—HOW WE GOT HERE—

--The American economy had stagnated and only the

stimulus of cheap housing finance that tapped a decade of home

price appreciation made it appear to be growing.

Beginning in 1994, relatively low long-term interest rates and increasing median family income encouraged home prices to rise.  In the aftermath of 9-11, the Federal Reserve Board kept interest rates low for several years, further encouraging borrowing and rises in home prices despite federal fiscal deficits and static median family income. Looser lending standards in 2004-2006 encouraged a boom in home prices on top of the already elevated base. Home prices surged, especially in four states—California, Nevada, Arizona and Florida—the Boom States.  Surging home prices, buoyed by easy

credit, encouraged construction of vast new housing subdivisions.  And for a portion of the population, the good times rolled.

2 The late 1990s rise in home prices was based largely on the decrease in long-term interest rates that followed the balanced budget deal between President Clinton and Republican House Leader Newt Gingrich in 1995-1996.  It makes sense that if interest rates are lower, the cost of financing a house goes down, leaving room for house prices to go up. In addition, with low unemployment and large increases in median family incomes in the late 1990s, more people could afford houses. In constant dollars, median family incomes rose from $52,000 in 1994 to $59,000 in 1999, keeping pace with the rises in home prices in that period. See census.gov. And remember this

conformity when we discuss the ratio between median family income and home prices in Chapter Seven.  


            Borrowings against home equity and use of profits from the sale of homes in the mid-2000s also powered consumer spending, which pumped up imports and increased America’s trade deficit. The consumer spending also fed corporate profits, and the corporate profits in turn propelled the stock market forward.  

            Although consumer spending is at the heart of every boom, this boom was different from any earlier boom because consumer borrowings against the build-up of home equity, rather than higher wages or improved productivity, made the consumer spending possible. Had it not been for Americans spending over a trillion dollars of cash that they took out of their homes by sales, refinancings and home equity loans, the economy would not have grown in the 2003-2006 period and the bubble would not have inflated.  

        The importance of equity extraction from homes has not been generally recognized. But we can see its importance from some fairly straightforward computations. We will measure the part of the nation’s Gross Domestic Product (GDP) in 2002-2006 that resulted from Americans taking cash out of their homes by mortgage borrowings and spending that cash, not investing it in another home or stocks, bonds or bank deposits.

        GDP is the standard way to measure the size of the economy.  “Real GDP” is a number that backs out the effects of inflation. I use Real GDP. The data also will count only the extra amounts that Americans took out of their homes and spent. By that I mean the amount above the $50 billion average yearly amount that Americans took out of their homes and spent in the 1990s, which already was far more than in earlier periods.  

        We will find that without the extra spending from home equity extraction, the U.S. economy would have been in recession every year from 2002 through 2006. My conclusion therefore is that the American economy had stagnated and that only the stimulus of cheap housing finance that tapped a decade of home price appreciation made it look like it was growing. Clearly this is not a repeatable trick. Once the equity build-up is spent, it is spent—at least until the next historic run-up in home prices.

            I conclude that all the economic growth of 2003-2006 was a bubble and government assurances that the economy was basically strong were incorrect.

Impact of Equity Extraction on U.S. GDP 2002-2006 ($$billions)

* This number has been deflated using the GDP deflator so that it stands in correct proportion to Real GDP. Net Home Equity Spending is based on a paper by Alan Greenspan and James Kennedy of the Fed published in 2007.  Greenspan and Kennedy estimated the amount of spending (as opposed to investment) of dollars derived from equity extraction from homes. I have subtracted $50 billion from each annual number to make it net of “normal” spending from equity extraction based on the average of such spending in the

1990s.

**1.5 is the most commonly used multiplier for the impact of spending on GDP.

        This table shows that without the unusual level of equity extraction, all other things being equal, the economy simply would have muddled along with no growth, as the Japanese economy did during the 1990s.  

        Of course all other things would not have been equal. Policies would have changed and people’s actions all over the globe would have been different in ways we cannot predict. But the analysis shows that spending with dollars extracted from the equity value of homes was crucial to the appearance that times were good.  

    When home prices turned downward and the weakness of prevailing loan underwriting standards became known, home equity extraction stopped. It did not decline. It just stopped. When American consumers recognized that they had no more home equity proceeds to spend, they stopped making discretionary purchases.

THE ORIGINATE-TO-SELL MODEL

            The Originate-to-Sell Model of mortgage lending loosened underwriting standards and encouraged homebuyers to put little money down and to buy more house than they could afford. Everyone involved seems to have thought home prices could go up forever.

