What went wrong with American finance

Via a link at Barry Ritholtz's Big Picture blog, there's a clear article about why things are so screwed up here.

Ritholtz likes this part:

There has been a “domino-like” character to the financial crisis that is now readily apparent to all:

• the bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;
• the peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;
• losses thereafter on the complex “Collateralized Debt Obligations” (CDOs) that were backed by these mortgages;
• increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued “credit default swaps” contracts (CDS) that insured the CDOs;
• losses suffered by financial institutions that held CDOs and/or that issued CDS’s;
• cutbacks in credit extended by highly leveraged lenders that suffered these losses.

These events, individually and in combination, have led to the bear stock market, whose downward slide accelerated Monday September 15 through mid day Thursday the 18, after Lehman Brothers filed for bankruptcy and the Federal Reserve loaned AIG $85 billion to keep it afloat—although the market quickly recovered at the end of the week after the Administration’s massive mortgage securities rescue initiative was announced.

What's interesting to me this evening is something Bill Clinton said the other night on Letterman (of all places). When the tech bubble burst back in 2000-2001, the Fed pumped liquidity into the economy to shore things up. Cheap money came pouring into the economy. But the only reasonable place to spend the money was the housing market because the US economy had no viable initiatives in alternative technologies. Think solar, wind, biomass and geothermal energy, for example. Or maybe radical new designs to promote auto efficiency or office building efficiency. The surviving tech equities were perceived as bad bets, guilty by association with Web Van, etc. The US auto industry looked pathetic -- innovation having become a synonym for selling out management. Consumer staples were their usual boring selves -- okay, but not a path to big bucks returns.

So the excess liquidity went into real estate. According to this analysis, Greenspan's Fed set the stage for our current crisis by making it possible for the housing bubble to take off. Innovation not in designing energy technology, but in designing more wacky credit default swaps fueled a lot of the rise in the value of the market for a few years. The really smart money went into Byzantine webs of real estate financial dealings, inflating both home values and the values of derivatives based on them until... Well, you know.

Accompanying the burst of financial innovation that propped up the bubble was a dearth of oversight that aided and abetted its rise. The guys at the Brookings Institution, whose work is quoted above, point out that both industry rating agencies (private enterprise people who rate secuities for a fee) and the SEC and other governmental financial regulators were not equipped to deal with what the new financial market was doing.

In retrospect, the crash was made to order.