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How the sausage was made

May 20, 2012

I’ve been reading Aaron Clarey’s book Behind the Housing Crash. I haven’t finished it yet but I think that anyone with savings or investments in U.S. financial institutions should read it.

It’s a well-told account of how the housing bubble came into being and then popped. Clarey tells the story from his point of view as an analyst/underwriter for commercial loans at a credit union and then at some local banks in the Minneapolis/St. Paul area. It’s like a tour of a financial butcher shop.

I think Clarey has a good grasp of financial basics – in part because he confirmed one of my own conclusions about the U.S. markets. I used to wonder about the phenomenal run-up in stock prices over the last 30 years. To illustrate, I recall a friend asking me in the early 80s, “When do you think the Dow will break 1000?” and then in the late 90s I called him and asked, “So, Mike, when do you think the Dow will break 10,000?”

My conclusion was that there was too much money chasing too few investments – that the increasing amount of retirement money was driving the demand up while the supply of equities remained relatively fixed. What else explained a 10-fold gain in the DJIA in less than 20 years? There had been nothing like it in the history of the U.S. exchanges.

My next thought was that maybe this was due to the way the tax code for retirement plans was written In the U.S., tax-deferred retirement savings can only be invested in stock and bond markets.

(What will happen to the price of stocks and bonds as the Baby Boomers start drawing out their retirement money and changing their investment patterns is left as an exercise for the reader.)

So I was intrigued to see Clarey mention this tax law factor himself as a reason for the bubbles of recent history. In particular, he writes about how all the retirement funds in the market drove the dot com bubble and then were a ready market to buy CDOs (bundled mortgages), which was one of the factors driving the housing bubble.

Clarey writes the Captain Capitalism blog.

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