Considering it was the greatest economic crisis since the Great Depression, most people probably remember (and were likely affected by) the 2007 Financial Crisis and the following global economic downturn. Banks and Wall Street are most commonly blamed (rightfully so) for the Great Recession and its absurdly negative economic impact. The acts of a few agents have stirred nationwide animosity towards the American capitalist system, especially among millennials. In fact, only 19% of Americans ages 18 to 29 identify themselves as “capitalists.” This does not imply that the other 81% are begging for socialism, but rather that they may be losing trust in the system for allowing the self-serving rich to breed such a crisis. Yet, it’s more accurate to center the economic crisis around the Frankenstein-like mutation of our monstrous financial sector rather than around flaws in the system itself. The distortion of our financial sector from an efficient and solid economic influencer to the unstable, dominant sector of our economy laid the groundwork for a pack of greedy bankers to wreck the global economy in the name of their love of the dollar.
Financialization refers to “the situation where the financial sector takes a bigger share of GDP and employment.” If pushed to the extreme, it creates a situation where the financial sector has a much greater influence on the wellbeing of the economy than it should. Financial markets are not inherently bad, but tend to be fairly beneficial for a financial system. Finance markets and institutions improve the “division of knowledge” in an economy by bringing together savers, who have extra capital to invest, and borrowers, who need extra capital to pursue their life ventures. For example, when I get older and choose to move out of my modest college apartment and move into a big house with my family, services from the financial sector are going to connect me with the needed capital to buy said house. Financial institutions that move money around in this fashion reduce the transaction costs of allocating extra capital (allowing me to buy my house), and increase market and funding liquidity (the ability to exchange financial instruments in markets) in our economy. Overall, the “division of knowledge” increases a nation’s economic efficiency by allocating extra capital to capital users, and decreases the associated “uncertainty that is inherent in investable projects.”
The financial sector went from accounting for about 3% of America’s GDP in the 1950s to about 7.5% in 2006, creating an overly financialized American economy in which “the finance industry swelled as the rest of the economy weakened.” Excessive financialization is undesirable: the increasing importance of the financial sector tends to widen inequality, increase the risk of unsustainable debt and lending levels, and a flailing, oversized financial sector usually has wide-reaching consequences on other industries. It allows for the errors of major financial players to push the whole economy in the danger zone.
So, what happened in 2007? Enter mortgage-backed securities. This ingenious financial instrument “represent[s] an interest in a pool of mortgage loans.” This means that when TD Bank gives me a mortgage to purchase my spotless new house, it now owns the claims to my scheduled mortgage payments. TD can now decide to sell the claims to my mortgage payments to Memes, Inc., a hypothetical company, which in turn can pool my mortgage together with other mortgages that are similar in terms of maturity, interest rates and other shared characteristics. Memes, Inc now owns one large mortgage-payment collection instrument and can sell shares that represent a fractional interest in this particular pool of mortgages (of which my mortgage is a small part) to interested investors; these are mortgage-backed securities. When TD Bank accepts any payment for a mortgage part of one of those securities, it takes a fee, then sends the rest of the payment to Memes, Inc., which then takes a fee, and spreads the rest of the interest and initial loan payments to the investors who own the mortgage-backed security. A mortgage-backed security acts in similar fashion to a bond; you buy the security for an initial amount, and then get monthly payments for however long you own it, or until the loan is paid off.
Since everyone pays their mortgage, this sounds like a safe and secure investment, right? TD Bank gets cold, hard cash by selling my mortgage, it uses this cash to provide more mortgages to its customers. Memes, Inc. also gets cash for selling the securities and proceed to use that cash to buy more mortgages so they can pool them. Because everyone involved made a killing off the fees they collected, banks and credit companies kept approving more and more mortgages and creating more and more pools. Inevitably, they ran out of high-credit customers in need of mortgages, and banks stopped issuing safe mortgages, only to repeat the process with subprime mortgages, a type of loan granted to individuals with poor credit. These were risky investments, as the lendees making mortgage payments were much more likely to default. Investors continued to purchase interest in these risky mortgage pools because they were still given triple-A credit ratings by credit agencies later revealed to have vested interest in the pools they were rating. Margot Robbie explains all of this exceptionally well in the following scene from The Big Short:
When a certain fraction of what Robbie describes as “s#*t” subprime mortgages in a pool are defaulted on, the entire security that these mortgages back becomes effectively worthless. During the financial crisis, a rapid increase in mortgage defaults and home foreclosures, followed by a collapse in housing prices, led to a loss in trust and interest in subprime mortgages. The prices of the securities representing these mortgages collapsed and financial institutions like TD Bank and Memes, Inc. were suddenly stuck with copious amounts of these worthless assets. Not only did the market liquidity for exchanging these instruments dry up, but no one would loan to the institutions because of their precarious financial situation, causing their funding liquidity to dry up as well.
Subject to unsustainable debt, major financial sector players such as Lehman Brothers had to file for Chapter 11 Bankruptcy. This, combined with the excessive financialization of the American market and the billions of dollars lost by imprudent investors, amplified the economic consequences brought by the actions of reckless financial companies to an unprecedented level.
This string of unfortunate events left the global marketplace in a state of disarray. I know what you’re thinking: how could we have let the actions of a few selfish individuals in a generally positive marketplace wreck the global economy? The answer is simple: greed. Greed and imprudence are to blame, not the capitalist market system and its ‘supposed laissez-faire structure that allowed for an economic sector to swell to such a large magnitude without proper regulation.’ The seeming crisis of faith in the capitalist system is distressing to me, as a proper consideration of our economic system should show that the crisis was an uncontrollable mutation of one usually beneficial sector distorted by greed. Like Proteus in Shakespeare’s The Two Gentlemen of Verona, the financial sector became “metamorphosed with a mistress,” but in the case of the US economy, that mistress was the dollar. Financialization, an otherwise economically-beneficial activity, mutated out of control, leaving a daunting economic collapse in its wake. I don’t want large parts of our post-recession society to stop identifying with capitalism based on the false idea that it inherently generates financial bubbles bound to burst. Excessive financialization is not a natural capitalist feature; Wall Street just let itself get too big, too greedy, and too risky, way too quickly.