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Did we blame the wrong villain for the 2008 financial crisis? Perhaps the real culprit is capitalism itself

If you ask anyone what caused the devastating 2008 financial crisis, you’ll invariably receive the same answer: Wrongdoing by the Wall Street banks.

This is no wonder because this explanation has been trumpeted everywhere. It’s all over the media, our politicians repeat it endlessly, and the current presidential candidates harp on it incessantly. So this explanation has now seeped into our public consciousness as the conventional truth.

But there is a tiny little nagging problem. There just seems to be some very curious flaws in the case that simply do not seem to add up.

The central charge is that Wall Street banks made risky mortgage loans to people who could not afford to repay these loans. So, for example, a taxi driver who earns an income of $30,000 per year should not be given a loan to buy a $200,000 house. This line of criticism also accuses the banks of wrongdoing by failing to verify the incomes of borrowers and thus enabling borrowers to overstate their incomes, which became known as “liar’s loans.”

The problem with this analysis is that it ignores the fundamental essence of what a mortgage loan is all about. The bank lends not based upon the income of the borrower, but instead, the bank lends upon the value of the house. The collateral for a mortgage loan is not the borrower’s stream of income, it is the house itself. If the borrower fails to repay the loan, the bank’s primary remedy is not to seize the borrower’s income, but instead, the bank forecloses upon the house, sells the house in the market, and applies the sale proceeds to repay the loan. So any analysis of the riskiness of a mortgage loan must be based upon the value of the house, not upon the income of the borrower.

Of course, banks customarily consider income as well, but as a secondary matter and not as the primary source of repayment for the loan. Income serves as a useful indicator of whether the borrower is likely to meet the monthly loan payments. But income does not determine whether a mortgage loan is fundamentally good or bad, only the value of the house does that. So income, no matter how badly misstated, could not possibly have caused the financial crisis.

In addition, incomes became less of a factor as a result of the housing bubble. As the bubble expanded, home values kept increasing. Year after year prices experienced double-digit increases. This attracted a stampede of investors, just like in every bubble. It wasn’t that the banks were negligently failing to consider the borrower’s income and concealing it, but rather, investors were not concerned about the borrower’s income when the value of the house was certain to increase. Thus is the nature of bubbles.

Another common charge is that the Wall Street banks were engaged in a massive fraud by making bad loans and selling them as good loans. Sounds sinister. But the facts simply do not support the charge.

In order for a fraud to exist, there must be some sort of a hidden deception. But there was no deception here because the banks went to great lengths to disclose all sorts of information about these loans. In fact, the entire classification of the riskier types of loans was openly named “subprime” mortgages, meaning “risky loans.” How in the world could there have been a fraud when the entire classification is named “subprime?” Obviously, buyers of these loans knew what they were buying.

But even further, for every transaction that offered mortgage-backed securities, the banks issued a “prospectus,” which is basically an entire book that can run several hundred pages in length that describes all sorts of facts and details about the underlying loans, including disclosure about the levels of risk. Again, the banks were hardly trying to conceal the nature of the loans, but instead, the banks disclosed extensive information about the loans.

Of course, when the bottom fell out of the market and people lost money, they resorted to the great American tradition of rushing to the courthouse and filing lawsuits against the banks. But these claims are not what you would expect for a “massive fraud.” The claims do not reveal any sort of a diabolical scheme of the banks pretending to sell “prime” loans when in fact they were selling “subprime” loans. No. Nothing like that. The banks clearly disclosed that they were selling riskier loans. Instead, the lawsuits seem more about the details around the edges, like the banks did not double-check things, or the loan files contained errors, or the number of loans in a given category did not exactly match the disclosure in the prospectus. But this hardly exposes any sort of a massive fraud that could have caused the financial crisis.

In fact, this whole claim of a massive fraud just doesn’t seem credible when considered with even a small dose of common sense. It just doesn’t pass the smell test. How could there possibly be a massive fraud in something as wide open as the housing market?

Fraud requires a hidden deception, but the credit standards banks use to make loans are widely known and readily available. Millions of people receive mortgage loans all throughout the nation all around us. Everything is out in the open in plain sight. Yes, it was easier to obtain a loan for a more expensive house, but everyone knew this. It was common knowledge. We all had friends and family who were buying bigger houses or repeatedly refinancing their mortgages for ever greater proceeds. This was hardly a big secret hidden away in order to perpetrate some sort of a massive fraud. That notion is simply absurd.

Then there is the little problem of the rating agencies, such as Standard & Poor’s, Moody’s, and Fitch. Before a bank issues bonds in a mortgaged-backed securities transaction, the bank presents all of the information to one or more independent rating agency that then analyzes the transaction from scratch and issues a rating on each class of bonds to signify the level of risk. The rating agencies are independent, third-party companies. Their entire business model is predicated upon them making sound financial judgments and their ratings being accurate. This makes it all the more unlikely that the banks could get away with any sort of a fraud scheme of trying to sell bad loans as good loans because the independent rating agencies analyzed every transaction separately.

So how does the conventional wisdom deal with this little problem? Well, as the popular tale goes, the rating agencies were in on the massive fraud along with the banks. So the banks would submit horrible loans, and the rating agencies would nonetheless fraudulently issue top triple-A ratings on this junk.

Really? So all of the various banks had some sort of a grand scheme cooked-up along with all of the independent rating agencies to commit a coordinated massive fraud? C’mon. It’s just not credible.