            In the Originate-to-Sell Model there are normally five parties between the borrower and the investor who buys the securities backed by the loans at the end of the process.3 Along the way, each of these parties takes a fee that naturally has to come out of the borrower’s (or the unwitting investor’s) hide. The five parties are:

1. The Mortgage Broker. The borrower hires the mortgage

broker to find him the best mortgage. But the

mortgage banker also pays the mortgage broker a fee

for sending the business to that mortgage bank.

Sometimes the mortgage broker also is affiliated with

the mortgage bank. The mortgage broker always has

two faces.

2. The Mortgage Bank. The mortgage bank (which

sometimes is a regular bank) enters into the mortgage

agreement with the borrower and advances the money

to the borrower.

3. The Investment Bank. The investment bank buys the

mortgage from the mortgage bank and creates the

securities that will be sold to investing institutions and

the public.

4. The Credit Rating Agencies. The credit rating agencies

rate the securities created by the investment bank.

The credit rating agency is paid by and does a lot of

business with the investment bank but claims

independence.

3 Many commentators use the name Originate-to-Distribute Model. Originate-

to-Sell seems simpler to me. Neither phrase is a complete description

but either phrase conveys an idea of the process.

5. The Securities Broker. The securities broker (often

an affiliate of the investment bank that created the

package) sells the securities to investors. Although the

investor may think of the securities broker as his

agent, the investment bank pays the securities broker

the commission on these sales.

            The investment bank sets the parameters for loans that it will buy from the mortgage bank. Naturally, those are the parameters of loans that are the most profitable for the investment bank to securitize. The mortgage bank that originates the loans does not really care whether they are good loans as long as they meet the criteria the investment bank has established.

            The  system is shot through with conflicts of interests. All the participants get paid for making the loan look like it complies with the specifications the investment bankers handed down. And all the participants get paid for inducing the borrower to take the loan. No un-conflicted party is looking out for the interests of either the

borrower or the investor.

            One of the key players in the disaster turns out to be the mortgage broker. The mortgage broker brings the loans to the mortgage bank and walks off with commissions; he never again has to have anything to do with the loan, regardless of what happens. This perverse set of incentives led to systematic fraud and collusion among loan brokers, borrowers, and lower level employees of mortgage originators who winked at the fraud being perpetrated by the brokers.  How far up the line the collusion went is difficult to determine, but it is almost certain that at many levels of banks, investment banks, and

credit rating agencies, executives didn’t want to know because their incentives, too, were slanted toward immediate volume.

            Mortgage brokers were not a designed part of the lending process. They just grew, given impetus by unemployed former S&L lenders who saw a chance to carve a profitable niche. By 2004 there were hundreds of thousands of mortgage brokers, almost all working to convince homeowners and home buyers they should borrow as

much money as possible.

            The rating agencies turned the switch on every sale of securitized loans. As the securitizations became more and more complex, end purchasers of the securities (the investors who ultimately funded the loans) had less and less possibility to evaluate what they were buying. They bought the ratings, pure and simple. But the rating agencies, whether because they had conflicts of interests or because they just made mistakes, did a very poor job. They were the last line of defense against the onslaught of lax lending and they proved to be no defense at all.

            The Originate-to-Sell Model could and did use all kinds of loans to make securities. The loans that brought down the economy, however, were subprime loans and Alt-A loans. Loans called subprime are high-cost loans made to borrowers with low credit scores. Alt-A loans usually are more normally priced loans made to borrowers with high credit scores but without verifying the earnings they reported on their loan applications. Alt-A loans are what became known as Liar Loans.

            We know that the Originate-to-Sell Model, as in effect in the mid-2000s, was the culprit because few banks originated similar subprime and Alt-A loan products to hold in their portfolios. These were loans they made to sell, not to hold for their own account. As Guy Cecala, the founder and CEO of the respected mortgage data firm IMF Publications, who has been watching the mortgage market closely for over 25 years, told me,

In the 2004-2007 period few loans were originated for portfolio.  The competition from the securitized market was just too great. Very few institutions originated subprime or Alt-A product for portfolio because practically everybody knew the risks were too great. The only subprime and Alt-A loans that stayed on balance sheets were loans that did not get sold in time before the market collapsed.

