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a little more than a decade ago the u.s and the world experienced the financial crisis that eviscerated retirement savings home ownership family economic security millions of jobs and businesses and wreck the global economy we all remember 2008 and 2009 today we're still recovering despite a decade of growth what really happened in 2008 what caused that crisis when the u.s or others have experienced anything similar what were the causes might there be some common denominators over the past 10 years a team of researchers and analysts that i've assembled have carefully examined critical economic data leading up to and into the numerous financial crises that have beset the united states and other nations over the past 200 years i wanted us to explore a hunch of mine coming out of 2008 then an explosion of mortgage debt and associated derivative instruments represented a massive expansion of private debt this enormous influx in the supply of debt sustained a housing boom that succumbed to compromise credit standards and a nearly religious conviction that home values could only go up we know how that turned out i wondered was runaway private debt present at the dawn of the great depression when japan's economy tanked in the 1990s or when the nation faced the panics of 1857 and 1873 among others surprisingly and troublingly rare was the conversation that flagged expansion of private debt as a cause or even a concern if i was right in my theory i wanted to do something to correct a flaw in the analytics of financial crises well it turns out that an unchecked expansion of private debts materialized just prior to every single major banking or financial crisis on record i invite you to be my guest for an excursion through a brief history of doom i'm richard vague [Music] since the dawn of lending there have been financial crises but the crises in the u.s in 1819 and in britain in 1825 are perhaps the first of the industrial age in 1816 the second bank of the u.s was chartered with the power to make conventional loans and make them it did at a time when most banks were not much more than one million dollars in loans its loans skyrocketed to 13.5 million in its first year and 41.2 million in its second the history of all newly industrializing nation evidences that early lending practices are rarely steeped in risk analysis the bank's losses were so enormous it was crippled in its dealings for six or seven years in the aftermath the bank found it held among its collateral for liquidation a substantial portion of the city of cincinnati britain too was on the cutting edge of the industrial age british investors seeking higher yields found newly issued bonds by the south american governments and enterprises enticingly priced between 1822 and 1825 nine latin american countries issued 22 million pounds in bonds on london exchanges the tenth issuer is quite a tale in and of itself an entrepreneurial scoundrel a scotsman named gregor mcgregor devised a scheme to capitalize on ignorance and greed he literally created a fictional country poise in latin america mcgregor circulated a map of that country in his offering materials he raised 200 000 pounds and he took the intensive speculation in debt that characterized the uk's 1825 financial crisis to a remarkable new level but the frothing in bonds was dwarfed by a much larger bubble when joint stock companies became a popular investment vehicle sold on margin one observer found that in 1824 and 1825 624 companies announced their intention to sell shares and over half existed only on paper ultimately ten percent of british banks failed rampant lending and speculation led to bad debt and failed banks france ii experienced a prolonged crisis from 1827 to 1831 resulting in the failure of 252 banks by the mid-1830s the u.s economy was in the throes of an enormous credit-fueled frenzy dominated by loans to acquire land for construction and to finance large-scale cotton plantations this frenzy drove up prices in gdp which grew 51 percent from 1830 to 1837 writing in part on a 22 percent surge in population not only was the population growing but it was moving west in the decade of the 1830s the federal government disposed of 75 000 plus square miles of land more land than in all of england fueled by debt finance purchases land prices investors skyrocketing speculators came to expect returns of a hundred percent or more no one thought they could lose money in real estate cotton two was booming and with it the trade and human slavery land under cotton cultivation grew from 2 million acres to 5 million acres through the decade the slave population grew rapidly as did the values they fetched on the market southern households and plantations bought and sold slaves with borrowed funds or collaterized their loans for other needs through their slave holdings slave collateral was a widely used financing tool in the pre-civil war south shamefully commercial banks accepted slaves as collateral largely