imagine that a stranger walked up to you on the street and asked if you were interested in buying his used car. He showed you the Blue Book value but was not willing to let you take a test-drive. Wouldn’t you be a little suspicious? The core problem in this case is that the stranger knows much more about the car—its repair history, its mileage—than you do. Sensible buyers will avoid transacting in a market like this one at any price. It is a case of uncertainty trumping risk. You know that you’d need a discount to buy from him—but it’s hard to know how much exactly it ought to be. And the lower the man is willing to go on the price, the more convinced you may become that the offer is too good to be true. There may be no such thing as a fair price.
But now imagine that the stranger selling you the car has someone else to vouch for him. Someone who seems credible and trustworthy—a close friend of yours, or someone with whom you have done business previously. Now you might reconsider. This is the role that the ratings agencies played. They vouched for mortgage-backed securities with lots of AAA ratings and helped to enable a market for them that might not otherwise have existed. The market was counting on them to be the Debbie Downer of the mortgage party—but they were acting more like Robert Downey Jr.
Lehman Brothers, in particular, could have used a designated driver. In a conference call in March 2007, Lehman CFO Christopher O’Meara told investors that the recent “hiccup” in the markets did not concern him and that Lehman hoped to do some “bottom fishing” from others who were liquidating their positions prematurely.79 He explained that the credit quality in the mortgage market was “very strong”—a conclusion that could only have been reached by looking at the AAA ratings for the securities and not at the subprime quality of the collateral. Lehman had bought a lemon.
One year later, as the housing bubble began to burst, Lehman was desperately trying to sell its position. But with the skyrocketing premiums that investors were demanding for credit default swaps—investments that pay you out in the event of a default and which therefore provide the primary means of insurance against one—they were only able to reduce their exposure by about 20 percent.80 It was too little and too late, and Lehman went bankrupt on September 14, 2008.
Intermission: Fear Is the New Greed
The precise sequence of events that followed the Lehman bankruptcy could fill its own book (and has been described in some excellent ones, like Too Big to Fail). It should suffice to remember that when a financial company dies, it can continue to haunt the economy through an afterlife of unmet obligations. If Lehman Brothers was no longer able to pay out on the losing bets that it had made, this meant that somebody else suddenly had a huge hole in his portfolio. Their problems, in turn, might affect yet other companies, with the effects cascading throughout the financial system. Investors and lenders, gawking at the accident but unsure about who owed what to whom, might become unable to distinguish the solvent companies from the zombies and unwilling to lend money at any price, preventing even healthy companies from functioning effectively.
It is for this reason that governments—at great cost to taxpayers as well as to their popularity—sometimes bail out failing financial firms. But the Federal Reserve, which did bail out Bear Stearns and AIG, elected not to do so for Lehman Brothers, defying the expectations of investors and causing the Dow to crash by 500 points when it opened for business the next morning.
Why the government bailed out Bear Stearns and AIG but not Lehman remains unclear. One explanation is that Lehman had been so irresponsible, and its financial position had become so decrepit, that the government wasn’t sure what could be accomplished at what price and didn’t want to chase good money after bad.81
Larry Summers, who was the director of the National Economic Council at the time that I met him in the White House in December 2009,82 told me that the United States might have had a modestly better outcome had it bailed out Lehman Brothers. But with the excess of leverage in the system, some degree of pain was inevitable.
“It was a self-denying prophecy,” Summers told me of the financial crisis. “Everybody leveraged substantially, and when everybody leverages substantially, there’s substantial fragility, and their complacency proves to be unwarranted.”
“Lehman was a burning cigarette in a very dry forest,” he continued a little later. “If that hadn’t happened, it’s quite likely that something else would have.”
Summers thinks of the American economy as consisting of a series of feedback loops. One simple feedback is between supply and demand. Imagine that you are running a lemonade stand.83 You lower the price of lemonade and sales go up; raise it and they go down. If you’re making lots of profit because it’s 100 degrees outside and you’re the only lemonade stand on the block, the annoying kid across the street opens his own lemonade stand and undercuts your price.
Supply and demand is an example of a negative feedback: as prices go up, sales go down. Despite their name, negative feedbacks are a good thing for a market economy. Imagine if the opposite were true a
nd as prices went up, sales went up. You raise the price of lemonade from 25 cents to $2.50—but instead of declining, sales double.84 Now you raise the price from $2.50 to $25 and they double again. Eventually, you’re charging $46,000 for a glass of lemonade—the average income in the United States each year—and all 300 million Americans are lined up around the block to get their fix.
This would be an example of a positive feedback. And while it might seem pretty cool at first, you’d soon discover that everyone in the country had gone broke on lemonade. There would be nobody left to manufacture all the video games you were hoping to buy with your profits.
Usually, in Summers’s view, negative feedbacks predominate in the American economy, behaving as a sort of thermostat that prevents it from going into recession or becoming overheated. Summers thinks one of the most important feedbacks is between what he calls fear and greed. Some investors have little appetite for risk and some have plenty, but their preferences balance out: if the price of a stock goes down because a company’s financial position deteriorates, the fearful investor sells his shares to a greedy one who is hoping to bottom-feed.
Greed and fear are volatile quantities, however, and the balance can get out of whack. When there is an excess of greed in the system, there is a bubble. When there is an excess of fear, there is a panic.
Ordinarily, we benefit from consulting our friends and neighbors before making a decision. But when their judgment is compromised, this means that ours will be too. People tend to estimate the prices of houses by making comparisons to other houses85—if the three-bedroom home in the new subdivision across town is selling for $400,000, the colonial home around the block suddenly looks like steal at $350,000. Under these circumstances, if the price of one house increases, it may make the other houses seem more attractive rather than less.
