In fact, it didn't even require much in the way of theory. As financial reform legislation moves its way through the legislative process, we're going to hear a lot of claims along the line of "No one could have predicted this." Which makes me wonder if we're going to militarily occupy Wall Street for a decade too. Of course, this is bullshit, and economist Dean Baker calls out this ersatz 'consensus':
Yeah, it's all really really complicated. Except it isn't.
Nationwide house prices had diverged from a 100-year long trend, increasing by more than 70 percent in real terms. There was no remotely plausible explanation for this run-up. What is hard to to understand to about this? What is complicated? Third grade arithmetic was all that was needed. It's simple, not complicated.
The follow on effects were also pretty obvious:
The run-up in house prices was driving the economy. This was also really easy to see. The government publishes GDP data every quarter. The data showed that housing construction had exploded as a share of the economy. You just had to look at the data. It's simple, not complicated.The data also showed that consumption was booming and savings had fallen to near zero. This was driven by the well-known housing wealth effect. It's simple, not complicated.
It was also easy to see the explosion in subprime and Alt-A loans that people were using to buy homes they could not otherwise afford. These loans were sure to reset at higher interest rates. This works until house prices stop rising. It's simple, not complicated.
And, it was easy to see that house prices would stop rising. Vacancy rates were running at record levels. There is a concept called "supply and demand" in economics and the data showed that we had serious amounts of excess supply. It's simple, not complicated.
And when house prices started to fall, we knew that millions of loans would go bad, construction would plummet and consumption would fall back to more normal levels. This implied a really bad recession and serious financial problems. It's simple, not complicated.
And while Dean Baker, to the best of my knowledge, was the first to call this in early 2000, others like Paul Krugman soon joined in. A few years later, many in finance realized that this was happening, but they couldn't afford to not go along (and just hope they got out in time).
Just like Iraq, we're going to hear the following:
1) No one could have predicted any of this.
2) We were wrong for the right reasons.
3) 'They' (e.g., Dean Baker) were right for the wrong reasons. Like looking at data instead of doing hard, tumescent theory.
And just like Iraq, they're covering up their own ineptitude.
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I've said this before and I'll say it again: I got my econ degree in 2004 from a small university not known for producing high volumes of economics research. My adviser was a very smart guy, not out on the edge of any fringe. Just a run of the mill mainstream macro guy. He devoted entire lectures to the housing bubble in 2003 and the potential banking crisis that could follow. By 2004, those lectures had gotten pretty scary. Maybe we were fringe nuts, but it all seemed pretty straightforward and unambiguous at the time. I didn't really see much controversy in the department over that.
I don't think that most economists were (or necessarily could have been) fully aware of how badly the finance industry had managed to tie its feet together into one gargantuan three legged race. It's well known that banking crises often follow property bubble bursts for obvious reasons, so I was prepared for bank failures and a major credit crunch. I was largely unprepared for the major players to collapse.
Even at private university rates, those few lectures definitely paid for the cost of tuition.
"A few years later, many in finance realized that this was happening, but they couldn't afford to not go along."
Nah. If they only had the capital (100,000,000 USD would do), they could short the housing market or banks and make big $$$.
More likely, they believed they were smart enough to be among the few who got disgustingly rich when the bubble popped. And some of them did get lucky.
I think he moment I realized we were doomed was when I found out what a negative amortization loan was. In the early part of the decade I'd noticed the obvious fact that housing prices had been rising very much faster than incomes for some time, but couldn't understand how people were affording to buy; surely there were not enough people who could afford these prices. Then I decided to check the numbers on a loan deal that was offered on a TV ad. And I saw that you could get a loan, for up to 103% of the purchase price, where every payment put you further into debt. What dumbass would take such a deal? Turned out, a lot of them.
A few years later, many in finance realized that this was happening, but they couldn't afford to not go along (and just hope they got out in time).
As it happens, I have just read Michael Lewis's book on the subject, The Big Short. It seems that there were a handful of people--but only a handful--who both predicted the collapse and had the means to short the market. But many others were riding this gravy train, and most of them got to keep their salaries and bonuses for doing so even after their trades ended up costing billions of dollars. The herd mentality was to be long, up until the day it collapsed, and for several of the shorts it was a near thing for them to be able to hold off long enough to collect on their bets (the market can stay irrational a lot longer than you can stay solvent).
As for negative amortization: I first encountered that concept in the wake of the 1990s housing bust, in which some homebuyers in New Hampshire were enticed into taking out such loans. Back then we still had some semblance of effective regulation, so some of these predatory lenders--anybody originating or underwriting such a loan either knows or should know that the loan cannot (without a sale or a refinancing) be repaid--went to jail over the issue. Fast forward a decade, when under Bush 43 the OCC pushed the state regulators out of the picture (and were upheld by the Supreme Court when state AGs protested), leaving lenders free to make these and other (e.g., teaser rate subprime) predatory loans. Surprise, surprise, these loans were not repaid, and in many cases the default came before the first scheduled reset/recast.