because they were mobile and easier to sell than land in both cases the sale of western lands and expansion in the land of cotton created a credit frenzy that financed super excess in capacity in 1830 the u.s produced one million bales of cotton priced at 10 cents per pound by 1835 the price peaked at 17 cents in production at 1.8 million bales 90 of britain's cotton was imported from the us and cotton was the raw material for its industrial revolution private debt fueled all of this between 1830 and 1837 it grew in the u.s from an estimated 340 million dollars to almost 800 million dollars at the center of the american banking system was the villainized second bank of the united states the same one that andrew jackson had correctly targeted for blame for the panic of 1819 jackson believed banking belonged to the states so he vetoed a bill to renew the second bank's charter and he ordered all federal deposits withdrawn from the bank and redeposited in state banks in so doing he gutted the second bank and unleashed a new monster virtually unregulated state chartered banks that grew from 381 banks in 1830 to 703 banks in 1836 and under regulation is a recurring theme in the history of financial doom fueled with their newfound government deposits loans by state banks surged from 153 million dollars in 1832 to 511 million dollars in 1836. to quell the credit fuel land sales jackson imposed the species circular requiring government land to be purchased by gold or silver instead of loan supplied paper currency annual land sales dropped from 25.2 million dollars in 1836 to 7 million dollars and haul the secondary market along with it u.s lenders saw land prices flatten and then dip before dropping precipitously taking down another group of bank lenders in march 1837 new orleans largest and most prominent cotton broker hermann briggs and company failed bringing down at least 10 other cotton brokers and dozens of smaller companies it took a week and a half for the news to reach wall street it reverberated quickly it was the beginning of the end according to the new york herald as with the price of cotton so would go the price of land and yes slaves which according to a vicksburg editor were selling for a fifth of their real value in new york it was fully observed that more than 250 commercial ventures had failed 20 000 people were suddenly unemployed and real estate values had plummeted by more than 40 million dollars a run on the new york banks followed reducing their reserves to a paltry 1.3 million dollars over the next 14 months through the spring of 1837 343 of the 850 u.s banks failed bank failures in new york alone hovered around 100 million dollars in losses 1837 a brutal year for a young nation it may properly be called the first great depression 500 000 people out of work 39 000 bankruptcies one of the most revealing case studies to reinforce our hypothesis can be seen in a series of financial crises that resulted from overbuilding of railroads the railroad industry was the most significant technological and transportation breakthrough of the 19th century for more than 60 years railroad lines grew like spider webs throughout the nation together with the telegraph whose lines ran along railroad rights of way these technologies consumed disrupted and transformed the united states and every nation that embraced them to finance their expansion construction and operations railroads incurred massive debts what resulted was a sprawling chaotic debt-financed expansion of hundreds of railroads throughout the industrial world that powered global gdp to miraculous heights to understand the boom and bust cycle of railroad take a look at this graph starting in 1836 we can track the number of miles of railroads built in the united states observed the spikes in 1854 1872 1881 1887 in the early 20th century you can also see the huge expansion in land sales each spike is followed by a collapse once supply has far outstripped demand each one of those spikes and collapse cycles brought about a financial crisis one of the best examples of this is the crisis of 1857. early that year reflecting a certain reckless optimism the new york herald tribune proclaimed the dawn of an exceedingly brisk and prosperous times with no threat of downturn on the horizon after the various land purchases of what became new states and territories following the mexican-american war the size of the u.s had almost doubled reliable long-distance rail service had become essential between 1853 and 1856 the us more than doubled total rail mileage by adding 9536 miles of track much of this growth came about as a result of large land grants made by the u.s government to encourage railroad expansion in one seven-year period land grants totaling 22 million acres were made in 11 western and southern states the railroad sold much of this land utilizing seller mortgage finance this easy money fueled speculation a lot that went for 500 in omaha in 1856 was up for five thousand dollars one year later and this part of the story