How the Rich Got Richer During the Financial Crisis

This story starts off with good intentions like most stories. The world economy was booming because of the productivity created by the internet and global trade. The world was printing tons of money and people were chasing higher returns because of the low interest environment all over the world. A great place for those funds was US real estate. During the wild wild west of real estate financing of the early 2000s, banks found an innovative way to make more money by providing more loans for people who did not quite qualify. By combining loans to low credit with loans of prime (high credit) customers, they created bundle of loans with three letter names called mortgage backed securities (MBS) and collateralized debt obligations (CDO). By doing this, these bonds were still rated as AAA or top quality. Ironically the same companies rating the bonds were paid by the banks to do these ratings. No good rating; no new business. No conflict there right?

This new source of funding for real estate became the fuel for the fire of the real estate expansion. Before it was difficult to give everyone loans so there were fewer buyers. With the relaxation of requirements for mortgages, banks were able to give loans to people who not only had low or bad credit but also people who only had unverified or stated income. This became a honey pot for people who wanted homes who never imagined it was possible. The American dream fueled by global growth and lax regulation. But it was also a recipe for a kitchen explosion. The kitchen got hotter and hotter as more and more buyers pushed prices higher and higher. Appraisers were using ridiculously high sale comparables to value properties. Appraisers who always magically made the valuation work for loans kept getting hired. People were making tons of money by selling a property that they just bought months before so people didn't care if they could not make the payment. As the banks made more loans, they sold more bonds thus giving them more money to make more loans while extracting enormous fees.

The truth is the going was good. No one wanted this party to end even though there was smoke in the kitchen. The house party was as the youngsters say "lit" and everyone was making money. Real estate agents, loan agents, bankers, and everyone involved the real estate transactions were making more money than ever. Builders and contractors were enamored by the profits and demand. The government was reaping more and more tax revenues; spending on local growth to satisfy constituents. Sellers were euphoric; their homes were giving them equity and they could take out money from their house like an ATM for new cars and material junk. Buyers were happy to get cheap money and the ability to buy their home with very little down and low teaser rates. Investors were happy to get a solid return on these so called safe bonds in a low interest environment.

Then suddenly people did not have enough money to pay for their bar tabs. Banks were lending money to people to party but no one ever expected to pay for anything. As low teaser rates jumped, People who put no money down in overpriced homes suddenly decided to not make payments. Perhaps it was because they could not pay in the first place because they lied about their income or were just irresponsible as indicated by their low credit scores. Or for some, they realized it made no sense to make payments on something that was worth less than the loan on the property. As property prices started to drop, more people decided to do the same and stop paying; walking away from their American dream. This started the downward spiral that affected not just Wall Street but also Main Street.

Wall street found themselves holding a lot of worthless loans. Banks were losing millions daily in 2006 based on the value of their once extremely safe AAA bonds. The value of these bonds were backed by the value of real estate which was dropping like a rock from the sky. The fire in the kitchen was raging and people were rushing out of the house party. No buyers to be found. Banks intelligently stopped making loans and stop the fire from spreading. But it was too late, the fire was spreading from the kitchen to the rest of the house. Real estate construction halted and the engine of growth for the economy stopped. Real estate agents found themselves with no listings. Buyers were no longer buying because no one was giving loans and jobs were disappearing. Sellers were stuck in more debt than ever after spending all their home equity. Bankers, agents, contractors, and everyone related to real estate found themselves jobless and broke. No one was spending money now as people started fearing the possibility of a recession. This only helped the fire spiral out of control as government cut spending and companies laid people off as the economy cooled. Banks were now saddled with debt as well and could not make loans for anything. With credit frozen, even the innocent hard working people who lived next door who went to school, worked hard and volunteered in the PTA were going to get burned. The fuel for the real estate industry was the same fuel for the rest of the economy. The whole house was burning down now.

Ten years later in 2017, our economy is back at new highs. What happened since then? Well we had to call the fire department to save the house. The Federal Reserve (Fed) came in and saved all the banks because if they didn't, the whole financial system may have broken the economy further including innocent people in main street who paid their taxes and worked hard. So the government decided it would need to save the economy by saving the banks who were also the people who started this fire. The Fed needed the banks to provide credit to companies to continue paying their employees and buying supplies. Banks were made solvent to do this. Banks were the only ones who could rebuild this house. But the government decided to take over most of the major banks by buying equity. Bank of America, Citibank, and AIG was once largely government owned companies.

For the government, there was only one solution. They needed to lower short term rates to spur the economy and lower long term rates to spur real estate prices. The banks bought more and more mortgage bonds and giving banks more money to lend to spur the economy again. These mortgage bonds would cause the government to lose billions if real estate prices did not recover. So here's where the incredible shift in wealth happened. People flushed with cash bought up real estate at fire sale prices. Blackstone, a private equity fund became the largest property owner in the US at one point. The banks took the losses while wealthy people gained control of real estate all over the country. Banks were backed by the government so the billions in loses were taken at the expense of the American public. Here is the thing, money does not disappear, it just goes from one person to another. The people who sold the properties at a high got their money from the investors or banks. Wealth stayed with all these people who sold high. When the economy was down in the dumps with artificially deflated housing prices instead of artificially inflated prices, those same people flushed with cash started buying. At the time in 2009-2011, there was little competition because loans were tough to come by so whoever had amazing credit and a ton of cash bought real estate dirt cheap.

When the economy finally recovered, people started buying homes again. Many wealthy people refinanced their properties and returned most of their investment to themselves. For example, if a house that was originally $500,000 was sold for $250,000, then the bank lost $250,000 but was bailed out by the government and shareholders took the losses. The new owner could rent the house out and wait for the price to go back up. If the house price went up to $350,000, the owner can refinance it with a loan to value ratio of 80% of $350,000 or a loan for $280,000. So the owner is paid back the $250,000 investment and $30,000 extra for their troubles. Of course this is not including the rent paid to them during this time. But amazingly, the owner still owns the property with $70,000 of equity or wealth. You can eat the cake and have it too! Now that most property prices are back to it's highs, this owner now has equity of $220,000 with monthly cash flow from the $500,000 house. Banks lost money. Buyers lost their homes, money and credit. The government printed more money. The money just went to wealthy people who had the cash to buy up homes when no one was left to buy. The trillions in bank losses went into the pockets of very wealthy people with the help of the government. This can also be said of the stock market. When people had to sell their shares during the crisis, people with extra cash bought and benefited from the efforts of the government to save the economy.

During recessions, money does not disappears, it just moves from one person to another. Usually it goes from a person with a short time frame who needs cash to someone who has a long time frame who has extra cash. Note this is not a critique of capitalism, banks, or the government. This is a systematic problem that we should all use as a reference for the future. We are all at fault for this crisis. Of course some of us more than others. We are the economy, each one of us. This will happen again and it will benefit those who are ready for it.