Finance 101
Tito asked me to dust off my 20+ year old MBA and attempt to explain how we (the Core 4, USA, planet earth) got into this mess in the first place.
Disclaimer: the events, policies, and market conditions leading up to the falling dominoes that are the world’s financial institutions and markets are far more complex than I am laying out here. Academics and financial professionals will be writing articles for decades trying to explain what happened. The following is an attempt to highlight the MAJOR causes and effects.
OK - on with the show. There are five foundational (to use an Obama/Biden-ism) causes for the current state of affairs; in no particular order, they are:
- Wall Street running out of control for years, betting every investor’s money on increasingly risky investments while constantly repackaging and reselling these investments to generate transactions (and transaction fees)
- The Federal government, not only turning a blind-eye to Wall Street’s practices (with a wink and a nod), but actually altering the regulatory environment to allow, even encourage, financial institutions to inappropriately sway markets while making risky bets with investors’ money
- An unrealistic rise in housing prices
- Mortgage lenders, both reacting to and eventually contributing to the artificial rise in housing prices, extending low-rate and sub-prime mortgages to home buyers who (a) did not understand what they were getting into, (b) believed that home prices would continue to skyrocket and could refinance, with more equity in their pockets, when their low introductory rates expired, or (c) ignored the risks because they wanted a home, or a bigger home, NOW!
- The wars in Iraq and Afghanistan which have driven the price of petroleum related products to unnecessary heights. You can also consider the greed of oil companies who continued to jack up prices, supposedly as a hedge against possible supply issues due to political instability in the Middle East, resulting in record profits - but that has been a constant and only became REALLY noticeable when prices got uncomfortably high
These five items amount to a “perfect storm” for a financial crisis. Here’s why:
When mortgage issuers wanted to further capitalize on rising home prices (higher price = bigger mortgage = more interest in the pocket of the mortgage issuer) they pushed their low-rate (often below the prime rate set by the Federal Reserve, hence “sub-prime”) mortgages. The theory was that by offering these mortgages, with very enticing low initial interest rates, home buyers could afford larger mortgages and therefore larger houses that they could not otherwise afford. To further fuel the fire, many issuers lowered the criteria for approval for these mortgages, essentially granting mortgages to people who were bad credit risks or who simply could not afford the payments after the introductory rates expired.
With all these new mortgages flooding the market, the folks on Wall Street saw an opportunity. Pools of mortgages can be bought from mortgage issuers and then resold to investors as financial instruments called mortgage-backed securities, which are nothing more than shares of ownership in these pools of mortgages. Betting that home prices would continue rising, even if only modestly, and mortgagees would be able to pay the soon-to-increase mortgage payments, Wall Street and investors snapped up these mortgage-backed securities and everyone started making piles of money. So much so that complex variations of mortgage-backeds, called “derivatives” were devised and offered by Wall Street firms; a derivative is simply a financial instrument whose value is dependent (”derived from”) on the value of another underlying instrument, in this case pools of mortgages.
With each sale of mortgage-backed securities and derivatives, Wall Street earned a transaction fee. But transaction fees is not where these firms made their big money. Most of these firms engage in a practice called proprietary trading, which is where the firms invest their own money and assets for the sole purpose of making money for the firm itself; they essentially play the role of individual investor, except with a HUGE amount of money to invest. So simultaneously these firms are packaging securities to entice investors, collecting fees from investors, in some cases providing investment advice to investors, and investing their own money at the same time. Sound like a conflict of interest? Not according to the government. A steady stream of deregulation legislation has been passed over the past two decades that has essentially given Wall Street free reign to engage in all sorts of activities that the founders of the stock and bond markets never dreamed of. And since these firms are permitted to borrow against a (frighteningly large) percentage of their held assets to buy additional investments, their exposure to fluctuations in the value of these investments, like mortgage-backeds, was tremendous.
And if housing prices continued their rise, and home-owners were able to handle their mortgage payments, there would have been no problem (other than the wildly irresponsible behavior of all involved, but in a flourishing market nobody seems to care about these things).
Sadly, housing prices did not rise. They began to tumble. As the price of oil crept up, ostensibly because of supply fears resulting from our wars in the Middle East, so did the price of everything. Transportation costs, production costs, and often blatant price gouging drove prices up for everything that families consume. Home-owners, who often weren’t going to be able to afford their mortgage when the intro rates expired anyway, were suddenly faced with tough choices like “pay the mortgage” or “feed the family”. The result? Mortgage defaults and foreclosures, slow at first but reaching flood stage in a matter of 18 months.