    By 2009, although mortgages made under the Originate-to-Sell Model accounted for only about 15% of total outstanding mortgages, they accounted for over 50% of seriously delinquent mortgages!4

4 See Mish’s Global Economic Analysis, May 31, 2009 at http://globaleconomicanalysis. blogspot.com/2009/05/mortgage-meltdown-more-pain-tocome. html

FRAUD AND COLLUSION AS ANTI-COMPETITIVE PRACTICES

            The boom and subsequent bust were products of institutionalized fraud and collusion in the Originate-to-Sell process. As a consequence of the fraud and collusion, a very high percentage of the loans the process funded were bad from the start. If the underlying loans had been well underwritten, the problem would not have occurred or would not have been so large.

            I do not use words like fraud and collusion lightly. Mortgage brokers and borrowers routinely falsified loan applications. Other market participants routinely looked the other way in order to earn commissions. The entire mortgage-making mechanism turned out to be a fraud on the investors who supplied the money, though it is hard to pin the crime on a single participant. Let’s just say the Model did it.  

            The effectiveness of a capitalist market economy depends on the market being competitive. Collusive practices among market participants can negate the benefits of competition. So can systematic and successful efforts to fool the people who buy the products. Fraud, collusion and systematic efforts to fool consumers and investors are nothing less than assaults on capitalism.  

            The frauds committed by borrowers and mortgage brokers—often with the connivance of others up the line, placed the lending process of the mid-2000s outside the competitive market paradigm.  The process assured that the market would mis-allocate resources.

            In addition, the complexity of the securitizations made it impossible for investors to evaluate the securities they were buying.  They could not properly play their market economy role of deciding where resources should go. So they relied on the rating agencies to tell them. The rating agencies permitted the securities to be mispriced.  Classically, mispricing leads to misallocation of resources. In this case, the misallocation was to bad loans and an excess supply of homes. During the time it takes for that excess supply of homes to be absorbed, the economy will suffer from a lack of construction activity.  In effect, the economy of 2004-2006 borrowed from the economy of 2007 until whenever it is that new home construction returns to a normal level.

WHY WAS THE IMPACT OF THE SUBPRIME LOAN MARKET’S

DEMISE SO WIDESPREAD AND EXPLOSIVE?

            When the subprime market started to unravel in mid-2007, most government spokespeople and commentators opined that its impact would be brief and contained. Few people, including sophisticated economists and central bankers, knew the volume of bad loans that had been made. Few people knew the extent to which mortgage-based securities had been mispriced and mis-rated. Few people had an idea of how far home prices would have to fall to reach equilibrium.

Few people knew the subprime meltdown would lead to an effective shutdown of securitization or that securitization had funded a majority of the Western World’s credit needs for a generation. 

           Few people knew that because the U.S. mortgage market is the largest, most liquid, most expandable capital market in the world, the subprime-mortgage-backed securities were in portfolios everywhere.  Greedy for higher investment returns than were available on government securities, investors from all over the globe had invested in securities backed by American home loans.

            Commentators also underestimated the leverage in the banks, investment banks, insurers and hedge funds that had participated in the securitization market. All these types of financial institutions had taken on additional risks in the mid-2000s and they all had very thin capital cushions.5

            When the inadequacy of capital levels to cover expected losses became apparent, the capital markets froze. Quite simply, most market participants became afraid to do business with each other. Each institution feared that institutions they dealt with would fail when they eventually would have to recognize how little their mortgage related assets were worth. Therefore they, quite logically, would not lend to each other.

            The leverage in the financial sector was a bomb looking for a fuse. Subprime mortgage lending turned out to be the fuse—and it supercharged the bomb because it was attached to the largest class of assets—the U.S. mortgage market. Financial player after financial player had to sell securities and close out trades to pay down debt as the mortgage losses rippled through the securities and derivatives markets and decimated institutions’ over-leveraged capital in a process known as The Great Unwind.

5 For an explanation of capital and leverage, see the Appendix to this book

that I have adapted from a paper by Professor Lawrence J. White of the Stern

School of Business at NYU. My thanks to Larry for permitting me to use it.

