The Alchemists: Three Central Bankers and a World on Fire (13 page)

There was a postboom recession in 2001, all right. But the interventions by the Greenspan Fed were so successful at arresting the economy’s decline that it was the mildest recession of the modern era. By the time the world’s central bankers gathered to honor Greenspan in Jackson Hole, the unemployment rate was back down to 4.9 percent, lower than it had been during even a single month in the 1980s.

Yet for all the global prosperity that the Jackson Hole Consensus had brought by that August, there were already hints that something was off. In the United States, home prices were reaching untold new highs. By 2006, the average U.S. home cost 5.2 times as much as the median American income. From 1985 to 2000, it’d cost only about three times as much. The increase was even more dramatic in certain parts of the nation, particularly Sun Belt cities like Miami, Phoenix, and Las Vegas, where the real estate market bore more than a few resemblances to the Internet stock boom of a few years earlier. “
South Florida is working off a totally new economic model
than any of us have ever experienced in the past,” a Miami real estate broker told the
New York Times
in 2005.

Lenders made their terms easier, competing for business by offering a proliferation of home loans that bankers never would have considered in a different era: zero-money-down loans, in which a person could buy a house without putting up any cash; stated-income loans—or, as they quickly became known, “liar loans”—in which people declared how much money they made rather than proving it; negative-amortization loans, in which the payments the consumer made each month weren’t even enough to cover the interest due, meaning the amount they owed rose over time rather than fell. It was a new era in which speculation in real estate seemed like a riskless path to fantastic wealth.

The United States wasn’t the only place where housing prices were climbing to heretofore unknown levels.
On the sunny Mediterranean coast of Spain
, retirees from Britain and Germany were buying up houses so fiercely that prices rose 145 percent from 1997 to 2005. In Britain, a nation in the midst of the best fifteen years of economic growth in a century, home prices increased 154 percent during the same period. In Ireland, thanks to a favorable business climate and rapid job creation, prices rose 192 percent. Across the planet, people were rapidly concluding that four walls and a roof were more valuable relative to earnings than they had ever been before. The
Economist
tallied the value of all housing in the developed world as having risen to $70 trillion in 2005, from $30 trillion just five years earlier.

But the run-up in home prices was an effect, rather than a cause, of some fundamental problems in the world economy. And indeed, the nations where home prices soared were the same ones where household debt levels also rose to previously unknown levels.
In 1980
, total American household debt—mortgages, credit cards, auto loans, and everything else—amounted to 52 percent of economic output. By 2005, Americans had run up enough debt to put that number at 97 percent, meaning it would take just about one year of the nation’s entire economic production to pay it off.

Over that quarter century, and particularly from 2000 to 2005, the ability to borrow money easily became a salve for all manner of economic hurts. Jobs may have been scarce at times—both the 1991 and 2001 recessions were followed by slow, “jobless” recoveries—but consumers were able to keep buying things because they could always put them on a credit card or take out a second mortgage when times were tough. The result: Americans in 2005 had $41,000 in household debt for every man, woman, and child in the country, up from $6,400 in 1980. If debt levels had grown only as fast as the overall economy, consumers would have owed less than half as much.

The details were different in other countries where home prices rose, but the basic trend wasn’t:
In Spain, for example
, mortgage debt rose at an average rate of 20 percent a year from 2000 to 2004, a period in which home prices rose 16 percent a year. It’s almost impossible for real estate prices to go through that kind of rapid price increase without borrowed money making it possible, which raises a question: Just who was doing all that lending—and
why
? To answer that, you have to go back a little bit.

•   •   •

I
n the late 1990s, a string of emerging nations experienced deep financial crises. Investors lost confidence in what had been rapidly growing economies in, among other nations, Thailand, Indonesia, and South Korea and pulled their money out. The countries’ currencies and stock markets collapsed, and millions found themselves newly unemployed. Governments around the world—not just the ones directly affected by that crisis—took a lesson away from the experience: What global investors give—an influx of investment dollars—they can also take away. And they’ll probably take it away at the worst possible time.

If you’re a head of state in a fast-growing economy, that tells you one big thing: You’d better have a lot of savings in the bank. You need reserves large enough to allow your country to weather a withdrawal by speculators. So you’d better buy some of the safest investments on earth. If you’re an extremely wealthy individual in the developing world—a manufacturing company owner in China, say, or an oil potentate in the Middle East or a well-connected businessman in a former Soviet republic—your thinking is much the same. Why worry about the risk that your government could fall, or that you could lose favor or otherwise lose the great privilege to which you’ve become accustomed?

The best way to protect against those hazards would be to own a bunch of ultrasafe investments in a country that’s politically stable. For various other idiosyncratic reasons, some cultural, some legal, even people in many advanced countries were similarly eager for safe investments during the early 2000s. Germany, with its saving-oriented populace, had so much money filling its banks that they had to find other places to put their money. With the baby boomers in the world’s advanced economies in their peak earning years, pension funds were desperate for places to park cash, too.

In 2005, Ben Bernanke, then a Federal Reserve governor, called all of this extra cash the “
global savings glut
.” Because there was so much of it, there were more people looking for safe, secure places to put money than there were safe, secure places to put it. Capitalism is a powerful force for creating that which is in demand—even something as intangible and elusive as a safe investment. To try to meet the demand for reliable places to park cash—and to make a great deal of money for itself along the way—the finance industry more or less conjured them out of thin air.

