An honest assessment of the crisis’ causation (and timeline) would look something like the following:
1. Ultra low interest rates led to a scramble for yield by fund managers;
2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;
3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;
4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.
5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.
6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.
7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;
8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.
9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.
10. Once home prices began to fall, all of the above fell apart.
Politics and policy from inside Washington
A classic predictions piece from economic analyst Ed Yardeni crosses my desk. First, excerpts from his bullish Black Swans (70 percent probability, he says):
1. The Old Normal trumps the New Normal. The US economic recovery is par for the course.
2. Unemployment subsides faster than expected. The unemployment rate peaked at 10.2% during November 2009; it falls to 8% by the end of 2010.
3. Consumer spending leads the recovery in 2010.
4. The federal funds rate ends the year at 1%.
5. Inflation remains subdued, with the core CPI inflation rate remaining under 2%. While most commodity prices continue to move higher, the price of oil drops to $60 a barrel on ample supplies. The dollar continues to rally in 2010.
6. Stocks-and profits-are stronger than expected. Stock markets around the world (including the US) rise to record highs by the end of 2010.
7. The federal budget deficit starts to narrow, and stress on state and local budgets starts to lift, as a result of better-than-expected economic growth
8. The Obama administration turns more centrist after Congress passes a token health reform bill that alienates the left wing of the Democratic Party. Nevertheless, the Democrats lose their majorities in both chambers of Congress in November.
9. The Iranian government falls and is replaced by a more democratic regime.
10. The Bush tax cuts are extended, following the congressional elections and before year-end. (Fairy tales can come true and usually have happy endings.)
Now his bearish Black Swans (30 percent probability):
1. The US economic recovery is subpar. After rising 4% during Q4-2009, real GDP grows by only 1%-2% during the four quarters of 2010.
2. The unemployment rate rises to 11% by the end of 2010.
3. Consumer spending is very weak due to rising unemployment. Housing starts and home sales decline as mortgage rates and foreclosures rise. Home prices fall.
4. The Fed keeps the federal funds rate near zero through year-end, and is forced to continue buying Agencies to avert a complete housing collapse.
5. Inflation concerns give way to fears of deflation.
6. Stock markets around the world plummet again, led by bank stocks. Sovereign debt crises in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) spill over into Japan, the UK, and even the US.
7. More bailouts and stimulus programs expand the federal budget deficit on a cyclical basis to another record high.
8.The Obama administration turns more leftist after Congress passes a health reform bill–and pushes for even higher taxes on the rich. The Democrats narrowly hold onto their majorities in both chambers of Congress in November.
9. The Iranians crack down on the pro-democracy movement. Tensions in the Middle East intensify, particularly between Israel and Iran. The price of oil soars over $150 during the summer, but then tumbles.
10. The Bush tax cuts expire. This sets the stage for another recession in 2011. Future historians describe this period as the “Second Great Depression.”
He also gives his “known unknowns”:
1. Will employers expand their payrolls as they normally do at this point in the business cycle? Or will we have a jobless recovery?
2. Will consumers save more? Or will near-zero interest rates discourage thrift? If consumers pour more money into stocks to get better returns, might the resulting positive wealth effect boost their spending on goods and services?
3. Will higher taxes depress consumer and business spending?
4. Is a second wave of foreclosures ahead? Might higher mortgage rates put a lid on the upturn in home sales?
5. Or, will a normal inventory-rebuilding cycle set the stage for self-sustaining economic growth? In the past, fiscal and monetary policy stimulus measures were no longer needed once self-sustaining growth kicked in. Is this time different?
6. If the private sector deleverages, will the government continue to leverage even more? Will mounting concerns about the creditworthiness of sovereign debt stymie the ability of governments to continue to prop up economic growth?