is another example of an observable pattern that accompanies financial crises and that is the emergence of a new creative and ultimately disastrous lending instrument like the railroad farm mortgage one such instrument was created and first implemented by the lacrosse and milwaukee railroad farmers were encouraged to purchase shares in the railroad through funds borrowed by mortgages on their farms this looked like a winner to the farmer dividends from the railroad stock would cover the mortgage payments for the land once the railroad was completed the value of the land and the value of the shares would both rise yielding profits to the farmer it was a catastrophe waiting to happen one historian noted that by june 1857 the amount of indebtedness incurred by railways manufacturers and promoters had overreached the saturation point railroading wasn't the only squeeze point wheat prices had peaked in early 1856 and then began a precipitous decline ohio life despite its name was not in the insurance business its investment portfolio was heavily weighted towards the public securities issued by western railroads when the railroad boom went south ohio life failed that led to further plummeting in the price of shares and railroad stocks farm prices crashed and the land parcels that were selling for a thousand dollars could now not be sold for ten dollars soon railroads were failing then the wisconsin farmers who had entered into the railroad farm mortgages to purchase stock suddenly found themselves without a farm now repossessed by their lender nor the stock now worth pennies on the dollar banks trying to reinforce their financial position started calling in loans as well adding to the mounting financial turmoil after a steamship carrying 425 passengers and almost two million dollars worth of california gold bound for new york sunk hopes for buster seeing the banks sunk with it in philadelphia banks decided to suspend all payments as another historian noted all hope disappeared a new york daily tribune journalist writing in london observed that the crisis came from the quote industrial system which leads to overproduction that journalist was named karl marx let's fast forward to the crisis of 1873. the 1870s were another boom time with a massive expansion of railroads as you can see in the crisis matrix rail miles built grew from 2468 in 1868 to 5217 in 1873 agriculture was a huge driver of this expansion and grew to be as big a revenue source as were passengers wheat production increased by 89 between 1865 and 1873 and rail mileage more than doubled from 31 919 to 67 409 this demand fueled domestic and overseas investment in railroad bonds notably from investors in germany and austria who were flush with cash after a successful war against france railroad promoters in north dakota named a town bismarck in order to attract this german capital jay cook had made his fortune as a young man and then gained another fortune and a national reputation selling u.s war bonds during the civil war seeking a place in the burgeoning railroad business he looked where the big guns were not already to the northern frontier cook took control of the northern pacific railroad it had an enormous land grant in a sparsely populated region the company needed money so cook sought to raise a hundred million dollars selling land and bonds let's just say that this was a very hard sell when j cook and company gap funding the northern pacific failed on september 18th the nation was shocked this failure brought on a full crisis dozens of banks brokers and railroads failed mercantile failure exploded from 1873 to 1875 121 u.s railroad companies defaulted on 552 million dollars in outstanding bonds freight traffic fell by 50 percent passenger service would not recover until 1879. u.s foundries closed companies tried to survive by laying workers off reducing hours or paying with company ious this was the first financial crisis in which as a result of a large number of americans having become wage earners most could no longer easily retreat into a subsistence life on a farm from then on the prevailing character of a wage labor economy would fundamentally change how financial crises were experienced unemployment was punishing at one point 25 percent of all workers in new york were jobless leading to protests and violence the crisis of 1873 had other far-reaching ramifications it contributed to post-civil war racism as many whites blame slaves and not railroads for the economic woes bolstering the collapse of reconstruction and an increase in violence against former slaves it's easy to forget the death and despair of the great depression one historian captured it best when he described us a nation simmered in misery with 34 million americans in households without a breadwinner oceans of ink have been spilled to explain why the bust phase with the collapse of gdp was so protracted painful and deep but almost entirely absent from the most widely read economic histories of the great depression is any attention