Alarming Economic Parallels—1920s and Today
by Foreclosure-Fighter staff writer
Whether you've been affected by the United States' current foreclosure crisis personally, through a friend, or only via your newspaper, you've probably wondered at some point why and how so many foreclosures occurred at the same time. If so, you're not alone.
Robert Kuttner, an economics and financial journalist, testified before the House Financial Services Committee this month to present his views on what was going wrong with the credit industry and what needed to be done to fix it. His insights are enlightening and, in some cases, disturbing.
Kuttner's testimony focuses largely on the similarities between the lending industry's practices in the 1920s that led to the stock market crash of 1929 and its practices today. Specifically, he outlines five major parallels between the two markets and what should be done to correct the common problems.
- Asset Bubbles: In his testimony, Kuttner explains that asset bubbles are what happens when too much leverage is used and loans or stocks are attributed with a value much higher than their actual worth. In the housing market, home prices rose more quickly than was natural because credit was so cheap. People paid too much for properties and-now that the bubble has burst-are stuck with payments much higher than they can afford.
- Securitization of Credit: Banks offer speculative loans and then sell them off, relying on their established reputation to assure buyers of the loans' ability to perform. In the subprime lending boom, many investors purchased home loans that are not earning them much money now, since borrowers just don't have the money to pay their reset mortgages.
- Excessive Use of Leverage: After the stock market crash of 1929, the government set limits on margins, or what percentage of a risky investment an investor could borrow. According to Kuttner, though, in today's market, very wealthy investors aren't burdened by these limits, and can access huge sums of money. But leveraging-making investments that could potentially gain OR lose large amounts of money-can be dangerous, especially when everybody's doing it. When the subprime bubble burst, many investors lost huge sums of money because of investments that weren't backed by real value.
- Conflicts of Interests: Kuttner points out that the market is arranged so that the borrowers' best interests aren't necessarily considered. For example, he points out that bond issuing firms are the ones who pay bond-raters. In other words, those who determine the validity of the bond are paid by those who make the loan. And riskier loans cost more than safe ones, so their pay rates are higher. Basically, borrowers lose out because things that are costlier and more dangerous to them are often more lucrative for their lenders.
- Belief in Market Self-Regulation: In both the 1920s and the 2000s, the popular belief has been that the financial market will correct itself if it gets too out of whack in either direction. Government intervention is seen as unnecessary and unwanted-until there's a serious crash. Kuttner suggests that this belief is preventing Americans from seeking preventative government action, even though it could prove helpful in the long run.
Kuttner's analysis includes an irony: American investors don't want government intervention while the market is booming (and they're making lots of money on risky loans). But when things turn sour, they trust the Federal Reserve to bail them out.
According to Kuttner, this is an unhealthy way to operate. He suggests government action that would limit the excesses of the market and potentially prevent a crash, rather than simply allowing the government to do damage control when things go bad.
He points out that most of the home loans that were not affected by the burst of the housing bubble had stricter underwriting standards than those that were, and offers this as evidence that regulation can prove helpful in tighter economic time.
Kuttner's testimony provides us with a valuable wake-up call and an insightful look at the causes of the foreclosure crisis-and what might still be to come.