The Recession - How Did We Get Here?

*hat tip to Molly for asking this question*

I find the nature of the economy and the dynamics of the free market fascinating.  Perhaps one of the most interesting parts about the financial world is that once you look beyond the arithmetic of dollars and cents, our economy actually has a HUGE psychological component.  Confidence can quite literally cause markets to climb, while panic can cause markets to fall.  Another very interesting aspect about our economy -- and about people in general -- is that we can't seem to help ourselves when it comes to greed; in order to get that extra buck we will consistently keep putting our collective hands back on the stove even though we know that it's hot.  About a year ago I wrote a piece about the historic nature of this greed phenominon (which actually goes all the way back to the first big market crash in the 1600's) and how human beings can't seem to escape the cycle of repeating history when it comes to deregulating the free market.  Against this backdrop, the events which ultimately led to our current recession should come as no surprise.

1929 - The events which caused our recession today can most readily be traced back to the stock market crash of 1929.  We all know (or at least we should know) that the 1929 stock market crash led to the "Great Depression," but not many people know why the stock market crash led to the "Great Depression."  It was caused primarily by the unregulated commingling of commercial banks (banks like Wells Fargo, Chase, CitiBank, Bank of America, etc.) and investment banks (banks like JP Morgan Chase, Goldman Sachs, Morgan Stanley, Lehman Brothers, etc.).  This commingling caused conflicts of interest to arise where, for example, the American people's savings accounts (typically held by commercial banks) were being used to fund risky bets on the stock market by investment banks. This was par for the course during the late 1800's into the early 1900's.  Because there was no division between the two banking systems, when the investment banks on Wall Street collapsed, they took the commercial banks right along with them. Millions of innocent people -- who had nothing to do with the stock market -- had their entire life's savings wiped out.  What's worse is that they didn't even understand why it happened.

1933 - As a direct response to the foolishness described above, Congress passed Glass-Steagall (named after Senator Carter Glass (D) Virginia, and Representative Henry Steagall (D) Alabama).  It was promptly signed into law by President Franklin Delano Roosevelt.  So what did Glass-Steagall do?  Well, for starters it established the Federal Deposit Insurance Corporation (the "FDIC") which guarantees that your bank account will be insured by the Federal Government for up to $250,000.  We probably take this for granted today but back then this was literally news.  Most importantly, Glass-Steagall created a legal barrier between commercial banks and investment banks.  No more using grandma's savings account to roll the dice on Wall Street.  Investment banks were legally prohibited from reaching their hands into the cookie jars (aka checking accounts and savings accounts) held by commercial banks.  

Our economy slowly recovered and life moved on.

1992 - President Clinton is elected; he directs the Department of Housing and Urban Development (HUD) (which in turn directs Fannie Mae and Freddie Mac) to start taking steps to increase home ownership among low-income families.  In order to achieve this, commercial banks -- but not investment banks -- start handing out more and more "subprime loans" which are loans handed out to people with bad credit.  These subprime loans -- unlike regular or "prime" loans -- were usually loans where the payments started out low at first but then "ballooned" up to something crazy after, let's say, 10 years or so.  The justification for doing this (which is key to understanding this entire mess) is that everybody assumed that property values would continue to go up as they always have.  So the rationale was that poor people would be able to refinance their respective subprime loans later on down the road before their balloon payments would hit.  It probably sounded like a good idea at the time.

