Why the Collapse of the Housing Bubble Devestated Financial Markets

Nobel Laureate Vernon Smith and research associate Steven Gjerstad write here about why the decline in worth of houses of about $3 trillion since 2006 has caused such devastation in financial markets, while a decline in worth of stocks of about $10 trillion in 1999-2002 did not. They write

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, and Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

As Smith and Gjerstad note, the big difference is where the money came from to purchase the assets. In the 1999-2002 collapse of stock market wealth, investors had purchased the stocks with money they had saved. In the 2006-2008 collapse of housing values, people had purchased the houses with money that no one had saved, least of all the people buying the houses.

That's right. No one had saved the money that was lent to subprime borrowers, Alt-A borrowers, and "liar loan" borrowers. The money they borrowed came from the Fed, created from nothing.

Had the money used to finance the wretched mortgage loans been saved, financial markets would not have been devastated. While Smith and Gjerstad's analysis is useful and insightful, they don't emphasize the real root of the problem---bogus money creation by the nation's banking cartel, the Federal Reserve System.

Some of us grow weary of economists, the media, and politicians blaming just about everyone for the financial meltdown---except the single-most guilty party---the Fed. And what is the Fed's solution? That's right; create more bogus money.

And  we the people were heard mumbling softly in the background.