to its one central cause runaway private debt in their classic monetary history anna jacobson schwartz and milton friedman dismiss private debt and therefore miss the human factors involved in the crisis competitive intensity the drive for wealth pervasive hubris and self-delusion the great depression was a massive residential and commercial real estate crisis like most financial crises the great depression rolled out in three stages first the lending [Music] as the decade of the 1920s opens the nation's housing had become a national issue commerce secretary herbert hoover advocated for home ownership as the foundation of a sound economy and social system banks building and loans bond underwriters and other lenders responded to the call sound familiar it's also typical in the arc of a financial crisis new lenders compete with conventional banks after all these are less regulated or unregulated players building and loan associations are a case in point these grew from 8 000 to 13 000 in the decade and were often formed by developers who would make loans to their own projects no conflict of interest there real estate bonds also came into fashion yielding billions in new capital for apartments hotels office buildings a d more to capitalize on the profitability of this underwriting and trading banks formed securities affiliates that grew from 10 in 1922 to 114 in 1931. the result an increase in office space by 92 percent in manhattan 96 in san diego 89 in minneapolis and 74 in chicago all between 1925 and 1931 this represented over capacity run amok real estate development was finance driven and not demand driven this led to more projects more jobs and over capacity in the labor pool the boom in lending extended to business as well and notably in the area of utilities on the exchanges utility stocks were hot and heavy representing about 18 of the market cap of all shares traded on the new york stock exchange in 1929. there were utility stocks that traded from 57 to 90 times earnings per share hubris and a sense of invincibility typically run rampant in the years leading up to a financial crises lots of folks were predicting permanence to describe american prosperity and stock market valuations in 1929 the stock market spiked in the swirl of this exuberance in the first nine months utilities gained 48 percent industrial is 20 percent and railroads 19 with the good times rolling americans learn to buy stock with borrowed funds or as it is called on margin these quadrupled from 1.6 billion to 6.4 billion dollars when the numbers were added up private debt growth between 1923 and 1928 skyrocketed by 40 billion dollars from 116 billion representing 137 of gdp to 156 billion representing 161 of gdp most of this increase came from residential mortgages 13 billion commercial real estate 5 billion utility debt 5 billion and broker loans 5 billion the expansion of private lending is clear in the graphic when the private debt to gdp ratio grows by 15 to 20 percent in a five-year window especially when that ratio reaches 150 or more a financial crisis is likely next the contraction in october 1929 the stock market collapsed eventually shedding more than 80 percent of its value margin calls were epidemic those utility stocks we were chatting up dropped by 55 industrials by 48 and railroads by 32 but hubris remained andrew mellon the u.s treasury secretary expressed confidence in a revival of activity in the spring as lending shrank and defaults metastasized the u.s gross domestic product contracted by 48 billion to understand this catastrophic development gdp would have had to have collapsed from 14.7 trillion to 7.3 trillion in 2009 to be comparable to the collapse of the great depression in fact gdp in 2009 dropped by less than 300 billion dollars loan losses led to early calls on debt write-offs and bank failures off a capital base of 8 billion banks charged off 3.1 billion 80 of the 3.9 billion in real estate bonds issued were failing to meet their payment obligations so banks sold the collateral depressing prices in land real estate and businesses as losses exceeded loans more than 9 000 banks failed between 1930 and 1933 quite simply the contraction of loans and other debt was the single most impactful event of the period fear itself contributed mightily in some respects the great depression and the great recession were similar both saw mortgage finance and real estate lending soar together with a blind eye towards credit risk the critical difference between the two crises was the willingness of the government to intervene to save certain banks and financial institutions from calamity this was the lesson learned from the great depression that enabled the contraction in the 2008 economy to be shorter most of us remember the decade of the 1980s as a time of economic renaissance in the u.s president ronald reagan and paul volcker chairman of the federal reserve had defeated inflation gdp was growing at a 3.3 percent rate by the end of the decade the stock market was up 228 and the