Why You Should Care
Financial literacy and knowledge in the United States is awful. How many American citizens know what caused the financial crisis of 2007-08? Sure, a lot of people have seen (or read) The Big Short or Too Big to Fail, but I’m willing to bet that most people still don’t understand the system that led to the collapse of the housing market.
The following is a brief history of the root causes behind the financial crisis.
In 1933, Congress passed the Glass-Steagall Act as a response to the Great Depression. This law forced commercial banks and investment banks to remain separate. Commercial banks take deposits from ordinary people and use that money to make small business loans, mortgages, and so on. Normal banking stuff that is boring but necessary for the economy. They generally have a lot of cash on hand but are conservative about how they use it.
Investment banks make money by facilitating the economy at a higher level. Their clients are major companies, not mom-and-pop businesses. They help companies issue stock or bonds, they consult on mergers and acquisitions, etc. For a time, they were also able to invest and trade for their own account. Investment bankers were historically considered the "smartest guys in the room.” When most people picture Wall Street, they are picturing investment banks.
Both types of businesses are necessary for the economy to function, and neither are inherently evil.
In 1999, after 66 years without a major financial crisis, Congress repealed Glass-Steagall. This kicked off a huge rush of mergers between the banks, and a lot of people, made a lot of money. Commercial bankers wanted the profits and glamour of the investment banking lifestyle, and investment bankers wanted access to the huge piles of cash (customer deposits) that commercial banks had. These deposits became house money that funded investment bankers’ ambitions.
Looking west down the Chicago River.
Eight years later, the financial crisis nearly destroyed the world economy.
Meanwhile, in the late 1970s, the private-label mortgage backed security was created at Salomon Brothers (an investment bank). Fannie Mae and Freddie Mac originally created mortgage-backed securities in the 1930s, but these securities were insured and implicitly backed by the federal government, which made them extraordinarily stable and safe.
Investment banks created the private-label versions (also called non-agency mortgages, because Fannie Mae and Freddie Mac are government-sponsored agencies), and, initially, they were a great idea. They extended credit to millions of potential homeowners and were incredibly profitable for the banks, which could turn around and sell them to pensions, endowments, and other investment firms. In the beginning, they were just as stable and safe as the government-backed versions because lending standards were high. Everyone was happy: The housing market and U.S. economy were growing, and the banks were making money.
After the Glass-Steagall Act was repealed, things began to change.
Banks began running out of mortgages to sell, because there are only so many people who could afford to meet the lending standards. But by then, they were addicted to the profits. They needed mortgages to sell, so they began to lean on the lenders they worked with, encouraging them to lower their standards. This trend accelerated, until eventually lenders were offering adjustable-rate mortgages (ARMs) and NINJA loans (no income, no job, no assets) to people who historically have never been able to afford a home.
The increasing number of home buyers pushed up housing prices, which encouraged more people to get in on the action, and so on, creating a reinforcing cycle. The problem, of course, was that many of these people couldn’t afford their mortgage payments. They stopped paying, the mortgage securities supported by those payments became worthless, and the banking industry supported by those securities nearly collapsed.
At this point in the story, most people have one of two reactions. Either they blame Wall Street for preying on the poor and uneducated, or they blame the people for being stupid enough to buy a home they couldn’t afford. These arguments often fall along political lines, with Democrats espousing the former and Republicans the latter.
Of course, both are right. People who only blame the banks ignore the personal responsibility involved in buying a home or any other major financial decision. Those who only blame the uneducated homebuyers ignore the financial system that willfully exploited them, putting short-term profits and bonuses ahead of the long-term health of the economy.
Both sides of the argument could be solved with more financial education, on both personal finance and how the financial system works. But even if the education system were revamped tomorrow, it wouldn’t benefit those who have already moved on. This isn’t just “the systems” fault — individuals are responsible for filling the gaps in their education, no matter what political party they associate with. More importantly, people who are educated on these topics are responsible for helping and teaching their fellow citizens. But without looking at it from both the left and the right, any potential solution is going to be half-baked and ineffective.