LEVERAGE IN THE BANKS

            Banks are, by their nature, highly leveraged. They cannot make money without leverage because the spreads between what they pay for money and what they earn for lending it are not large enough.  Banking is a business in which a more credit-worthy bank borrows short-term (from depositors and others) to lend to a less credit-worthy borrower longer term. This business has a fundamental problem:  If the bank’s capital gets low because the less creditworthy borrowers default, the people and institutions that lent money to the bank short-term will demand their money back. That is called a bank run.6

            Bank regulation has, since the Depression, sought to manage the natural risks of banking, partly by establishing minimum capital requirements. These capital requirements initially took the form of an amount of capital that a bank had to maintain as a percentage of all assets or all liabilities. In the 1980s American regulators introduced the idea of two tiers of capital, one composed basically of permanent capital or equity (dubbed Tier 1 Capital), and one composed of capital

on which the bank paid a return and which would have to be repaid at a date certain or under specified circumstances, as well as loan loss reserves (Tier 2 Capital). A bank had a requirement for Tier 1 Capital and a requirement for Total Capital (which includes both tiers).

6 The term bank can be used to refer to many different types of institutions.  These include commercial banks, universal banks, and investment banks.  Commercial banks are deposit-taking banks that are regulated for safety and soundness. Investment banks do not take deposits and are freer from prudential supervision. Universal banks encompass both commercial bank functions and investment banking functions. Hedge funds are none of the above. They are not publicly owned, do not take deposits, and are very lightly regulated. A hedge fund appears to be much like a mutual fund except that, because it does not offer its securities to the public in general, it is not regulated like a mutual fund. Mutual funds are regulated quite strictly.

to which Basel II actually influenced bank capital levels in 2006-2007.  Probably the impact was greatest in the investment banks that became subject to Basel II under SEC rules adopted in 2004.

            Regardless of whether any particular bank actually managed its capital according to Basel II in 2006-2007, all banks knew the final framework had been published by the BIS in July 2006 after a decade of work, and the banks were anxious to adopt its approach.

            That approach is based on something called VaR, or Value at Risk. Suffice it to say for current purposes that VaR is a complex measurement, done by the bank itself, which is designed to measure its risk profile at any time. And the amount of capital that a bank or securities firm is required to maintain is related to its VaR. Thus Basel II basically entrusts a bank’s capital requirement to the same quants (mathematically gifted bankers) who create the complex securities into which mortgages and other loans are made for sale to investors.  Most CEOs understand VaR in principle. They know what VaR means but they could not compute it themselves and could not second-guess their employees who do know how to compute it.

            In addition, VaR, as a measure of real risk, has come under heavy attack. Even Chairman Greenspan, a fan of VaR, has recognized at least a part of the problem: “The whole intellectual edifice, however, collapsed in the summer of last year,” he said in 2008, “because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” Many others think that was not the only problem.

            I will confess that I have been highly dubious about the concepts that Basel II embodies ever since I heard about them ten years ago. I could not believe they became the law of the world, so I am prejudiced, but I think Basel II has made our problems worse—maybe even much worse—because, even if they did not yet apply officially, the concepts encouraged banks and investment banks to take risks that they thought minimal that turned out to be maximal. The risk16 based numbers mean very little when the banks decide for themselves how much each asset counts in the weighting.

         Loan Loss Reserves. Banks also decide how much they are going to take as loan loss reserves, subject to review by auditors and regulators. Loan loss reserves are included in Tier II capital.

            Loan loss reserves are supposed to be deducted from a bank’s income in good times so that they are available to cushion losses from loan defaults that inevitably occur in bad times. Unfortunately, the Securities and Exchange Commission (SEC) didn’t see loan loss reserves that way. Beginning in 1998, the SEC reprimanded banks for taking excess reserves in order to “smooth” earnings over time. (That is what loan loss reserves are supposed to do!) The SEC thus elevatedquarterly earnings reports over sound management, and the banks stopped taking “excess” loan loss reserves. The accounting profession went along with the SEC, ruling that the reserves estimate was to be based on conditions at the balance sheet date in question, not at some possible future time when markets might be under greater stress. In

effect, the SEC required the banks to leverage up. To be blunt, that was stupid. Predictably, when the hard times came, the banks were woefully under-reserved and capital had to take the hit.

            In truth, banks almost never have sufficient capital to cover their losses when really bad times come. But the regulatory system over the last decade has embraced procyclical rather than countercyclical policies that, along with bank managements’ shortsightedness, have made bank capital woefully inadequate. As a consequence, bank capital was inadequate even to absorb the losses caused by the initial disclosures about the U.S. real estate market. That capital inadequacy in turn made the capital markets seize up and helped turn a difficult situation into a crisis.7

7 European banks were in the same boat as American banks when the crisis hit. That was because they had invested in securities backed by U.S. mortgages, just as the American banks had done, and had leveraged themselves highly, just as the Americans had done. Indeed, the European banks had committed some of the most extreme indiscretions in their capital management and quickly paid the price. For this reason, there never was a question of containing the banking problem to America.