bond market was up 253 not too shabby yet the 1980s were also among the most economically turbulent chaotic and crisis-laden in american history 2 000 bank failures an snl crisis a junk bond crisis the commercial real estate crisis the energy lending crisis the latin american debt crisis even farm lending reached a crisis moment i would suggest that 1981 was a watershed moment in u.s economic history it was the line of demarcation between post-war deleveraging and a new era of leveraging this is also the moment when the upward rise of u.s interest rates reversed and rates begin a long decline note that in the brief period from 1983 to 1988 the ratio of private debt to gdp expanded from 103 to 124 one of the largest increases in such a short time in the 20th century mortgage loan growth almost doubled from 1.1 trillion to 2.1 trillion accompanied by a sharp spike in delinquency foreclosures and loan losses commercial real estate and manufacturing lending also doubled taking on so much debt left industrial companies vulnerable to increasing global competition as the decade opened the savings and loan industries business model of paying depositors three percent while making fixed rate mortgage loans at six percent had been blown apart by rising rates attempts to save the snls led to congressional and federal regulatory actions one such move enabled snl's to sell their underwater mortgages and amortized their losses over 10 years it was accounting magic these new rules ignited the market for underwriting and trading in these mortgage loans solomon brothers taking the lead of louis ranieri made the market in these mortgages and was able to acquire billions at very cheap prices from weakened snls soon mortgage lending was on the uptick growing 12 annually between 1984 and 1989. a renieri innovation collateralized mortgage obligations enabled the securitization and trading of these mortgages now snl somewhat rehabilitated needed new sources of funding in 1982 the federal home loan bank board changed ownership requirements that required community-based ownership now a single person could own a savings and loan if that was not enough the government empowered snl's to lend up to 40 percent of their assets in commercial mortgages up to 30 percent in consumer loans and 10 percent in commercial loans which led to a rush of ill-advised loans in those areas in the spirit of unintended consequences these changes made snl's potential investors in junk bonds and many became active buyers soon as traditional banks stepped up their chase of the business a boom in real estate lending led to massive overbuilding between 1981 and 1987 commercial real estate lending more than doubled and loans grew from 14 to 20 percent of gdp office vacancy rates climbed to from 4 to 16 delinquencies followed another new development was reshaping the financial markets junk bonds stock prices to earnings ratio had fallen below seven during the 1970s and was still below 12 by 1982 leaving company management's highly vulnerable to a new breed of investors seeking higher valuations their instruments of preference combine debt deep cost cutting and whatever else they could conjure up leveraged buyouts became the rage and junk bonds high-yield debt instruments provided the means to make the m a business a leading revenue generator for the bankers putting these deals together and the guy who was the legendary leader and innovator in these junk bond deals was michael milken of drexel burnham lambert milken built a machine to source the deals and to distribute the bonds milken sometimes insisted that his issuing clients increase their offering size to enable them to have the funds to purchase junk bonds from other milken clients with their new powers snl's could become active junk bond buyers and many did leveraged buyouts weren't the only source of runaway lending but they epitomized the era's aggressive tone milken's banking machine was so successful he started to run out of deals invention was required so drexel went after increasingly larger deals paying ever higher prices in short order it found a new opportunity the hostile takeover business suddenly anyone backed by drexel was capable of acquiring all but the largest enterprises there were other tactics deployed by milken and others that left the target company shattered while their parts were sold off for profits the junk bond market soon reached a ponzi level deals could never be repaid from earnings or cash flow the long prelude to the 1987 crisis commenced with runaway private lending in real estate lbo and snls sandwiched in between was the latin american debt crisis which led to forbearance and gargantuan loan write-offs an energy lending crisis exacerbated by hugely unrealistic expectations in the rise of the price of a barrel of oil incapacitated many texas and oklahoma banks bank failures erupted amidst these cascading disasters 2 304 banks failed or needed assistance from 1986 to 1992. by late 1987 stock prices had reached new heights were accompanied