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Home Publications Blogs Beat the Press It Was the Housing Bubble: Not the Damn CDOs

It Was the Housing Bubble: Not the Damn CDOs

Saturday, 17 April 2010 07:10

The folks who got it wrong when the housing bubble was growing seem determined to prove to the world that they are incapable of learning anything. The latest tales of Goldman designing CDOs are fascinating in that they reveal the incredible level of corruption at Goldman and on Wall Street more generally, but it was not the CDOs that gave us 10 percent unemployment.

Unemployment soared because demand collapsed. And the reason that demand collapsed is because housing bubble wealth disappeared. And housing bubble wealth disappeared -- well, because it was a bubble that was not supported by the fundamentals.

For the 87,865th time, the collapse of the bubble led to a falloff in annual construction (residential and non-residential) spending of more than $600 billion. The loss of $6 trillion in housing wealth led, through the housing wealth effect (this isn't radical -- it is as old an economics doctrine as you'll find) to a loss of close to $400 billion in consumption demand. That gives a combined loss in demand of more than $1 trillion and hence a really bad recession.

This story has nothing directly to do with CDOs. Insofar as CDOs and other games helped to drive the bubble beyond the levels it would have otherwise attained then they made the crash worse than it otherwise would have been, but the CDOs were not directly the problem. It was the bubble.

The folks who played games on Wall Street should be put safely behind bars for long periods of time, but it is important to know that the real story of this crisis was not the complex shenanigans of the Goldman gang. The real story was a huge bubble that was easy to see and guaranteed to burst. The fact that those involved in making and reporting on economic policy somehow did not see the bubble was a failure of immense proportions that should cost many many people their jobs.


--Dean Baker

Comments (27)Add Comment
..., Low-rated comment [Show]
written by RueTheDay, April 17, 2010 9:46
@izzatzo - The fundamental flaw in your line of thought is that we had booms/busts LONG BEFORE we had Keynes, central banks, or concerted attempts at monetary/fiscal policy. Those things all came about BECAUSE capitalist economies naturally tended towards wild swings. The Austrian/Libertarians have the causality precisely backwards.
written by skeptonomist, April 17, 2010 10:10
The monumental size of the housing bubble was made possible by a number of things: low interest rates, both- short and long-term; trick mortgages; sell-off of mortgages by banks and other originators and bundling into securities; and CDS's which were touted as reducing risk but actually did the opposite. To say that the bubble could not have been recognized is nonsense, but it is a fact that the dangers of the various financial operations were not recognized by the operators themselves. Goldman Sachs saw opportunities for short-term profit in CDS's whether or not they crossed the line into illegality, and disregarded the long-term dangers.

Prosecuting Goldman for legal violations will not solve the problem but neither will demanding that we somehow get authorities who can recognize bubbles and use powers which they may or may not have to puncture them. This might happens sometimes - and bubbles may have been avoided in the past - but it is absolutely predictable that most of the time authorities will not have the mindset or the courage to destroy what looks to most people like a good thing.

The only way to avoid bubbles like this one is to set up the rules so they don't get started in the first place. To some extent this was done during the Great Depression. But the world economic establishment still seems to go by the assumption that any kind of financial manipulation that is set up in a "free market" is necessarily good until proven otherwise - and in the case of CDS's they are somehow still considered beneficial even after they have been proven to be disastrous.
written by skeptonomist, April 17, 2010 10:36
CDO's, that is bundled mortgages in general, worked pretty well as long as they were done by the government. Fannie Mae was established as a government agency in 1938. After WW II both short- and long-term rates were very low and there was a huge housing boom which did not turn into a bubble. But starting in the 60's, there was both expansion and privatization of mortgage bundling, without abandoning implicit government backing. Rules and practices became ever more lax until what Goldman did could conceivably be regarded as legal and could eventually be so judged in a trial. The real question is not whether Goldman cheated some institutional investors out of a couple of billion, but the general effect of CDO's on credit markets. This is a more ambiguous case than CDS's.
Housing Bubbe vs Financial Collapse?
written by Kosta, April 17, 2010 11:45
Respectfully, I think your suggestion that it was the housing bubble that caused the economic troubles we're facing is too simplistic. I agree that the housing bubble was a (the?) root cause of the recession, but it was the collapse of the financial system which turned a garden variety recession into the Great Recession of 2008-2009.

