Anchorage Daily News

We all know that the sub-prime home loan fiasco caused the current financial crisis. But what caused the initial financial bubble in the first place?

A good explanation can be found in a new book "House of Cards; A Tale of Hubris and Wretched Excess on Wall Street" by William D. Cohan. In this book, Alan Schwartz, the former president of the Wall Street investment company Bear Stearns, provides his version. Bear Stearns is one of the companies that collapsed in the crisis. The following is based on Schwartz's explanation.

This all started at the beginning of this new century when commodity prices doubled. In the past, an increase in commodity prices would have caused increases in the price of finished goods. For example, the price of wood would go up, causing the price of furniture to go up. This made the world poorer, except for the commodity guys selling the wood, who got richer.

But unlike before, the cost of finished goods did not rise, because producers made the finished goods in low-labor-cost countries. The world did not get poorer; instead there were huge profits and growth in liquidity (money) occurred for the commodity guys, the countries where the goods were produced and the companies producing the finished goods and their shareholders.

At the same time, the Federal Reserve Bank was concerned the dot-com bust might cause deflation. The Fed had seen Japan suffer with deflation when its economy fell in the '90s and liquidity was not provided by its central bank. To prevent deflation, the Fed flooded the world with more liquidity and lowered interest rates.

Simultaneously, a whole lot of people were approaching retirement and were concerned with building up their retirement accounts. Because they were relatively short-term investors, they wanted to minimize risk by investing in securities backed by hard assets, like real estate. But they could not accept the tiny rate of return caused by the Fed lowering interest rates. This was a huge pool of money that was looking for both financial safety and higher returns.

Meanwhile, real estate loans were being securitized. That meant that mortgage loans, instead of being held by the lender, were sold and then combined with other loans and resold as mortgage-backed securities, for huge profits.

These instruments held a great deal of appeal because they appeared to be safe investments with high yields. They were backed by real estate, a hard asset that had a long and excellent performance history, as well as by excellent credit ratings. The credit rating companies did not understand the new instruments they were rating as safe, but they did know they were collecting huge fees from the companies creating these instruments.

About this time, the U.S. government starting pressuring mortgage lenders to lower their lending standards so poor people could own homes. (This actually started under President Bill Clinton.) Under the relaxed standards, most anyone could become eligible to buy a house -- and they did, often at prices they could not afford. This resulted in mortgages bound to fail.

The new system of selling the mortgages, which were packaged and resold as securities, separated the original lender from the borrower. If the borrower did not pay the loan it was no longer the lender's problem. The buyers of the mortgage-backed securities made from these loans thought they were safe because housing prices were rising.

Investment companies got greedy and were aided by the U.S. Securities and Exchange Commission, which allowed them to leverage as many as 30 times. That meant putting up $1 and borrowing the rest of the money to buy a $30 security. Leverage cuts both ways. It levers up the profits when prices rise. But when prices fall, it levers the loss just as dramatically. For example if a $30 stock went up 10 percent to $33, the dollar the owner put into the investment saw an increase in value of $3 -- for a spectacular 300 percent return. But if the value of the security dropped to $27, the investor not only lost the dollar he put in, he had to cover another $2 of loss.

All these events combined into the perfect storm.

The system was built on many false assumptions. While it looked safe, it was actually very unstable. Any disruption could bring it down.

The disruption started when undeveloped nations directed their profits from low-cost labor into infrastructure development. This sopped up some of the available liquidity. At the same time, the Fed was beginning to back off its super-low interest rates. As liquidity dropped, interest rates rose, which put a brake on the housing boom. Without ever-increasing house prices and continued demand for mortgage-backed securities, the system could not support itself.

Foreclosed houses could not be sold without huge losses; investors lost faith in the system and withdrew their money (or tried to). Liquidity dried up and highly leveraged investments houses like Bear Sterns and Lehman Brothers collapsed. The house of cards toppled. We came frighteningly close to a total financial meltdown that would have rivaled the 1930s Depression.

There are a lot of lessons from this sad tale. One is the old saying, "If it is too good to be true, it probably is." People and markets get carried away sometimes, but reality eventually is going to rule. Housing prices do not go up forever, poor people do not have the financial capacity to own homes, and you cannot have exceptionally high-yielding investments that are also low risk.

When you forget that the unrealistic is unrealistic, you are kidding yourself. We did, and now we are paying the price.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every month.

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