The Great Recession

Chapter 2. The Roots of the Great Recession

21 Chapter 2 The Roots of the Great Recession Neil Fligstein and Adam Goldstein T he proximate cause of the “Great Recession” was the unraveling of the mortgage securitization industry beginning in 2007. What had been a relatively small niche market at the beginning of the 1990s was, from 1993 to 2007, transformed into the core activity of the rapidly expanding financial sector. At the peak of the mortgage business, in 2003, the financial sector, comprising about 10 percent of the labor force, was generating 40 percent of the profits in the American economy (Fligstein and Shin 2007; Krippner 2010). These profits were mostly being made from businesses engaged in selling mortgages and creating various forms of mortgage-backed securities and related financial products . In 2003, the mortgage business represented a $4 trillion industry. Beginning in late 2006 and early 2007, the housing and mortgage-backed securities markets began to collapse, taking the larger financial sector down with them by the end of 2008. That crisis threatened the existence of the entire banking system in America. As banks and other financial institutions panicked, the system of granting access to short- and longterm credit for both businesses and consumers appeared to seize up and threatened to shut the economy down. In response to this uncertainty, consumers and businesses stopped buying. This created a downward spiral in the economy, and the most severe crisis in American capitalism since 1929 rapidly took hold. 22    The Great Recession Our basic argument in this chapter is that the Great Recession happened because the growing American financial sector sought to base its business on selling risky mortgages to individuals. These mortgages were risky both because of the questionable creditworthiness of the borrowers to whom they were sold and because key features of the mortgages made them dependent on continued growth in housing prices (Mian and Sufi 2010; Bhardwaj and Sengupta 2009a; Demyanyk and Van Hemert 2009). Over $5.2 trillion worth of these “unconventional,” subprime , Alt-A, and home equity loans were sold to residential borrowers in the United States between 2003 and 2007. Banks and other financial institutions made money from the fees generated by selling the mortgages , packaging them into bonds, and selling the bonds to investors. They also often retained a significant portion of the securities in order to profit from the lucrative spreads on high-yield bonds that could be funded through cheap capital in the period from 2001 to 2006. By aggressively pumping so much credit into housing markets, the banks helped fuel a housing price bubble on which the boom in mortgage-based securities in turn fed (Nadauld and Sherlund 2009). The bursting of this bubble after it peaked in late 2006 set off a wave of mortgage defaults that reverberated back through the mortgage industry and global financial markets. The purpose of this book is to document the recession’s wide-ranging effects in various spheres of social life. This chapter helps set the stage for that discussion by tracing the roots of the recession in developments within the mortgage-finance industry. We have two main aims. The first is to answer the question of what happened and how. We begin by recounting the key events and examining how a drop in housing prices could catalyze a wholesale implosion of the financial economy. We outline the sequencing of these events and connect them to the broader economic downturn they created. We then go back and document the history of how the mortgage finance industry expanded during the 1990s and how the character of this expansion fed the housing bubble that ultimately led to the near collapse of the economy. The second aim is to explore some of the commonly voiced explanations for why the crisis happened. Was it a perfect storm that nobody could have seen coming? Or was it simply that the incentives in the securitization process were misaligned, such that mortgage originators and securitizers had little reason to care about borrowers’ ability to repay, since they were passing the risk off onto others? To what extent can we see the crisis as a result of Wall Street’s infatuation with mathematical models and securitization technologies whose complexity concealed risks and eventually outstripped the ability of people to understand them? We evaluate the strengths and limits of these explanations of the crisis in light of the evidence we will present. What we find is that Roots...