Chronologically, the recession started in December 2007, and yes the proximal cause was the popping of the housing bubble. But in the fall of 2008, some 9 months after the start of the recession, Lehman failed, the global banking system was paralyzed, international trade nearly stopped and growth around the world turned negative. Are we to blame all of these effects on the popping of the US housing bubble? Or should we perhaps examine the immediate cause of the downturn in the Fall of 2008, namely the failure and near-failure of the global financial system.

Undoubtedly the downturn in the housing market increased the strain in the US financial sector, including leading to the failure of Lehmans. But it is hard to imagine that the housing bubble on its own was sufficient to bring down the US banks. Some countries exhibited US-like run-ups in housing pricea in the 2000s without collapess (e.g., Australia and Canada), and other countries saw larger downturns in their housing markets without having their financial centres collapsing (e.g. Spain, although they do have unemployment now).

To reiterate, I agree that the housing bubble lead to the recession starting at the end of 2007. I also agree that this recession increased the strain on the US financial sector. But it was the collapse of the US financial sector which turned the garden variety recession into the nasty downturn we're now dealing with. Effort should be made to understand why the financial sector collapsed, rather than just pointing out that it was the housing bubble. There will be bubbles in the future; we should try to make sure that the next time one happens that when it pops, it doesn't take the financial system with it.
..., Low-rated comment [Show]
The credit bubble was the problem ...
written by Peter T, April 18, 2010 12:26
... and the largest credit expansion, by far, happened in the housing market. All this CDO squared and cubed depended mostly on underlying housing securities that were not secure at all. Dean is right to point out how obvious the housing bubble was and how little attention got those those who warned of it, even today.

> Dean's got a new blogging home but he still can't let a day go by without screaming "Housing Bubble! Housing Bubble!"

That reminds me of the old saying about how new but controversial insights are excepted: First it is ingored, then laughed off, then fought, until everything agrees to have believed it from the beginning. But one problem is that we still not discuss why some people ignored the housing bubble and why that would be repeated if we don't change.
written by Min, April 18, 2010 10:59
Would we have had a housing bubble without the CDOs? Would as many bad and fraudulent loans have been made?

Would the impact have been as great without them, and other derivatives? Would credit have frozen up? Without the freezing of credit, would there have been as many defaults and foreclosures?

I do not know enough to say for sure, but the headline suggests a lack of systemic thinking. :(
written by stephen, April 19, 2010 3:19
hi dean,

just thought you'd get a kick out of this article: http://www.economist.com/blogs...l_reform_0

to wit:

"No one can agree on the underlying causes of this latest crisis, or on why the world managed to avoid crises in the postwar decades, or on what steps should be taken to make financial systems more secure."

pretty disappointing.

written by purple, April 19, 2010 5:32
It's pretty clear this is a housing driven recession; residential investment started collapsing in 2006 and led nearly all other indicators.

The reason it led to a financial crisis is because "the models" never predicted that housing prices could fall nationwide, and banks gambled accordingly.

I lived in East Oakland in 2003; when a one-story house across the street went for 375K I knew we were already in a bubble.
written by zinc, April 19, 2010 6:21
I agree that the underlying cause was the collapse of the housing bubble. However, I also believe the housing bubble was a planned response to the collapse of the dot bomb bubble and to mitigate the obvious effects of massive job loss associated with off-shoring.

It is not as if the Bush family and their cohorts of Alan Greenspan, Dick Cheney, et al were strangers to the wonder of real estate bubbles to stimulate consumption. Remember the S&L crisis that was made possible by subversion of the commercial loan process ? That is why Texas actually had protections in place.

