The origins of the subprime bubble can be traced back to events in the 1980s, Early in the decade the idea that less regulation of financial institutions was a good idea took hold. The Savings and Loan industry was deregulated and it turned into a monumental failure that wound up costing the U.S. taxpayer $200 billion because of the out of control corruption, theft, and financial incompetence that deregulation allowed to occur. Nevertheless, deregulation of the financial industry continued and regulation of financial instruments such as derivatives or new industry players, such as hedge funds did not take place because 'regulation was too costly'. Federal Reserve chair Alan Greenspan was generally opposed to regulation and not only did everything possible to prevent new regulations, but didn't utilize the Fed's existing powers to regulate during the years he controlled the Fed from 1987 to 2006.
Decreasing regulation was then combined with a huge increase in liquidity provided by the Federal Reserve. This process began during the 1987 stock market crash, which Alan Greenspan handled successfully with a sharp drop in interest rates and by pumping money into the financial system. This set the tone for the next 19 years of the Greenspan Fed. In order to bailout the U.S. banking system from the Savings and Loan Crisis, interest rates were lowered
too much and for too long in the early 1990s. This excess in liquidity in turn led to the stock market bubble later in the decade. When the tech-stock bubble collapsed, interest rates were eventually lowered to one percent and this inflated a real estate bubble - something that Greenspan continually denied existed.
The conditions that led to these bubbles were no different than the ones the created all bubbles throughout history. Declining yields combined with an excess of capital (both are created simultaneously by the Fed), lack of regulation which allows for widespread fraud and corruption, and a technical or financial innovation. In the case of the tech stock bubble, the Internet was the technical innovation and for the real estate bubble, it was packaging subprime loans into bonds which could be sold, transferring the risk to other parties and providing capital to make more loans. As more and more loans were made, the quality of those loans by necessity deteriorated.
Bubbles always have feedback mechanisms as well and once started they become almost impossible to stop until they burst. Once they burst however, an anti-bubble forms with the original feedback mechanism operating in reverse. This anti-bubble in itself becomes almost impossible to stop until it exhausts itself. The feedback mechanism is what allows prices in bubbles to go way beyond anything reasonable or even imaginable when they start and then to the drop on the downside to levels that are incredibly low.
Ben Bernanke was desperately trying to reflate the real estate centric bubble with his rates cuts in the fall of 2007. This was a hopeless task, since once a bubble begins collapsing it usually takes many, many years before it can be reflated. What does occur is another bubble gets created elsewhere in the financial system. The Bernanke bubble would turn out to be in inflation.
Next: China's Olympic Size Bubble
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