LEVERAGE IN THE INVESTMENT BANKS

The investment banks, the big five of which were Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns and Lehman Brothers, all became very highly leveraged in the mid-2000s. If we looked back to the 1980s and earlier, we would see that most of the investment banks were partnerships of individuals. The partners were careful with their money. The firms had fairly lean balance sheets, dominated by loans to their customers, secured by stocks and bonds, on the asset side, and borrowings from banks to support that lending activity on the liabilities side. When they underwrote securities offerings, the investment banks temporarily bulked up their balance sheets to support the underwritten securities until they were sold.  But all that changed in the late 1980s.  At that time the conventional investment banking wisdom became that it was necessary to have a big balance sheet to support various types of lending, to be accepted as counterparties in derivatives trading, and to engage in proprietary trading.   All the major firms went public and bulked up.  (Goldman Sachs did not go public until 1999.)

            Net capital requirements. Brokerage firms have had strong net capital requirements since 1975. They have marked their securities positions to market values and computed their net capital on that basis. But the brokerage side became a small part of the activities at many of the investment banks. That made it logical for the firms to structure themselves so that most of their activities took place in a holding company and subsidiaries of the holding company that were not subject to the SEC’s net capital requirements for brokers. As a consequence, no regulatory capital requirements applied to the overall operations of any of the major investment banking firms.

                When the Bank for International Settlements went to work on the Basel II capital requirements, a process largely spearheaded by the American regulatory authorities, they intended that those new requirements would apply to large investment banks as well as large depository banks.

                In practice, however, the U.S. regulatory regime did not have any regulator that oversaw the large investment banks. In April 2004, the SEC adopted a tradeoff that the industry had suggested: The big investment banks would have the 1934 Act net capital rules for their brokerage subsidiaries removed, in exchange for the top-level companies becoming subject to the capital standards of Basel II. As described above, under Basel II the institutions basically set their own capital requirements based on their own assessment of the risks they are taking.  This is supposed to be monitored by a regulator that investigates the adequacy of the institution’s capital adequacy processes and policies.  In practice, the SEC did not have the ability to do this and the big investment banks not only got the benefit of the fairly lax Basel II standards; they also got to employ those standards without much governmental scrutiny. And quite predictably, in an era of financial confidence, they kept very little capital in relation to their assets.

                By the time the Crisis began in 2007, each of the five big investment banks had over $500 billion of assets, based on capital amounting to about 3% of that. These were now like huge hedge funds: large pools of financial assets supported on miniscule capital bases and, as such, could not afford to make mistakes. The mistakes some of them made in the mortgage securities markets killed them, forced the largest of them into a merger with a commercial bank, and forced the remaining two to seek refuge as commercial bank holding companies.

LEVERAGE IN THE BOND AND MORTGAGE INSURERS

Capital requirements for various kinds of American financial companies are inconsistent and almost bizarre. For present purposes, it is enough to know that insurance companies are under a different regime from banks (and brokers).   And the insurance companies do not have a federal supervisor. They are regulated by the states, each of which has its own requirements, and most large insurance companies have separate subsidiary insurance companies in several states, as

well as separate subsidiaries in foreign countries that often are not supervised by any American regulator.

                The largest insurers of municipal bonds are regulated mostly by the State of New York. These insurers, MBIA, Ambac and FGIC, started out insuring only municipal bonds. Over the years, the municipal bond business stopped being exciting enough and offered too little growth, so the bond insurers started to branch out. One of the ways they branched out was to use their triple-A ratings to insure packages of mortgages against high loss ratios.  This not only raised their own

risk profiles, it also effectively raised the risk profiles of all the institutions that relied on their insurance because, when the loans started to go into default, the value of all the insurance they had written came into question. Although these bond insurers have not yet failed, their credit ratings have declined markedly.  The lower credit ratings have required institutions that hold securities the bond insurers have guaranteed to take significant write-downs.

                The largest traditional mortgage insurers also had raised their levels of leverage during the mortgage boom. But worse than raising their leverage levels, they seem to have abandoned their traditionally conservative approach to writing insurance.

