What year did the financial system break?

Late in the House Financial Services Committee hearing today with Tim Geithner, Ben Bernanke and Bill Dudley, California Democrat Joe Baca asked Bernanke an interesting question: When did the financial system break? What year did everything go bad? Bernanke demurred, but I have an answer: 2003, or maybe 2004.

It was late in 2003 that subprime lending first truly exploded, and when Wall Street pushed aside Fannie and Freddie to become the main buyer of mortgage loans. It was in 2003 that house prices went from mere rising to outright climbing. It was around 2003-2004 that the Icelandic banking system first began growing like gangbusters. It was in 2003 that global trade began its sharp rise as a share of global GDP. It was in 2004 that Trader Monthly was founded. And so on. It was the beginning of the explosion in debt that left the financial system so staggeringly fragile.

Why then? I really don’t know. I find the popular explanation that it was all Alan Greenspan’s fault for keeping the Federal Funds rate at 1% in late 2003 and early 2004 pretty unsatisfactory. But I don’t have a better one.

Stocks Rally Further in Run-up to EU Summit

MOSCOW — Global stocks enjoyed one of their best days in weeks on Tuesday ahead of a summit of European leaders that’s expected to be dominated by calls to boost economic growth.

Europe remains the focus of attention across all financial markets in the run-up to the June 17 Greek election that could go a long way to determining the country’s membership of the euro as well as the future of the single currency zone.

dotybj

… it was 2004 that I moved to Los Angeles and said, “holy s—! these prices are unsustainable!”
tndod

Justin,

I think that you are spot on with this timing. 2004 was the year that the SEC allowed the largest investment banks to dramatically increase leverage. Also the period that bond yield “conundrum” or “global savings glut” was really picking up steam…lot of foreign money started getting thrown at MBSs. The investment banks might have helped stoke the fire with leverage, but they were essentially responding to this enormous amount of demand that led to the build-up of what we all know now as the “shadow banking system.”
plukasiak

I think it broke in 2001, when Greenspan dropped interest rates to ridiculous levels very early in the year in response to the threat of a recession (and then dropped them even lower in the wake of 9/11), and Congress passed Bush’s “fat cat tax cuts”.
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The next result was a massive increase in the availability of “investment capital” with almost no good opportunities to invest in additional productive capacity and job creation (especially in the USA). This glut in private investment capital lead to inflated stock prices, an epidemic of debt based mergers and acquisitions, and the creation of increasingly more complex and arcane “financial derivatives”.
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tndod

Maybe you could argue the seeds started getting planted in 2001, but you still had a solid 1-2 years of a really tough bear market for stocks to go. There was no inflation of stock prices during that period…they were deflating.

Maybe you could argue that the disgust with stocks as an investment helped enhance the halo that appeared to be around the only asset that “never declines,” real estate.

Greenspan dropping rates in 2001 was not so much a problem, it was warranted then. The issue was more to keep them too low in 2003 and 04 when the economy was recovering (Taylor rule gives a good illustration). And whether you liked the Bush tax cuts or not, it is tough to argue that a tax cut (just shifting money from the hands of the government to a taxpayer) creates a bubble.

In hindsight, these things appear to be the big events… (and all seemed to really take hold in 2003-04 as Justin notes). Granted, this oversimplifies a lot of it…

1. Low rates for too long.
2. Stock market bust makes real estate look particularly attractive, while low govt bond yields make MBSs look attractive…
2. Global savings glut creates a lot of foreign demand for MBSs.
3. Investment banks use 2004 SEC rule change to take leverage up to 30-40 to 1. Investment banks were the shadow banks of the shadow banking system. (Freddie and Fannie also got more aggressive as they started losing market share to the investment banks on their home turf.)