Chasing the Rainbow: Wall St. Gambled on Fictional Expansion-potential

The hardest thing to understand about the current, and deepening, economic crisis, is that it came about largely because some of the most experienced, well-staffed and prestigious financial institutions in the world gambled on untenable projects of unlimited expansion, without ever producing sound mathematics to back up the projections. Philosophical exuberance replaced philosophical underpinnings, and the dynamo of financial speculation greased the wheels of commerce in a way that masked underlying shortfalls.

It’s fair to say this is the hardest thing to grasp about how we got here, because it’s difficult to grasp no matter what angle you come at it from. Consumers are baffled that such expertise could not have seen what many did see, that there was not enough money behind the market valuations (in stocks, commodities and real estate) to back up the pricing and the accounting that was en vogue, for several years.

Meanwhile, the bankers themselves seem baffled, because even now, in the midst of financial and economic devastation, they still cling to the idea of an inherent validity to the claims that were so pervasive just a few years ago. Adjusting not only to the idea of sustained fallout from error and loss, but also, and perhaps more importantly, to the idea that the errors were rooted in the misapplication of market theory to financial “exotics” that were viable, but weren’t what their peddlers wanted them to be, is painful, and slow-going.

Many of the minds who more easily grasp this problem are in economics, not in finance, and the financial sector is still reeling from the news of its own mutability. Its heroes are not in fact “masters of the universe”, but individuals at play with forces far beyond their control, and which they may not sufficiently understand. And so, an overly serene approach to figuring the truth out of market dynamics could lead to missing the cues and to far more agonizing choices, in the midst of change, which markets, of course, are designed to bring.


When viable rent-returns from mortgaged properties fell below the cost of maintaining the property-owner’s debt, the problem was becoming evident. By 2005, it was clear that real estate markets were steeply overvalued, and that there might be a deficit in the amount of remaining wealth consumers could devote to pushing the prices higher. A fall was coming, a “correction”, and it could be widespread and sustained.

The Hot Spring’s sister publication, Cafe Sentido, saw this and published some initial reporting in late 2005, using The Economist and other widely available economic reporting as references. By early 2006, it was clear there was a property bubble and that the correction could be long and painful. It was also becoming clear the crisis could be artificially delayed by “masking” policies that were put into effect and that concealed the impact the bust would have on banks.

It was, in fact, possible, if you wanted to believe, to just commit to believing in unending positive returns and the ingenious “fairness” of markets. The right policies had been put in place to mask all the pitfalls. One could always get richer, and only the inattentive would lose out. But that was not so. There was a tipping point coming, and the believers would be left over-exposed, along with their institutions, their clients, and potentially even their national economies, to the fury of the gathering storm.

Presumed, or reported wealth was growing at a substantially faster rate than the amount of actual wealth that could be devoted (via consumer spending, commercial borrowing or capital investment) to sustaining the rates of overall price amplification. In effect, the relationship between what was reported and what was true became less and less factual, and that meant that larger and larger segments of overall investment wealth were structured around non-existent wealth, or fictional capital rooted in inviable “exotics”.

Subprime mortgages (money lent with less projected return —initially— than the cost of the bank’s securing the funds to make the loan) were treated as hot commodities worth far more than their initial asking price. The problem: those loans, which can be a good business, with modest profit margins, but huge gains overall when implemented on a large scale, go to the least well-to-do and the least credit-worthy. That means, they may get paid back, but not at high rates of interest.

The credit system, of course, works to give more options to those with more money and better records of debt-repayment, and punishes borrowers with more modest means and less secure credit histories. It demands more from those who can’t afford it, and gives money away to those who could easily pay higher rates of interest. There’s a logic in this, but it’s a logic riddled with flaws and not likely to succeed if applied universally.

The financial system became too universal, and it universalized the inability-to-repay found in some of the least credit-worthy. That credit system needs to be reformed, dramatically. There is, at present, no way to apply the prevailing western credit system to all parties in any given market, because it is built specifically to privilege some and exclude others, and its mathematical logic is not aimed at optimizing returns.

It has been obvious for years that a renewable energy economy would be beneficial for creating sustainable economic growth, but the prevailing trends in the financial system, where speculation and credit (as we know it) take priority over sustainability or optimization, have kept the biggest investors away from the best investment available, if you’re serious about building a viable economic future.

Major banks and financial institutions have not only lost unprecedented sums of money over the last two years, but they have (amazingly) resisted the inevitable need to accept that much of that “loss” was simply the factual inability of projected profits to materialize. That money was never there and it never will be. It is not even really an “opportunity cost”, because the opportunity to earn it never really existed.

Expectations have to be adjusted to account for all of this, to understand the nature of a massive, global correction that is not just about overvaluation, but about the hyper-expansion of expected returns being rolled back to figures based on fact. A new, more modest type of expected return has to take the place of the lascivious allegiance to fantastic speculation, and a bricks-and-mortar pragmatist approach to capitalizing on stable, long-term investment needs to take hold.