uncontrolled, or perversely incented, bankers.
There were other dark signs. One was the entry of “hard money lenders” like Beneficial Finance and Household Finance into housing finance. They specialized in high-risk, high-yield
lending, and were aggressive in going after defaulting borrowers. By the end of the 1990s, the high earnings of hard-money housing spin-offs, outfits such as the Money Store, Option One, and New
Century, made them darlings of the stock market. Riskier housing lending, although still a small fraction of the market, was growing. 7
High-risk mortgages were extremely profitable, particularly if their risks could be disguised, because they carried high fees and interest rates. They were also perfect for a Ponzi-like bubble,
which would temporarily conceal fraud. If housing prices were rising, then the loans could be paid off by flipping houses or by taking out additional home equity loans, based on the supposed
appreciation of the house.
The gradual rise in high-risk lending exploited the fatal flaw of securitization, namely that it broke the essential link between credit decisions and subsequent credit risk and
consequences . If people pumped out bad loans just to sell them, trouble would eventually follow, but it would be other people’s trouble. In principle, one could adjust for this,
for example by requiring sellers of loans to accept a fraction of subsequent losses. But nobody did that; in fact, compensation practices were moving in the opposite direction, and fast.
Securitization spread from high-quality mortgages to so-called subprime mortgages, and also to other classes of loans. Wall Street started securitizing portfolios of credit card receivables, car
loans, student tuition loans, commercial property loans, and bank loans used to finance leveraged corporate buyouts. Initially, again, only high-quality loans were used; but, again, quality
declined steadily over time.
At the same time, the securitization food chain became ever more complex and opaque. Its growth and increasing complexity caused a gradual, disguised rise in system-wide leverage and risk. Many
buyers of securitized products were hedge funds and other highly leveraged,unregulated “shadow banking” entities. Securitized mortgage products were increasingly
insured by specialized (“monoline”) insurance companies and/or via credit default swaps, a market dominated by a London-based unit of AIG (AIG Financial Products). These were
unregulated derivatives that generated potentially huge payments in the event of credit downgrades or defaults. But nobody knew the total size or distribution of these risks.
During the same period, the increasing criminality and systemic danger of finance was showing itself, even as the industry successfully pressed for more deregulation. The most visible signs were
the Internet bubble, the huge frauds at WorldCom and Enron, the Asian financial crisis, and the implosion of Long-Term Capital Management (LTCM), which at the time was the world’s largest
hedge fund.
The Internet revolution was very real, and certainly justified a sharp spike in venture capital investment, start-up activity, and initial public offerings, as well as in the share prices of
established companies well positioned to exploit Internet technology. What actually happened, however, was insane, and went far beyond rationality. Companies with almost no revenues, losing huge
sums of money, and with no plausible way to reach profitability, received enormous equity investments and then went public at extraordinary valuations. The Nasdaq index, a good proxy for technology
stocks, went from under 900 in 1995 to over 4500 in January 2000.
Then the bubble collapsed. Eighteen months later, in mid-2002, the Nasdaq was back down to 1100. Certainly much of the bubble was driven by general public overexcitement, but much of it was also
driven by fraud, on the part of both entrepreneurs and Wall Street. Dozens of
There were other dark signs. One was the entry of “hard money lenders” like Beneficial Finance and Household Finance into housing finance. They specialized in high-risk, high-yield
lending, and were aggressive in going after defaulting borrowers. By the end of the 1990s, the high earnings of hard-money housing spin-offs, outfits such as the Money Store, Option One, and New
Century, made them darlings of the stock market. Riskier housing lending, although still a small fraction of the market, was growing. 7
High-risk mortgages were extremely profitable, particularly if their risks could be disguised, because they carried high fees and interest rates. They were also perfect for a Ponzi-like bubble,
which would temporarily conceal fraud. If housing prices were rising, then the loans could be paid off by flipping houses or by taking out additional home equity loans, based on the supposed
appreciation of the house.
The gradual rise in high-risk lending exploited the fatal flaw of securitization, namely that it broke the essential link between credit decisions and subsequent credit risk and
consequences . If people pumped out bad loans just to sell them, trouble would eventually follow, but it would be other people’s trouble. In principle, one could adjust for this,
for example by requiring sellers of loans to accept a fraction of subsequent losses. But nobody did that; in fact, compensation practices were moving in the opposite direction, and fast.
Securitization spread from high-quality mortgages to so-called subprime mortgages, and also to other classes of loans. Wall Street started securitizing portfolios of credit card receivables, car
loans, student tuition loans, commercial property loans, and bank loans used to finance leveraged corporate buyouts. Initially, again, only high-quality loans were used; but, again, quality
declined steadily over time.
At the same time, the securitization food chain became ever more complex and opaque. Its growth and increasing complexity caused a gradual, disguised rise in system-wide leverage and risk. Many
buyers of securitized products were hedge funds and other highly leveraged,unregulated “shadow banking” entities. Securitized mortgage products were increasingly
insured by specialized (“monoline”) insurance companies and/or via credit default swaps, a market dominated by a London-based unit of AIG (AIG Financial Products). These were
unregulated derivatives that generated potentially huge payments in the event of credit downgrades or defaults. But nobody knew the total size or distribution of these risks.
During the same period, the increasing criminality and systemic danger of finance was showing itself, even as the industry successfully pressed for more deregulation. The most visible signs were
the Internet bubble, the huge frauds at WorldCom and Enron, the Asian financial crisis, and the implosion of Long-Term Capital Management (LTCM), which at the time was the world’s largest
hedge fund.
The Internet revolution was very real, and certainly justified a sharp spike in venture capital investment, start-up activity, and initial public offerings, as well as in the share prices of
established companies well positioned to exploit Internet technology. What actually happened, however, was insane, and went far beyond rationality. Companies with almost no revenues, losing huge
sums of money, and with no plausible way to reach profitability, received enormous equity investments and then went public at extraordinary valuations. The Nasdaq index, a good proxy for technology
stocks, went from under 900 in 1995 to over 4500 in January 2000.
Then the bubble collapsed. Eighteen months later, in mid-2002, the Nasdaq was back down to 1100. Certainly much of the bubble was driven by general public overexcitement, but much of it was also
driven by fraud, on the part of both entrepreneurs and Wall Street. Dozens of
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