The counterfactual argument goes something like this: If only the government had rescued Lehman, things would never have gotten so bad.
Rather than dwell in this fantasyland of what if, let’s study the history.
The decades leading to the crisis were a unique period in American history. Under Alan Greenspan, the Federal Reserve lowered interest rates to below 2 percent for three years and to 1 percent for more than a year. This monetary policy was unprecedented, and it had huge ramifications worldwide. The U.S. dollar took a hit; from the start of those low rates in 2001 until 2007, the world’s reserve currency lost 41 percent of its value.
This affected anything priced in dollars or credit. Prices of oil, gold and foodstuff skyrocketed. Home construction and housing sales and prices boomed. There was a land rush, as many banks abandoned traditional lending standards to stake their claim.
The low rates had sent bond managers scrambling for higher-yielding fixed-
income paper. They found that yield in securitized subprime mortgages, a novel financial product. Three elements made this possible: The first was ultra-low yields.
The second was a new class of lenders — Greenspan called them “financial innovators” — that were not traditional depository banks but were mortgage originators only. Their business was strictly making loans for the sole purpose of selling them to Wall Street securitizers. They did not hold the mortgages longer than a few weeks, and they sold these 30-year loans with warranties of only 90 or 180 days.
The third element was the corruption of the ratings agencies. They blessed this junk subprime paper with a pristine AAA rating. “Just as safe as a U.S. Treasury,” they claimed, while failing to disclose that they were paid large fees by the underwriting banks for those ratings.
How could this occur? In the years before, the banking sector helped push through an orgy of radical deregulation. The usual watchdogs had been defanged and defunded. At the same time, the Fed had all but abandoned its role as chief regulator of banks.
Hence, the banking sector had become a kind of self-regulating organization, writing its own legislation, weighing in on key appointments to oversight bodies.
Similarly, nearly all of the major investment partnerships had become publicly traded companies. This radically shifted the liability for failure. It put an end to “joint and several liability” — meaning that each partner was responsible for what any of his partners did, which focused the firm intensely on avoiding extreme risk-taking. Once they became public companies, the liability dropped from around the necks of the partners to the shareholders.