The supply side tax cutters have been selling their snake oil since prince Ron, the imbecile. The problem for them has always been huge deficits on the heel of massive tax cuts for the wealthy. Rather than accept the obvious, that massive tax cuts for the wealthy, when the existing marginal tax rate structure is not confuscatory, simply cannot pay for themselves and do little except create huge deficits. No, in both cases, it was decided that huge Keynesian stimulus was necessary to "jump" start the Laffer laugh. The situation was much worse in the 2001 to 2007 period, because domestic employment and consumption were falling as a result of massive direct and indirect job losses to the "fwee twade" movement. Something had to be stimulated. The housing bubble was a feature, not a bug. The Bush/Cheney/Greenspan was like the Reagan/Bush/Greenspan period and lax regulation was a necessary condition to stimulate and sustain both real estate bubbles.
written by bakho, April 19, 2010 8:00
Our elites don't care about unemployment. They only care about the bottom line GDP and whether the wealthy are making money. If our elites cared about unemployment, we would have a better labor policy to address it. Obama has been a major disappointment. They have done a lot to bail out the wealthy but have not done nearly enough to address unemployment. However, the Republican proposals would make things even worse.

Please keep hammering away at them.
written by alex, April 19, 2010 11:27

Slightly OT but I gotta put it somewhere. Is it possible to modify the format of this blog so that comments show time of submission as well as date? This is common practice and I find it helps give one an idea of how active a particular part of a discussion is.

P.S. I'm happy to see that the transition from TAP to your website for this blog seems to have worked out well. The volume of comments here seems to be as big as it was at TAP.
written by Michael, April 19, 2010 11:52
What were they thinking when they abolished Glass-Steagall?
written by Stan Duncan, April 19, 2010 12:02
I agree with you here that the biggest and most unsung part of the debacle was the cataclysmic collapse of the housing bubble, but isn't there a case to be made for there also being a Wall Street Bubble? Every time the mortgage backed securities changed hands and were leveraged, and loaned and swapped and invested, they "increased" in value. They were bet on higher and higher until they bore no resemblance to the underlying (and increasingly shaky) assets that they were supposedly based on. That is also a bubble. People were claiming higher and higher values on the same financial entities. That's a bubble, and that is a part of the story that was driven by (such things as, but not exclusive of) the CDOs.
Just an addition of a compatible point.
written by Jerry Glynn, April 19, 2010 12:55
One more step Dean. The masses were piling up credit so they could maintain their standard of living. Why ? Because the masses have consistently over the past 20 years received less money for their efforts. Why ? Because the rich people took more and more.
The "recovery" from the last recession was phony.
written by Walter Map, April 19, 2010 2:11

"The real story was a huge bubble that was easy to see and guaranteed to burst."

All too true.

Since the 2001 recession the US economy nothing but a credit bubble, particularly a mortgage credit bubble. Discounting that bubble, the 2001 recession never actually ended. All that bubble did was disguise the fact that the economic fundamentals for a real recovery simply were not there. And those fundamentals are still not there.

Economic stimulus cannot succeed because a lot of that money simply gets exported and a lot of the rest gets sucked up by the financial industry. Very little, if any, actually helps the US economy. Deficit spending to support economic stimulus therefore does little but put the US that much deeper in the hole. It's unproductive debt.

The US economy leaks like a sieve. Those leaks have to be plugged: investment in the real economy must be made and the financial industry has to be reregulated. Only then will a stimulus program work. Until then, economic stimulus may stimulate the economy of other countries, but not the US economy.
written by BobS, April 19, 2010 2:19
Jerry Glynn, you're correct in walking back the 'roots' of this problem to the wage stagnation and credit spending that are the sequelae of the neoliberalization of the US economy, but these problems extend back more than 20 years to the 1970s.
Izzatzo is attempting sarcasm
written by PMA, April 19, 2010 8:29
I realize there is a way to view low-rated comments, but consider that Izzatzo's trying to be funny before giving his comment the minus sign.
CDOs and moral hazard
written by jon, April 20, 2010 1:57
Is it possible that CDO's could have accounted for a non-trivial portion of the $6 trillion bubble?