by an acceleration in lending including a high level of margin debt for stock purchases on october 19 1987 the dow plunged 23 percent worse than any one-day loss than in the crash of 1929 after the 9 11 attacks or during the 2008 crisis the massive overcapacity in bad loans of the 1980s led to a spate of failures a major pullback and a recession in the early 1990s real gdp growth fell by 1.33 from july 90 to march of 91. bank failures mortgage delinquencies defaults and foreclosures boom all of the variables and weaknesses were present for a precipitous decline in a major crisis potentially on the scale of 2008 but it didn't happen although private debt grew dramatically it never exceeded 124 percent of gdp while in 2008 private debt reached 169 percent of gdp also rather than lead to a long and difficult contraction the pace of private lending continued to grow in the 90s as the pain was more geographically focused on the southwest japanese corporate takeovers were in high gear in the 1980s prompting paul harvey to characterize japanese business presidents in the u.s as an economic pearl harbor from 1985 to 1990 japan's private debt business and household loans catapulted from 143 to 182 of gdp an increase of 2.4 trillion in u.s dollars that expansion far exceeded the increases in private debt growth leading up to the great depression runaway private lending in japan was concentrated in commercial real estate the profligate construction of office buildings hotels and apartments and the development of tracts of land at home and abroad from 1985 to 1990 commercial real estate loans more than doubled from 75 trillion yen to 187 trillion yen financing buildings that would not be filled for years japan had been devastated physically and emotionally following its defeat and surrender to end the second world war but just 40 years later the economic recovery rebuilding and resurgence of the japanese economy and its people was palpable reinforcing the sense that japan had arrived the pace of growth and change in japan felt meteoric it was enabled through massive private lending the country's most intense lending growth occurred over three years from 1987 to 1989 averaging 13 annually nearly 75 percent of this lending was to small businesses a move in the mix of bank assets necessitated by the recent access to capital from public debt markets for japan's largest corporation bypassing the banks by definition this translated to more risk when the frenzy extended to household lending the risk profile of bank loan portfolios eroded further credit card accounts tripled fraud as it always does in financial crises appeared on multiple levels in japan crime syndicates use bank loans to purchase shares and move in on established publicly traded companies it was a bit difficult for bankers to call in those obligations when the customer was a mob boss lending actually supercharged the japanese economy in the five years between 1985 and 1990 japan's gdp grew by 36 but the financial tipping point the point of over capacity was fast approaching by the end of the decade private lending was growing significantly faster than japan's bursting gdp land prices skyrocketed to unsustainable and preposterous valuations then came the correction the nikkei stock market lost an alarming 39 percent of value and like the great depression a symptom and not a cause the bottom fell out of the real estate market prices declining by 15.5 1991 and 18 in 1993 rather than address the festering problems japan's banks and regulators chose a different path they looked the other way they chose denial by 1991 touhou sogo bank became japan's first bank failure since the end of the war but the japanese government treated it as an aberration by 1995 the government could no longer ignore its provider of deposit insurance would announce protection for all deposits and bonds of banks for five years and then extended that guarantee instead of calling loans liquidating collateral and cleaning up their balance sheets japan's regulators showed leniency and allowed extended time frames over which impaired loans could be written down this is called forbearance and so these zombie banks simply marched on through seven years of denial and delay the day of reckoning was at hand major securities firms sanyo securities hokkaido takushaku and yamaichi securities failed or required an infusion of public support japan then entered what i have referred to as the third phase of financial crises the recapitalization and the long climb back in 1998 the government began a large-scale intervention in the crumbling banking system injecting 1.8 trillion yen into 21 banks a literal drop in the massive bucket of 100 to 200 trillion yen and bad debts still on the books of japan's banks even after a 50 trillion yen write-off so the government-led recaps of japanese banks went on and continued piecemeal through 2003. in the final analysis japan had strung out its massive 1990 overcapacity and bad debt problems for almost 15 years the crisis cost