Just as suddenly, those investments in mortgage-backed securities that were so popular began to lose their value because the underlying mortgages were losing their value. Fearing the loss of their invested money, investors tried to dump these investments. But there were few buyers, which drove prices of these securities down further. Having borrowed against their own assets, their own balance sheets and investors’ money, Wall Street firms found themselves in the perilous situation of having lost money made on a bet with that borrowed money. A loan shark would break their collective legs for this behavior. Many of these firms found themselves deeply in the red, unable to cover their short term borrowings. Their only hope was to try and borrow further to keep themselves afloat. But there was no one to borrow from - no one wanted to risk the money they had on what were suddenly very risky bets on over-extended financial houses.
And so the dominoes began to fall. Countrywide. Bear Stearns. Lehman Brothers. AIG. Merrill Lynch. Washington Mutual. And the list will go on.
Eager to reduce their risk and exposure, remaining financial institutions are cutting back on loans made to anyone except those who can prove they have the means to pay them back. Mortgages are now very difficult to get. Credit card companies are reducing credit lines and increasing minimum payments. Small businesses and large businesses are having increasing trouble getting short-term financing for expansion and inventories. The result of this inability to get credit is a big stomp on the brakes for the economy. People will buy less, companies will produce less. Faith in the economy is faltering, which means that people no longer think that companies will do as well as they thought just a few months ago; when people lower their opinion of the value of companies, it is reflected in their desire to own stock in those companies, which has resulted in a massive sell-off of stocks across all industries, further fueling panic. Irrational fear has replaced irrational exuberance.
Good news? There is some, actually. First of all, the vast majority of companies whose stock prices have plummeted over the last two weeks are doing just fine. They may not be spending as much as in previous years and many not be as profitable, but they are certainly not in as dire condition as their current stock price would indicate. We have that irrational fear, and the Wall Street geniuses selling off to get cash to reduce their personal risk, to thank for that. Once the panic subsides a bit, investors will collectively realize that a huge number of companies are grossly undervalued and they will try to grab these bargains. Meaning they buy stocks. Lot of ‘em. This will drive stock prices back up. Not back to where they were a few months ago most likely, but not where they are now. I would guess it’ll be 3-5 years before we see the Dow Jones index cross 14,000 again - but that is purely a guess. I hope I’m wrong.
The bailout is also good news, despite what critics say. The bailout is designed to keep credit markets from failing. The government is basically lending money to companies that extend credit and whose exposure to bad debts have crippled them. Some will still fail despite the bailout, but that is ultimately a good thing (except for the innocents in those companies whose jobs will be lost which is, as those of you who know me personally, an issue to which I am very sensitive); culling out the really badly managed companies will help in the long term. Some of the government money will also be used to secure some of the bad mortgages, to avoid further foreclosures. Wide-spread foreclosures helps no one; banks don’t want an inventory of houses that they have to sell in a bad market, and most home-owners don’t want to lose their homes. Propping up some of these mortgages (presumably the least risky ones) will further reduce the losses by the mortgage lenders and the tightening of the credit market.
The election may also be good news. If whichever candidate wins is viewed as someone who will take control and stabilize the economy, then people will be less nervous, resulting in more rational if not optimistic behavior. I have my doubts about one of the candidate’s ability to do this, but that is a topic for another post.
Oil prices have also been dropping, making life a little easier on Main Street (wink, you Mavericky Maverick, you).
What can go wrong? Lots. If the federal government doesn’t get its act together regarding regulation and oversight of Wall Street, greedy opportunists will find a way to rebuild the house of cards again. And if you ever doubted that greed existed in the world, just look at the amount of money the folks on Wall Street have taken in the last couple of years as we marched toward the eradication of trillions of dollars of wealth. Since these obscene bonuses are for good performance, can we exact fines for their atrocious performance of late?
Also, if the irrational panic continues for too long, we could have a “run on the banks” as we did in 1929. The FDIC, which insures bank deposits up to $100,000 and soon $250,000 for a limited time, will be there to help - but even they could get overwhelmed which would lead to more government money (tax-payer money) being committed to stabilizing this mess.
And of course we have the age-old problem of the National Debt. The more we spend on bailouts and wars overseas and disaster relief and humanitarian aid and education and and and - the more we go into debt. Will taxes go up? Hell yes - I don’t care who says otherwise. They have to. As a country we spend too much, much of it wastefully. And this is where we begin to face economic Armageddon for real. If the US government gets to the point where spending puts us into irrevocable debt to foreign countries or where increases in the money supply so devalues the dollar and drives up inflation, our economy will collapse. For real. This will seem like a bump in the road if that happens. Preventing that will take some fiscal responsibility on the part of our elected officials (which is always a bad bet since politics and re-election always seems to trump good judgment) and a commitment by the American people to demand the right things from our economy. I have my doubts, but I am optimistic as always - but I am keeping my change jar under my bed, safe and sound.