The institutions most qualified to evaluate the risk for individual mortgages, retail banks and mortgage companies, had little financial incentive to do so. The investment banks were buying the risk, but had little expertise, and even less interest, in evaluating individual mortgages.

Selling CDOs requires buying the mortgages. If a bank issuing mortgages knows that they can sell the new paper to a buyer whose only requirement is that it conform to some real estate category, why should it care about proper valuation of the asset? They are selling that problem to the big bank.
Why everyone wants to blame it on the CDOs
written by AndyfromTucson, April 20, 2010 10:19
There are a lot of people in America who bought real estate during the bubble even though it was obvious it was a bubble, and many of those people are hurting now. Newspapers who point out that the bubble was obvious and was the source of recession are pointing out that ordinary Americans are suffering because of their own stupidity in ignoring an obvious bubble. Nobody gets popular, or sells papers or books, by telling people that their problems are their own fault and were entirely avoidable. Hence the media and the punditocracy cheerfully blames everything on exotic financial instruments and Wall Street banker and continues to sell product.
Don't forget egalitarian accessories.
written by Vincent, April 20, 2010 8:44
The housing bubble indeed was the root of the housing/ credit crises. But more important, we should not leave out the political variable to this equation of doom. The Boston Fed, rent-seeking soapbox politicians and absent underwriting standards, financially unstable homebuyers all contributed to the the credit crunch.
Bootstrapped Bubble
written by MinnItMan, April 20, 2010 11:13
While I guess I'm happy for those who sold real estate and got close to 100% of the purchase price for what they sold, the more typical scenario that I saw as a real estate attorney was property that had been log-rolled (sold frequently), each transaction having some combination of seller-paid closing costs of 3-6%, realtor commissions of 6%, a seller-carry back note of 10% (usually bogus - not intended to be paid), and lender financing going ever higher as loan-to-value.

Look at the turnover of existing homes, and then how many were new construction with "investor" middle-men squeezing out an additional 20% from the builders' target prices. You will find that a substantial amount of affluence was derived from these deals, and everybody liked it (g-damn legal ethics kept me on the sidelines, regrettably).

An additional factor was that valuation/appraisals never took into account the fact that certain lenders were notorious for loaning on gassed appraisals (See eAppraisIt/Wamu, but there were many more). Official metrics never discounted for this, and consequently "reported" prices were not reliable, for this and the reasons stated above.

There seem to me to be four major sources of the bubble: 1) Wall-street backed sub-prime and alt-A lenders convincing somebody else that their lending wasn't really risky and allowing their sales people to go wild in ways that 5 minutes in the office would convince any sensible investor to go short; 2) the fact that real estate is at all times a scam-ridden business; 3) the out-size rewards that are available to uneducated hustlers who often don't have other high-earning alternatives; and 4) that real estate appreciation creates a generally excellent political and business climate for those at the top.

So, CDOs/CDS's didn't "cause" the bubble, but they certainly helped it along and were "a cause."
written by Thimbles, April 23, 2010 5:27
I just posted a defense of your piece, making several assumptions on your behalf, on Columbia Journalism Review.

Does my defense properly represent your position?
written by Thimbles, April 23, 2010 5:29
Fudge. The link got mangled. Let's try it one more time. The link.
written by Thimbles, April 23, 2010 5:36
Oh, you have url tags.

Just call me the Sheriff of Nottingham
4 minutes in.
Fannie and Freddie
written by Judy Bloss, April 24, 2010 12:41
Probably someone already has said this. i am new to this site but Leslie Paige wrote a great "prophecy" of the coming financial debacle waaay back in 2000 for "CAGW"

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.