the japanese government enormous sums estimated in a range from 22 trillion yen up to 150 trillion a motivation for forbearance was the importance of keeping people employed social cohesion was critical to the japanese society and as a result unlike what we experienced during the great depression japan experienced little in the way of social disruption but at a significant economic cost at the end of the summer of 2007 unemployment was at a five-year low the stock market and overall household wealth were nearing all-time highs consumer and business confidence solidly positive and the banks their assessment of risk and their loan portfolios was so spirited that they made only small contributions to the reserves for future loan losses everywhere and most everyone seems sanguine about the future but a few weeks later the largest and most consequential financial crisis since the great depression hit the nation and ricocheted across the globe stocks lost 50 percent of their value unemployment ballooned into double digits banks and corporations began to implode crisis was inevitable before it was obvious the 2008 economic crisis in the u.s was the direct result of runaway growth in private debt from 2001 to 2007. home mortgage lending led the way doubling from 5.3 trillion dollars to an astonishing 10.6 trillion dollars in six years subprime loans those approved with lax credit standards accounted for 1.7 trillion of this debt the other 8.9 trillion included plenty of those prime loans whose credit standards had also been compromised commercial real estate contributed its part to the private debt build up shooting up 90 to 3.4 trillion dollars this is the story of the global crisis in great recession rampant lending yielding prodigious excess and then widespread failure [Music] aggressive lenders were incentivized to boost mortgage originations a new form of lending credit appeared ninja loans when lenders dispensed with the task of checking so borrowers often had no income no job no assets this lending made home buying easy and home prices higher the house price index rose from 117.2 in 2001 to 204.8 in 2006 the higher prices rose the greater the opportunity to build more the capacity to expand in an environment where many people believe prices could not fall was fueled by mortgage lending for many households the mortgage loan terms being offered to buy a new home were too good t resist artificially low introductory rates zero down payment there was little or no diligence on the credit of the borrower who cares the house price will go up and if they have to they can refinance country-wide mortgage led by its ceo angelo mozillo was the poster child for this excessive ambition mozillo advocated ending down payments entirely as he drove his executives and their subordinates to develop and sell affordable products countrywide grew its mortgage originations up by 132 billion in one year mozilla extended preferential mortgages to influence elected officials in washington d.c being a friend of angelo's counted the securitization of mortgages into an instrument known as a mortgage-backed security or mbs a technique pioneered in the 1980s enabled mortgage banks to bundle their portfolios into marketable securities to be sold to investors life insurance companies pension funds mutual funds hedge funds and banks sourcing a huge flow of capital into the housing industry fannie mae and freddie mac accounted for 55 of the activity in this area everyone goldman sachs morgan stanley lehman brothers virtually the entire street was in on the action [Music] between 2002 and 2007 3.6 trillion in mortgage-backed securities were sold their underlying security were the mortgages themselves but how to sell securities filled with substandard mortgages the issuers mix together mortgages from different regions to create the illusion of diversified risk further by slicing and dicing the mortgages into tranches the issuers created a waterfall that gave securities that had first dibs on mortgage cash flow the highest ratings while others at the bottom of the waterfall had lesser ratings the rating agencies bought it but the rating agencies themselves were intrinsically compromised they competed for the rating business and got paid as part of the issuance expense of bonds they were rating they earned the blame they got from missing the boat yet little has changed in their business models or their relationship to credits a few wise investors were reading the data and noticed the terrible credit conditions of these mbs portfolios and their underlying borrowers as well as the coming rate adjustment that would knock the heck out of the capacity to make principal and interest payments and so the mortgage party origination and securitization would soon be joined by another toxic guest derivatives one investor mike bury worked to help create a mechanism to bet on the coming calamity he saw a credit default swap through these burrie paid an insurer a premium to cover the possibility of losses in his fund's