This is similar to the little problem of why no executives on Wall Street have gone to jail for causing the financial crisis. This is a favorite issue of the prophets of the conventional wisdom of the massive fraud by Wall Street. They love to hammer this point with a mob mentality. They are outraged at the injustice of it all. They want heads to roll. Send some bankers to jail!

But a fair society does not just send people to jail without proof beyond a reasonable doubt that they committed a crime. So, there is a perfectly reasonable explanation for why no executives on Wall Street went to jail. And that is, simply, because they committed no crimes.

Shocker!

Yes, Wall Street executives lost a lot of money for a lot of people. But that does not mean that they broke the law doing it. Sometimes markets go down. And sometimes markets go down a lot.

This is by far the most rational explanation. It just makes no sense that there was some sort of a massive fraud but now no one can figure out how that fraud was perpetrated. A fraud so enormous like this could not possibly remain completely concealed. The fact that no one can find any evidence of this massive fraud leads us to the obvious conclusion that, in fact, there was no massive fraud.

It also makes no sense to think that prosecutors discovered this massive fraud scheme, they know full well all about the heinous crimes that were committed and who committed them, but the prosecutors secretly decided not to charge anyone. Why in the world would they do that? It’s not that they are afraid to prosecute Wall Street. In fact, prosecutors certainly did not hesitate to aggressively prosecute executives on Wall Street only just recently for insider trading.

And just think of the massive conspiracy that this would require. The financial crisis has been endlessly examined by legions of investigators from all sorts of different authorities, such as financial regulatory agencies, the U.S. Department of Justice, federal prosecutors, and numerous state prosecutors. Many of these ambitious crusaders for justice would have loved to make a name for themselves by uncovering the fraud that caused the financial crisis and then jailing the Wall Street executives behind it. That would have been a huge career grand slam. But to think that all of these prosecutors and regulators are secretly conspiring to conceal from the public the massive fraud scheme that they uncovered? It just makes no sense. It is a wild conspiracy theory.

So if there was no underlying fraud on Wall Street, then what caused the horrendous financial crisis?

Well, the answer actually seems quite clear and simple, although it is rather disturbing.

The cause of the financial crisis appears to have been nothing more than the plain old basic functions of free markets. That’s all. Nothing more complicated than that. Markets cycle through booms and busts. Markets develop bubbles and when the bubbles burst, this can lead to a financial crisis. We have seen the same thing over and over again. And this is exactly what happened in 2008. Plain and simple.

The market in question this time around was the national housing market. Housing prices were going up, up, and away. One cause of the housing bubble was the easy availability of credit and the lowering of credit standards, meaning that Wall Street was willing to make mortgage loans to riskier borrowers. But this wasn’t all some grand scheme manufactured by Wall Street. No. Wall Street could not have created such an enormous market demand all by itself. The demand was driven by investors who desired to buy the bonds that Wall Street was issuing in the form of mortgaged-backed securities. These investors were often financial management firms, like mutual funds, pension funds, private equity firms, and hedge funds.

These investors desired more and more of these bonds, and the investors were willing to buy bonds that were backed by riskier underlying mortgage loans. So Wall Street produced more of these bonds and underlying loans in response to the demand from their customers. It wasn’t that Wall Street was fraudulently packaging bad loans since investors well knew what they were buying, despite their later claims to the contrary after they lost money in the bust. Indeed, these investors were very sophisticated themselves. The Wall Street banks could not possibly have duped all of these sophisticated investment firms for years. That is utterly absurd.

So why were these investors buying these bonds? Because investors were “chasing yield.” They were under enormous pressure themselves to deliver higher and higher returns on their own investments, so these funds desired to receive higher interest rates, and these bonds offered such higher interest rates because they were riskier. But with home prices constantly increasing, the risk of loss seemed remote. Also, some of these bonds could appreciate in value and generate enormous profits.

So a main driver that caused the housing bubble was just the simple desire for greater returns by these investment firms. Maximizing profits. It’s as simple as that. After all, this is what our free-market system is all about.

So the bubble kept expanding. Wall Street kept pumping out these bonds, investors kept snapping them up and were delighted with their higher returns, and all the while home prices kept increasing ever greater.

And then, suddenly, the music stopped. Home buyers started to realize that home prices had become inflated, so they stopped buying homes. Uh oh. Panic set in. Home prices plummeted followed by the value of the loans and the bonds. Hundreds of billions of dollars of value were wiped-out. The bubble was bursting. This triggered the entire financial crisis, and the rest is history.

It was all due simply to the typical boom and bust of our free-market system. That’s all. There was no deep and dark sinister force behind it.

So why has such an elaborate false narrative taken hold so deeply in our society about a massive fraud on Wall Street? Well, one likely factor is that public officials must certainly have felt compelled to identify a culprit, any culprit, and Wall Street was indeed a convenient target. But also, it is easier on our collective psyche if we can identify and blame a bad guy. We feel safe by telling ourselves that the catastrophe was caused entirely by an abnormality of a bad guy acting outside of the established system.

This spares us from having to face the much more difficult proposition that perhaps something is wrong with our underlying system itself. Perhaps something is wrong with our cherished free markets. Perhaps something is wrong with our beloved system of capitalism.

Oh good heavens no, it cannot be. There must have been massive fraud on Wall Street.