Any one mortgage can be quite risky as an investment. The borrower might lose his or her job and be unable to repay it, or prices in the home’s neighborhood might go down instead of up. But if you put a whole bunch of mortgages together into a single pool that people can buy or sell in financial markets, you get rid of some of that risk. And to turn all those risky mortgages into an ultrasafe investment, you can create tiers: Instead of just one bundled-mortgage bond, there can be several.

At the bottom is a security for people who want to take on some risk and get a greater return. The first time somebody doesn’t pay back his or her mortgage, those investors lose money—that’s the price they pay for getting a higher return on their investment. At the top is a security for more cautious investors, people who don’t give up a dime until the losses hit, say, 40 percent of what was loaned out. Those investors get paid a much lower return for their investment. But they also have almost no risk of losing their money. After all, what are the odds that so many people will be unable to repay their mortgages? Or that housing prices will have fallen so far that 40 percent of what was loaned out is lost? Low, indeed—or at least it seemed so.

As if by magic, the financial industry transformed all those risky loans to individual borrowers into that which global investors most coveted—a supersafe investment the firms that rate the safety of bonds would call AAA. The basic idea had been around since the 1980s, but it took off in a previously unseen way in the 2000s.
In the United States alone
, $901 billion of these privately issued mortgage-backed securities were issued in 2005, up from $36 billion a decade earlier.

And the trick wasn’t just applied to mortgages; the big financial firms did the same thing with almost any type of loan you could imagine: credit cards, student loans, corporate loans. In the United States, there were $8.1 trillion worth of such securities in existence in 2005, up from $2.6 trillion in 2000. When that number peaked, in 2007, it had reached almost $11 trillion. Each one of those eleven trillion dollars was simultaneously an asset to one party (perhaps a German bank, or South Korea’s government investment fund, or a wealthy Indian) and a debt of someone else (perhaps a family in Florida who bought the three-bedroom house with a pool that they’d long dreamed of using borrowed money, or a family in Kansas who paid for a trip to Disneyland with their credit card, or a real estate developer in New York who bought an office tower at an unprecedentedly high price).

The idea that one man’s debt is another’s savings is nothing new. Banks have been the intermediary in that exchange for centuries. But in the old days, a banker could look a borrower up and down, study his financial standing, and make the loan knowing that if the borrower didn’t repay, it was the banker’s problem. In this new era, the people with direct contact with borrowers were separated from the lenders by a chasm. The mortgage brokers who proliferated in storefronts all over the country were mere suppliers for the Wall Street bundlers. The brokers knew that some of these were terrible loans, but the big Wall Street firms had such a hunger for the fees they could earn by assembling packages and creating new securities to sell all over the world that they had little interest in knowing too much about what they were getting. The global investors buying the securities did so without necessarily understanding all the gory details of who the borrowers were and what their capacity to repay might be. The gold seal of an AAA rating was enough.

The giant banks were the great intermediaries that made possible an apparent explosion of wealth.
There were, by 2007, $202 trillion in financial assets on earth
, 3.6 times the annual economic output of everyone on the planet; in 1990, the ratio was 2.6. That represents an extra $42 trillion in paper wealth over what would have existed had the ratio stayed constant. Global megabanks, hedge funds, insurance companies, and countless other financial firms were links in the chain that connected borrowers taking on ever larger amounts of debt with the global savings glut. And in Jackson Hole in 2005, almost no one seemed to understand just how weak that link was.

But what
did
they understand? What did central bankers know about what was out of whack in the world economy? And when did they know it?

On both sides of the Atlantic, central bankers had been fretting about the run-up in housing prices, even if they weren’t quite sure what to do about it. Without solid answers, they resorted to just trying to describe, with gentle euphemism, what was occurring in the property markets. There were “
elements of buoyancy
” in Spanish and Irish housing markets, as Jean-Claude Trichet put it in May 2007. Greenspan had conceded two years earlier not that a bubble was building, but that there was “froth”—a number of small bubbles in certain markets. “
It’s pretty clear there is an unsustainable underlying pattern
,” he told the Economic Club of New York. Three weeks before the 2005 Jackson Hole conference, Mervyn King was sufficiently worried about a British housing bubble that he tried to raise interest rates in order to slow down the housing market. Unusually for a central-bank governor, he was outvoted by Britain’s interest-rate-setting committee.
The joke that went around London financial circles
was that as a fan of the perpetually mediocre Aston Villa football club, King felt comfortable losing.

The debate that went on behind closed doors at the Federal Reserve in 2005 reveals how challenging it was for the central bankers to convert their sense that something was wrong in housing into concrete policy. When the Fed’s Federal Open Market Committee met privately around the grand mahogany table overlooking Constitution Avenue in Washington to set interest rate policy for the United States, those concerns were sometimes aired—but rarely with a sense of urgency about finding policies that might alleviate them.

“
Hardly a day goes by
without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy,” said a dismissive Richard Peach, an economist at the Federal Reserve Bank of New York, in a confidential presentation to the FOMC on June 29, 2005. The rapid gains in the housing market, he said, “could be the result of solid fundamentals underlying the housing market”: low interest rates, strong productivity, peak earning of the baby boom generation, and rising incomes, particularly among the affluent.

The same day, the committee heard a presentation on how a housing decline might affect the financial system. “
Neither borrowers nor lenders appear particularly shaky
,” economist Andreas Lehnert told Fed leaders as he gave an analysis of exposure to risky mortgage lending by U.S. banks and other institutions. “Perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices.”

Fed policymakers were attuned to the possibility that housing prices could decline, perhaps sharply. But they failed to understand just how deeply intertwined housing had become with the financial system, or how vulnerable the system was to a shock. “In the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited,” said Michael Moskow, the president of the Chicago Fed.