Housing Market Mess? Blame Mike Milken

Michael MilkenThe founder of every new business hopes that what he or she creates will eventually become not just a business, but an industry. They want their business to scale -- to get as big as possible as fast as possible. But sometimes businesses are forced to scale when they really shouldn't. That's what I have come to realize is at the heart of the current home ownership crisis. And I blame it all on legendary 1980s white-collar criminal Mike Milken.

Before Milken revolutionized the junk bond market at Drexel Burnham Lambert in the 1980s, banking was both more regulated and more sedate -- precisely the attributes being called for in bankers lately from both sides of the aisle in Washington. But with President Reagan working back then to reduce regulation and guys like Mike Milken pushing the envelope on what was possible (ethical, even legal -- remember Mike went to prison), the world of finance quickly changed. Milken was master of a killer new financial technology, the phone bank, and used it to sell enough junk paper in 1987 to score himself a salary and bonus of $550 million (more than $1 billion today), setting in every way the trend we see now.

That trend is using technology to force increases in both supply and demand -- increases that, absent the enabling technology, would have appeared absurd on their face.
But that didn't matter to Milken's telephone sales force. All they knew was that rich people who had never bought junk bonds before would do so if you called them at home after they'd had a couple of drinks and offered what appeared to be fabulous terms.

The terms were fabulous because the bonds were, well, junk. They didn't come up with that name as a joke.

The bond business under Milken and his ilk grew enormously, financing the profligate 80's and setting us up for the dot-com 90's. But that doesn't mean the business scaled well. In fact it scaled poorly. Scaling well would have produced big sales without having to compromise the quality of the bonds being offered. Applied to the housing market, scale would mean selling more mortgages, but only to people who could actually afford their new homes.

So here's the drill. A charismatic leader uses a new technology to dramatically expand a financial market to the benefit of his company and its people, but not necessarily to the benefit of people in general or the market overall. Milken blew out the bond market, ratcheting up demand and then supply until the market reached a state of equilibrium that was defined not so much by its success but by its EXcess. It was as big as the market could get without crashing -- an equilibrium of pain.

And thanks to the marvel of derivatives (and a little groundwork by Lewis Ranieri of Salomon Brothers), that's just what happened in the mortgage-backed securities and credit default swap businesses in the decade just passed. There is no real difference between junk bonds in the 1980s, day trading in the late 1990s or trading mortgage-backed securities two years ago. All three markets were artificially expanded beyond what they could reasonably sustain.

They didn't scale.

Greed is a great attractor. By scaling these businesses beyond what was even remotely sensible small organizations could make huge profits. The ultimate example of this was Bernie Madoff, who made a fortune doing nothing at all -- scaling to $60 billion a business that should have supported his family and a few employees and maybe that house out in Montauk.

Through the use of computers to create and trade synthetic securities, little companies could look big, posting big company profits and granting obscene bonuses because they cleverly avoided big company overhead. But of course it depended on creating more and more demand, which meant more and more home owners -- even owners who couldn't reasonably afford the homes they were buying. And that's how we got to where we are today.

Thanks for nothing, Mike.
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