1999 - Glass-Steagall is repealed.  Republican Senator Phil Gramm and Republican House members Jim Leach and Thomas Bliley passed the Gramm-Leach-Bliley Act which was signed into law by Democratic President Clinton.  The Act specifically repealed Glass-Steagall's separation of commercial banks from investment banks.  This is what is known in Ghostbusters as "Crossing the Streams."   Wall Street, which had been watching the commercial banks get fat off of the subprime mortgage lending industry since 1992, now had a legal right to join the party.  A new creature is born unto the world:  The Subprime Mortgage-Backed Security.  This completely changed the housing market.  Back in the good old days, when you wanted to buy a home there were only 2 parties: (1) The Home Owner and (2) The Commercial Bank.  In the event that the home owner fell on hard times, the commercial bank had the option to work with the Home Owner on lowering or deferring the monthly payments until the Home Owner got back on their feet.  This is key. Under the sub-prime mortgage backed security system created by the free market after the repeal of Glass-Steagall, a third party was introduced into the Home Owner-Bank model: The Investment Bank.  This changed everything.  

2000-2008 - Under this new system, if a person wanted to buy a home they went to a commercial bank and took out a loan, and the commercial bank now had the choice of giving that person a traditional loan or a sub-prime loan which the commercial bank could then turn around and sell to the investment bank.  The investment bank would then take that loan, bundle it with other loans and then market them as a mortgage-backed security to investors.  Under this model, if a Home Owner fell on hard times the Bank had no flexibility to work with the Home Owner because now the Bank has to answer to the Investors.    Whereas before, missing a monthly payment meant sitting down with a loan officer at the commercial bank and working out a plan, under this new model missing a monthly payment means that the investment bank is defaulting on its obligations to the investors.  Thus, homes that would not ordinarily have been foreclosed on were now being foreclosed on because of the obligations to investors. Multiply that situation a few million times and, voilà, you have now crashed the housing market.

When Wall Street investment banks began to bundle and package subprime mortgage-backed securities, they used a very complex financial formula.  At the root of this forumla was a basic assumption that property values always go UP over time.  Because property values always go up, investment banks like Lehman Brothers and Bear Sterns were able to "max out" the leveraging on the risk they assumed because the financial models all predicted that the money would keep coming in from the subprime mortgage-backed securities.  Everybody and their kid brother was using this same formula apparently, so nobody bothered to question the wisdom in any of this.  

Investment banks began to leverage the revenues produced by the subprime mortgage-backed securities at record levels.  In some cases, lending out 40 dollars for every 1 physical dollar that they actually had in their vaults.  To cover themselves, they issued something called a "credit default swap."  A credit default swap is a fancy way to say "insurance."  In other words, if Goldman Sachs, for example, made a risky $600 million dollar bet, then they would literally take out a $600 million dollar insurance policy on the bet (known as a "credit default swap") so that in the event that they lost the bet, the insurance would make them whole.  This is one of those things that sounds really good on paper but in reality it's a different story. 

In reality, investment banks were using credit default swaps as if they were going out of style.  The main reinsurance company that was backing all of these credit default swaps was AIG.  Just before the proverbial stuff hit the proverbial fan, AIG was (in theory) covering credit default swaps on half the planet's investment banks.  Again, this probably sounded like a good idea at the time.  After all, insurance companies usually make out like bandits, right?  Well the reason why insurance companies make out like bandits is because many people pay insurance premiums to them each month but in return the insurance companies only have to cover a few claims.  Now imagine what would happen to those same insurance companies if everybody filed their claims all at once.  Well that is, in fact, what happened to AIG. When the housing market crashed and all of the investment banks were forced to file their credit default swap claims with AIG, AIG literally did not have enough money to service them all.

END RESULT -  Investment banks and commercial banks were allowed to commingle once again; they collaborated on turning home loans into subprime mortgage-backed securities; the people with low credit who had been given subprime mortgages continued to default on their subprime loans (go figure); panicking investment banks foreclosed upon their homes in record numbers; property values went DOWN; Wall Street's financial model for subprime mortgage-backed securities was destroyed; investment banks attempted to hedge their losses with credit default swaps; AIG was unable to cover the massive losses; many investment banks failed (Lehman Brothers, Bear Sterns, etc.); the financial engine of America's economy (the banking system) was nearly destroyed; the World's economy was dragged down with us; four years later our collective economies are still trying to recover; and history has repeated itself once again.