                Mortgage insurance was never the world’s easiest industry. In a sense, mortgage insurance is like insuring junk bonds.  Traditionally, lenders only sought mortgage insurance on loans they made at high loan-to-value ratios (LTVs), usually over 80%. Since the LTV is the most important factor in underwriting a mortgage, the insurers were insuring only the riskiest mortgages.  They protected themselves—and had pretty good default experience—by being careful about the lenders whose loans they insured and by making sure the LTVs were sound and other underwriting criteria were within guidelines.  Their largest customers were the government-sponsored mortgage companies, Fannie and Freddie, which traditionally applied sound underwriting criteria.

                Unfortunately, as the mortgage world went crazy in the mid-2000s, the mortgage insurers went hog wild themselves, not only increasing their gross exposures but also writing insurance for Wall Street’s Private Label packages of subprime loans and other types of loans that should not have qualified under their historical standards.  Like the bond insurers, the mortgage insurers haven’t failed yet, but their ratings have declined and therefore those who hold mortgages or securities backed by mortgages that they have insured have been forced to write down those mortgages or securities.

LEVERAGE IN THE HEDGE FUNDS

Hedge funds usually are the most highly leveraged players in the financial sector.  Not only do they typically borrow as much as possible against their assets, they also may, in many cases, hold assets that are themselves highly leveraged. In some investments, a hedge fund’s leverage can get as high as $100 of assets supported by a single dollar of capital.  Only a very small mistake might cause the scheme to unravel.  And that is what happened. Many of the highly-leveraged schemes did unravel, with predictable (though largely unpredicted) consequences: The write-downs of the mortgage-backed securities caused the banks that had lent to the hedge funds to require either repayment or additional collateral. The hedge funds therefore had to sell other securities into a bad market in order to raise the money to repay the banks. That caused further effective markdowns and the Credit Unwind process continued, propelled by its own logic, until finally the hedge fund could reach equilibrium or, as some did, go out of business.

                Some farsighted hedge funds shorted the subprime market.  They made a pile of money. Hedge funds are both sides of the coin.

LITTLE LEVERAGE IN THE CORPORATE SECTOR

One of the reasons that commentators initially thought the “real economy”—the corporate sector outside the financial companies—might not be affected by the credit implosion was that in general the corporate sector was not highly leveraged when trouble started in 2007. Corporate profits had been robust for several years, which had enabled most major companies to reduce their debt. For this reason, although many firms will fail, especially those firms involved with

construction or commodities used in building, the corporate sector in general may escape the worst of the carnage.

            What has damaged the real economy companies has been the steep fall in consumer demand. With homes and stock portfolios impaired, American families stopped their discretionary spending and have begun to rebuild their damaged balance sheets.

MACRO IMBALANCES

Macro imbalances that prominently included the U.S. fiscal deficits of 2001-2007 and the U.S. balance of trade deficit, mostly to China and the oil exporting countries, set the stage for the Originate-to-Sell Model to work its toxic magic.

                Whereas America long had been a creditor nation, large fiscal deficits in the 2000s made America a debtor nation. In the mid-1990s China had begun supporting the U.S. by investing the proceeds of its positive balance of trade with the U.S. in U.S. dollar securities, almost all U.S. Government or Government guaranteed securities.

                In 2003 through 2006 the United States’ negative balance of trade with China worsened. In 2002 the deficit was $99 billion. The deficit rose to $117 billion in 2003, $148 billion in 2004, $178 billion in 2005, and $199 billion in 2006.8 The U.S. had similarly increasing negative trade balances with the petroleum exporting countries. These deficits were sustainable only because the U.S. also ran a high fiscal deficit that was financed by sales of U.S. government and agency

securities to China, Japan and the petroleum exporting countries. Like the home equity extraction that I described above, that kind of fiscal imprudence cannot go on forever.

                I will discuss the macro imbalances and other macroeconomic theories of what caused the Crisis of 2007-2009 in Chapter Twenty, called Alternative Causes. For present purposes, it is enough to say that I have identified six categories of macro causes that have respectable foundations, as well as six less overarching causes that also have respectable advocates. These potential causes are not mutually exclusive. Indeed, many of them could have been operating at once. The causes that I have identified in this Chapter One are, however, the one that I believe were most proximate to the boom,

downward spiral, and consequent Crisis.

                In Part II, I have criticized some of the Government’s failures to act promptly to ameliorate the Crisis. I do not think that even the right Government actions after some time in 2006 could have avoided a deep recession entirely. I do believe, however, that the right actions taken in 2007 could have avoided the crisis atmosphere and the steep fall in stock markets and economic activity.

8 Balance-of-trade-with-China data, which is adjusted using the GDP deflator so it can be compared to the GDP data in the foregoing table, is based on data from census.gov.