Before the credit bubble burst in late 2007, America’s financial services industry was having a field day. Representing only 15% of corporate America’s gross value added and a mere 5% of private-sector jobs, the finance industry earned 40% of total corporate profits (Economist 3/22/2008). The number one dream job of Ivy League grads was in finance which paid twice as much as non-finance jobs. One out of every $13 of employee compensation in the US went to those working in finance. The top 25 hedge-fund managers combined earned more than CEOs of the Standard & Poor’s 500 companies combined in 2004 (WSJ 1/17/2008).

The finance industry has not always been so over-blown. In 1980, its profits were only 10% of total corporate profits. And US financial assets represented only 450% of GDP instead of over 1000% of GDP (Economist 3/22/2008).

The meteoric rise of the finance industry had been divorced from the real economy. GDP increased by only 30% between 2002 and 2006, but the DJIA increased by 92%, and (debt-based) asset prices increased by a multiple of three (Asia Times 1/11/2006).

These asset bubbles were based on the securitization of sub-prime loans originated by banks. When loans were re-packaged into debt securities, they could be sold off to investors for various yields dependent on their risk ratings. Since banks did not have to keep their loans on their balance sheets, they were not concerned with the credit worthiness of their borrowers. Instead, they were more interested in the fees generated by originating the loans. Hence the origin of no-document and no-down-payment subprime mortgage loans.

The subprime borrowers were happy to go on the joy ride because with the short-term interest rate at 1% (thanks to the cheap-money policy of the Fed) and home prices rising by more than 30% annually, a full-price mortgage can be amortized in a little over 3 years (Asia Times 1/11/2006). The mortgage rate was of course more than 1%, but the adjustable short-term mortgage rates were well below 5%. And of course there were tax incentives on top of the low rates.

Housing prices were skyrocketing because the Fed was eager to reflate the economy with cheap money after the 2001-02 dot com bust. This cheap money did not inflate the domestic prices of consumer goods because their manufacturing had been offshored to low-wage China. Instead, the cheap money was channeled into a speculative housing bubble. Meanwhile, the US dollars sent overseas due to trade deficits were recycled back to the US financial markets to provide fuel to the housing boom. (See Trade Surplus Trap.)

The housing bubble thus worked like an inexorable positive feedback loop. Homebuyers bought homes with no down-payment; lenders sold the loans to debt securitizers who sold securitized debt to institutional investors who borrowed money using the invested securities as collateral to buy more securities. In turn, the resulting soaring housing prices abet more speculative buying of homes. In the end, structured financiers did not even need new consumer loans to create additional debt securities. Instead, they generated more fees by creating (aka structuring) new debt securities based on derivatives of existing securities. The so-called collateralized debt obligations (CDO).

This bubble was exhilarating to all participants while it lasted. Home buyers, land speculators, home builders, real estate agents, investment bankers, mortgage originators, structured financiers, household furnishers, and retailers could not believe their good fortunes. Even Greenspan, the US central banker, could not understand how interest rates and inflation rates could stay so low even when the Fed tried to increase the short-term rates after 2004.

This bubble would not have lasted so long if the debt investors were not fooled into believing that the securitized debts were AAA-rated and insured. When the bubble burst, some 50% of the AAA-rated subprime asset-backed securities (ABS) and virtually 100% of all AAA collateralized debt obligations partially defaulted (Fortune 11/10/2008. See also Who Rates the Raters). If the words of the rating agencies were not enough, investors could buy swaps (unregulated and no-reserve insurance) to insure against credit default. Because anybody could sell swaps and pocket the premium without any reserves, the credit default swaps market nearly doubled each year from 2001 through 2007 (Fortune 10/13/2008). It is the failure of major issuers of such swaps to honor their contracts that finally burst the housing bubble once subprime mortgages started to default.