The Language of the Boom and the Bust

The widespread use of “securitization” in the financial sector was an important feature of the boom before the crisis. Securitization entails creating a financial instrument that you can trade quickly and that takes its value from other financial assets that you can’t sell easily in their original form.

A major component of the financial crisis was the massive transformation of mortgage debt from traditional mortgages (held by local banks in the usual way) into securitized assets, representing claims over amassed quantities of mortgage debt. The repayments from the customers’ mortgages provided investors with profit for holding the new asset.

But the main danger of this securitization is that it reduces the mortgage originator’s motivation to make safe loans in favor of passing that mortgage debt quickly along to other institutions.

“The language of money is complicated because the underlying realities are complicated.”

“The basic premise of banking is that you lend money only to people who can pay it back” has disappeared in securitization. The difficult nature of the way institutions used securitization led to an “uncontrollable dispersal and magnification” of the risks of the housing bubble.

The risks were destabilizing because they were harder to assess when the crisis hit.

“There are no economic tendencies which act as steadily and can be measured as exactly as gravitation can; and consequently there are no laws of economics which can be compared for precision with the law of gravitation.” (economist Alfred Marshall, 1890)

The basic nature of “derivatives” added complexity to the innovations in securitized financial assets before the crisis. The values of other assets contribute to the price of a derivative product, but the actual financial instruments are not solidly connected to those underlying assets.

Thus, two parties can create a derivative trade if both agree to a contract based on, but not connected to, the price of a real underlying asset. Thus, derivatives’ market volume can rise well above the market volume of the assets that underlie the derivatives’ values. This happened with securitized mortgage assets; the huge volume amplified and complicated the risk when the bubble burst.

Derivatives are useful for many genuine reasons, such as the classic case of farmers reducing their uncertainty ahead of a harvest by locking in future crop prices. In any case, some trader on the other side of that contract has to be willing to make the gamble. However, the enormous size of modern derivative markets suggests that speculation is more in play than any type of conservative business risk management.

“Baked into this neoliberal model is a set of assumptions that embody what Marshall saw as the economist’s mistaken belief in ‘constant and mechanical actions’.”

The “credit default swap” is infamous for its role in the 2008 crisis.

This instrument allows an organization to charge a fee for guaranteeing that a third party will successfully repay a loan. The surprising aspect is that an enterprise can enter into this contract even if it isn’t the organization that made the loan.

“That’s less like insurance and more like a form of gambling.”

The layered structure of such financial instruments along with the boom and bust in real assets made the boom more profitable and the bust more severe.

Consider also “hot money,” which is cash that moves around the globe looking for the latest quick return. Hot money rose from 60% of global gross domestic product (GDP) to more than 450% from the 1990s to the first decade of the 2000s. Combining the uncontrollable risk of securitized derivatives with hot money portends an increase in the potential for booms and busts.

“The link between neoliberalism, efficient-market theory and bubbles was one of the reasons for the disaster of 2008.”

The 2008 crisis is sometimes referred to as a “credit crunch,” because it brought about a contraction in lending. As the housing market started to turn downward it exposed the weaknesses in the financial system.

“Deleveraging” which is reducing the ratio of debt to income or assets – and a pullback on extending new credit both took place abruptly on a massive scale. Deleveraging is often a sensible course for an individual or a business.

However, recessions occur when everyone deleverages at the same time.

“If you are a farmer…the derivative contract can be bought and sold many times, whereas the wheat will be delivered only once.”

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