While the markets themselves appear to have calmed down a bit, the noises emanating from politicians and pundits about the financial crisis have reached new decibel levels.  Over the past month, we've been treated to the AIG fiasco, Jon Stewart's public flogging of Jim Cramer, and Time Magazine's "25 People Responsible for the Financial Crisis."  This gem includes naming Lew Ranieri, the creator of the mortgage-backed security, as a culprit (which is like blaming Henry Ford for all car accidents), while studiously ignoring the role of Congress in impeding the more active regulation of the GSEs.  

The most telling piece was a New York Times column by David Brooks entitled "Greed and Stupidity." In attempting to evaluate the causes of the global economic downturn, the piece outlined the two "general narratives" that are gaining currency among observers, which he labeled the Greed Narrative and the Stupidity Narrative.  To me, this column illustrated the type of simplistic and arrogant thinking associated with the recent reporting on the financial crisis.  I strongly believe that it's a necessary exercise to attempt to understand what has happened over the past few years to both financial markets and the global economy, and Brooks certainly makes a number of good points.  However, there are critical flaws in his analysis.  It is extremely simplistic to divide it into these two elements.  What he categorizes as "stupidity" on the part of bank management was actually the result of overconfidence in the ability of financial modelers to replicate the behavior of human beings, as opposed to physical phenomena such as particle motion or heat diffusion, on which a lot of models are based.  (I hope to explore this subject at a future time.)

However, the column's most troubling and dangerous assumption is that it's other people's greed and stupidity that is responsible for the crisis, with the general population being innocent victims overwhelmed by events beyond their control.  A fair analysis would lead to the conclusion that responsibility for the crisis is shared by 1) Wall Street banks, 2) mortgage lenders, and 3) borrowers.  (In fact, the only people that bear no responsibility were renters that didn't work for banks, brokerages, or realtors.)

While bad lending practices have been the focus of much attention, the amount of equity taken out of the housing market by homeowners had an equally profound affect on the financial system.  The sad case of Ed McMahon serves as an example.  The former Tonight Show sidekick bought a house many years ago which had, over time, appreciated in value to more than four times his purchase price. Unfortunately, he had "monetized" the growing equity through cash-out refinancings.  When he was unable to work due to health problems, he could no longer pay his mortgage(s); moreover, he could only sell his house at a loss, since the downturn in the real estate markets left him underwater on his loans.

The accompanying chart illustrates this phenomenon at the macro level.  According to Federal Reserve statistics, the total value of real estate in the US at the end of 1999 was $12.3 trillion while total mortgage debt was $4.7 trillion, resulting in a combined LTV of 38%.  By the second quarter of 2007, the value of real estate peaked at $21.6 billion, while mortgage debt had grown to $10.2 trillion, pushing the market's LTV up to 47%.  This suggests that almost $2 trillion in equity was pulled out of the housing market through second-lien financing and cash-out refis during that period.  Moreover, homeowners continued to pull money out of their homes even after real estate prices began to drop.  In the third quarter of 2007, total mortgage debt increased by $118 billion even as real estate values declined by almost $500 billion.

The massive removal of equity from the housing market had a number of disastrous effects.  The combined effects of high leverage and declining home prices clearly contributed to the spike in defaults and foreclosures.  Homeowners who couldn't continue to service their loans could no longer be bailed out by selling the property, leaving homeowners with the choice of either selling at a loss or defaulting on their loans.  The decline of home prices in an over-leveraged market has also impacted consumer behavior.  Over the last few years, economists recognized that "equity takeout" (i.e., the ability of homeowners to finance a variety of purchases by treating their homes as piggy banks) was a key ingredient in the rapid economic growth experienced between 2002 and 2006.  The sharp declines in consumer spending experienced during the current recession, in that case, are at least partly attributable to the decline in equity takeout.

The loss of this funding source resulted from both the decline in home prices and the reduced availability of mortgage financing, especially for credit-impaired and self-employed borrowers.  This is in addition to the obvious fact that large numbers of people bought homes that they clearly couldn't afford, and were (either unconsciously or explicitly) banking on the dual hopes of rising incomes and real estate prices.

Therefore, it's disingenuous to point fingers at "banks," "lenders," "Wall Street," etc. without taking into account the important role played by huge numbers of borrowers in the disastrous events of the last two years.  I don't dispute the fact that Wall Street executives were egregiously overpaid, and the Street's compensation practices created incentives for a host of bad decisions and behaviors at all levels.
However, the collective activities of homeowners had equally pernicious effects on the financial system.  Although it is satisfying for politicians and the media to rail about the "unbridled greed" on Wall Street, it is both foolish and disingenuous to ignore the role of homeowners and borrowers in crippling the financial system.

While it's necessary to examine the events of the past few years and assign responsibility, it's important to do it in a fair, complete, and dispassionate basis.  The blame games being played by politicians and the press, exemplified by the witch hunt surrounding AIG's bonus payments, flirt dangerously with a descent into McCarthy-ite bullying.  (This includes the Administration, Congress, and the state Attorneys General that tried to intimidate AIG employees by threatening to release their names.)

Finally, "blame" itself is a dangerous concept without the requisite thought and discipline.  An apropos thought on the subject can be found in the 1973 movie "Papillon."  The character Louis Dega was asked whether he would blame the title character, suffering from starvation and inhuman conditions in solitary confinement, for turning him in.  His response:  "Blame is for God and small children."