What if subprime and CDOs never happened?

I was watching the Inside Job for the other sleepless night (great movie by the way, both substantively and artistically), and I had a thought about the whole bubble and financial crisis that had not really occurred to me before. It's also a point that I think has been generally overlooked in commentary thus far.

First, some context:

Inside Job does a fine job spelling out the history of deregulation, development of CDOs and growth of the AAA bond market. They also do a really nice job explaining how CDOs worked and ultimately failed and the blatant corruption of the bond rating agencies. These features account for how financial markets were able to innovate new securities in an effort satisfy a nearly unquenchable thirst for low risk assets.

The movie basically blames Greenspan for low interest rates. But if Greenspan was at fault, it was only in that he didn't use the Fed's portfolio to help quench the world's thirst for safe assets.  Consider, however, the size of AAA bond market and how much it grew between 2000 and 2008.  I don't have the specific numbers in front of me, but it was in the tens of trillions of dollars.  The Fed's balance sheet at the time was only about 800 billion.  Yeah, maybe the Fed should have tried to increase rates a bit by selling some of its portfolio.  But even the Fed was small relative to the demand forces at play.

It's that demand side that gets too little billing in the movie Inside Job.  That demand side is the focus of an excellent radio story from This American Life that was broadcast on NPR.  (You can listen here--note this was first broadcast before Lehman Brothers collapse and the ensuing crisis).  The giant pool of money derived mainly from booming China and oil producing countries, aided partly by China's currency manipulation, which continues to this day.

Okay, that's the background.  Now here's my thought of the moment: 

What if there wasn't any funny business on the part of the banks and wall street?  What if CDOs were regulated all along and we never had a boom in subprime lending and liar-loan mortgages with unverified income?   Well, the basic economics tells us that the supply of AAA bonds would have been a lot less than it was.  Which, in turn, means that the price of the AAA bonds would have been bid up even more than they were.  Which, in turn, means that higher-risk bonds would also have been bid up to a higher price.  Which means that interest rates would have fallen to a lower level--probably a significant lower level--than they had already fallen.  And with interest rates falling even lower people with suitable credit would have wanted to buy even bigger houses.  And people with suitable credit would have been even more tempted to take out even larger home equity lines of credit.  And home prices would have kept going up.  And so "the bubble," such as it was, almost certainly would have happened anyway.

The best example of this is Canada, where banking didn't get out of control but home prices still boomed.  But unlike the US and much of the rest of the world, prices there haven't fallen much either.  To the extent that they have fallen, it's probably due to the near collapse of the world economy, not Canadian problems.

Anyway.  While all the shenanigans exposed in Inside Job boils my blood as much as the next guy or gal, I think the economic forces at play were even larger than the movie suggests.

Update: I changed the title to something more appropriate.


  1. It was fundamentally a problem of excess liquidity. How we could have stopped it happening is beyond my pay-grade, but suffice to say that most of the simplistic answers are, well simplistic.


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