It's very simple, what I said was that there were low interest rates and lacks of regulations. The financial sector mortgage flight encouraged people to borrow. When you are alone, there were $950 billion of what are called mortgage equity withdrawals; people were taking money out of their mortgages, out of their houses and spending much of that. The low interest rates didn't stimulate a investment boom in factories and things that would have made our economy more productive. What happened was there was a little bit of investment but in houses beyond people's ability to pay. They had innovation but their innovations that were in effect intended to get around the kinds of potential standards that had been the basis of the soundness of our system. So, for instance, they were lending mortgages that were 100%, some cases more than 100%, they didn't even have to the pay the interest that was due. At the end of the year, they owed more money that they did at beginning of the year. They said, don't worry because the price of housing was going to go whopping, you would be wealthier. What they were promising was what economists would say, is free lunch, but we say, there's no such thing as a free lunch. If it were true then just by buying a house at the end of the year, you would be wealthier, everybody would have done and system couldn't have worked.
So, what made a particularly obvious that something was wrong was that while housing prices were going up and up, the income of American's was not going up and up. The median, the extra person in the middle income was going down. People at the bottom were getting worse off. So, you had an impossibility, you will need a Nobel Prize to figure out that if houses are going up and incomes are going down, there's going to be a problem; you can't expand more than 100% of your income on housing. It was a gamble but it was a gamble which we were fairly sure, we knew what the outcome would be and that was the disaster that we are seeing.
Now, what they did then was to take the mortgages in the old days, a bank would originate a mortgage and then hold on to the mortgage and if you made a bad mortgage, it would bear the consequence. But there is a new innovation called Securitization. Securitization enabled the diversification of risk around the world. But diversification had another problem and I sometimes joke the students in my class, after I explain the advantage of diversification ran down to Wall Street to make money and didn't listen to the second half of the lecture. The second half of the lecture was about the problems of diversification. The problems of diversification, it creates a new information asymmetry. The person originating the mortgage knew more about the mortgage than the person buying mortgage. You sold the mortgage to people all over the world. We did it, we based it on the principle that a fool was born every minute and we would find those fools anywhere in the world, globalization opened up a new opportunity to find new people to exploit, their ignorance and we found them. The losses in Europe have been actually greater than in America in the subprime mortgage area. But this was all the house of cards.
So, Lehman was one of the companies that was particularly exposed to having bought these mortgages. They repackaged these mortgages, there were many other people involved in this scam. The rating agencies believed in financial alchemy. You know in the old days alchemy, you took lead and converted it into gold; we can't do that, of course. They believe they could take f-rated subprime mortgages borrowings by people well beyond their ability to pay and then engaging some magic of financial alchemy and converted into A-rated products that could be held in the portfolios of pension funds, safe enough to be held by banks, to be hold by anybody. But of course, it wasn't based on reality and there were some obvious problems that rating agencies were being paid by the people who are engaged in producing these complicated financial products that were so non-transparent that not even those who owned them understood what was going on.
So, the reason Lehman Brothers went down is two-fold; they owned a lot these bad assets, but also because the products were so non-transparent, because they engaged in so much of this accounting gimmickry that no one had any confidence.
The financial markets are based on trust; you give your money today and you hope to get the money back with interest. But if the people you give your money to may walk away with your money, pay it to their executives in high bonuses and what you are left with is a lot of rotten assets, you are not going to have that same trust. And what's happened is, has been the loss of that trust. So, no one wants to turn over their money to help Lehman Brothers because they said, "We don't know what your assets have worth."
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