mbs holdings his exposure was a modest premium his upside was enormous if the value of the mbs's on which the swaps were acquired declined what was needed was an insurance company aig stepped up lured by the highly rated nature of the securities soon others jumped into the game in 2007 more than 61 trillion dollars in credit default swaps were sold credit default swaps simply made the crisis deeper and longer and caught more players up in its economic tsunami commercial real estate soon was enveloped as delinquency spiraled from 1.02 in 2005 to 8.67 in 2009. the ensuing pull back by lenders yanked the rug out from under pricing of commercial buildings wall street too was humbled if only briefly bear stearns came near to collapse in march 2008 holding 30 billion dollars in rapidly deteriorating mbs instruments but was rescued by its acquisition by j.p morgan with u.s government support for 10 dollars per share its stock had traded at forty dollars just days earlier fannie and freddie teetered and collapsed into the arms of the u.s government they held a combined 4.8 trillion in mortgage debt out of a market sized at 10.6 trillion 1.6 trillion or 33 percent of that portfolio represented loans the quality of which turned out to be much worse than forecast huge losses came next 54 billion dollars alone in the third quarter of 2008 lehman brothers was a doomed legacy securities business in 2007 the firm's net income reached a titanic 4.2 billion on revenues of just 19.3 billion its market cap was 60 billion reporting a 2.8 billion loss in june did not deter 10 billion in new investment from flowing into lehman but bad news kept pouring in and on september 15 2008 with reported but highly overstated assets of 639 billion in debts of 619 billion the once venerable lehman brothers was bankrupt soon the litany of giants crashing would reach a crescendo merrill lynch now joining countrywide to be acquired by bank of america aig a government bailout right after treasury secretary henry paulson claimed that bailouts were a thing of the past but soon the troubled asset relief program tarp was enacted and then the emergency stabilization act provided the means and the authority for the federal government to invest directly in the stock of trouble banks now paulson forced the major banks to accept government investment in the associated implicit guarantee believing it would be a confidence restoring move on the monetary side the federal reserve dropped interest rates from 5.25 in 2007 to 4.25 in 2008 to 2 by april in december rates were lowered to zero percent soon it would be general motors and chrysler getting bailouts the 831 billion dollar american recovery and reinvestment act dealt tax cuts infrastructure funding green energy schools and health care investments to sustain employment a new regulatory regime was enacted by congress through the dodd-frank bill requiring stress tests for banks to ascertain capital adequacy establishment of a consumer financial protection bureau increased liquidity for banks stricter standards for mortgage lending and new regulations for systemically important institutions yet with all this government intervention economic growth remained tepid the u.s had learned the hard lessons of the great depression it intervened to prevent contraction of vastly better response than in 1929 the unraveling of the economy while predictable was unanticipated by anyone responsible for preventing it yet enough things were done correctly to stop lone contraction and avert a deeper and more chaotic crisis amid the post-crisis finger-pointing former federal reserve chair alan greenspan secretary of the treasury tim geithner hurried to assert the impossibility of predicting a crisis while others refer to the global crisis of 2008 as a black swan too rare to predict yet catastrophic sadly both suggestions are far wider to the mark the 2008 crisis was visible in plain sight all forecasters regulators and financial executives would have needed to do was consider the expansion of private debt those few that did saw their warnings unheeded [Music] we now know that it is never solely the bad actors who end up suffering in a financial crisis thousands hundreds of thousands even millions of people get hurt along the way the effects of a financial crisis are devastating lives are ruined governments and political parties are forced from office in banking investment banking and other forms of lending there will always be an intense desire to win to increase wealth this is the ferocity of ambition but in the world of lending if unchecked this can lead to overcapacity and large-scale lender failure so this ambition can lead to much greater hardship than the same ambition in almost any other arena if you'd like to know more i hope you'll visit our website where you can find plenty of data if you're interested in doing your own analysis you can order a copy of my book on amazon or through the university of pennsylvania press i'm richard vague thank you for watching [Music] [Music] you