I spent the weekend reading and researching and working on my interpretation of the events leading up to our “current” financial crisis. I hope this helps to put matters into a perspective that make senses to you. As in most cases, complex issues can be broken down into simple components. Here is an attempt to do just that.
Let’s start by asking: how did this financial crisis happen? The unfortunate truth is that this financial crisis has happened to us before and each time we have been told, “It’s different this time.” Well here we go again and this time let’s not believe that this crisis is different, because it isn’t. It’s just a different version of the same fundamental concept behind every financial crisis.
Let’s examine the common thread in virtually every financial crisis. First, we need a new financial invention, one that will revolutionize the economic landscape and bring forth unimaginable profits. Once it is created this new invention is pushed out by a select few who want to market it to the masses. To have success the masses must jump on board and then greed takes over. It helps to have an abundance of credit, coupled with leverage which accelerates this process and buying leads to more buying. Then comes the panic: some event shakes confidence and wakes up investors to the mania that has clouded their judgment. The early adopters are long gone by now having taken their profits and moved on. The panic leads to a crash: borrowed money needs to be repaid and investors will sell anything at any price to meet the bankers’ needs. That is the story that has been replayed many times in our financial history, sometimes with disastrous results.
To find examples of this crisis we don’t have to look back too far. In April 1977 Drexel Burnham’s bond department underwrote its first junk bond and quickly became the lead issuer of junk bonds. In 1981 those financial instruments were the main source of funding for leveraged buyouts. As is often the case the imitators stepped in and the securitization of this type of funding mechanism was soon abused and ultimately the federal regulators stepped in to rein in the practice. Fortunately the impact was not that large and a few members of the investment community went to jail. Many insiders got rich and many, many pensioners received less income than they deserved.
Ten years ago, the New York Federal Reserve Bank along with the major Wall Street firms, and senior bankers from Europe put together a consortium of 14 banks to invest $3.65 billion to save Long Term Capital Management (LTCM). In its first four years, LTCM, acting much like a hedge fund, achieved phenomenal profits with virtually no downside. With some of the greatest financial minds at the helm, LTCM amassed unbelievable profits and was able to attract and leverage capital like no other firm in history. Unfortunately their egos took over and they ignored signs that the fortunes of the markets were turning. Losses continued to mount and when they passed the $4.8 billion mark, LTCM’s losses put such strain on the world’s financial system that they had to be stopped and rescued. Within a few weeks, calm returned and the crisis passed.
Now we find ourselves in a slightly different version of the same story where easy money and greed come together to create a hole so deep that digging out of it will put stress on our financial system that will be felt for many years to come.
We have reached this point through the combination of a housing bubble and the easy credit that fed the bubble. Not long ago when a home buyer came to a lender with plans to buy a home, they usually had a strong credit history and 20% down to finance the transaction. The buyer would have a mortgage that was likely backed by a government sponsored enterprises (GSE) such as Fannie Mae or Freddie Mac. The bank would make the loan and collect the loan payments with the confidence ultimately they would get their loan principal back. They then would repeat the process over and over.
In recent years banks began to sell these bonds to institutions which enabled them to create more loans and collect more fees. They also didn’t have to worry about the loans defaulting because they no longer owned the mortgage; some other investor was bearing that risk. Therefore they had little incentive to check out the credit worthiness of the borrower. They started to specialize in new types of mortgages, such as sub-prime lending to borrowers with poor credit histories and weak documentation of income. They also included “jumbo” mortgages for properties over Freddie Mac’s $417,000 mortgage limit. They urged mortgage brokers to sell more and more of these mortgages and soon it was possible to secure a mortgage over the internet. Fees came down which was deemed good for the consumer and with the development of interest only loans, 100% financing, adjustable rates and many other varieties of loans, the dream of owning a home was in the grasp of virtually any citizen. Builders were putting up homes as fast as they could sell them and soon first time buyers were buying homes that rivaled their parents homes in their size and luxury.
Very quickly the abuses set in as mortgage firms began to bundle questionable loans, often a billion dollars at a time. They would assemble loans into a package and quickly receive a rubber stamp rating from one of the rating agencies. The next step in the process was to sell this loan package to one of several waiting investment banks who couldn’t buy them fast enough. The investment banks with the benefit of whiz kids right out of the prestigious business schools would slice and dice these loan pools into myriads of complicated securities and then sell them off to other investment banking firms. Soon all of the banks and investment firms were on each other’s balance sheets, and they were all depending on everyone to live up to the terms of the deals.
Soon not only the credit worthiness of the borrower was being ignored, but also the quality of the property securing the loan came under less and less scrutiny. With the number of loan transactions increasing, there was no time to perform the many value comparisons that resulted in a fair value of property, there just wasn’t enough time and the competition to flip these loans was growing and growing. Just as dangerous the mortgage firms were throwing more and more questionable loans into the package and the rating agencies continued to rubber stamp them and buyers were just as eager to step up.
Compound the lack of accurate market values with the compound effect of leverage and you have a recipe for disaster. To keep profits growing, these firms borrowed huge sums relative to their size, in some cases reaching debt to asset ratios of 35 times their capital. When things go well this can be immensely profitable. If you borrow 35 times your capital and those investments rise only 1%, you’ve made 35% on your money. If, however, things move against you, you are in big trouble.
By this time the value of the mortgage bond market had reached $6 trillion, and was the largest single part of the whole $27 trillion US bond market, bigger even than Treasury bonds.
It ultimately became a house of cards and when the first card fell, there was no stopping the rest. In August 2007 the sub-prime loans were the problem and they were just the beginning. Soon financial institutions were looking to each other for payments on loans that weren’t coming. We began to hear about illiquidity in the markets and weren’t really sure what that meant.
When you have an investment that is illiquid, it means it is difficult to sell, maybe even impossible to sell. For example if you have ever tried to sell a used car and no one wanted to buy it, that asset is illiquid. In the case of illiquid securities, financial firms are stuck holding securities they can’t sell and can’t borrow against. Since these firms borrow short and lend long, that’s a killer. It becomes a critical problem when someone you owe money to is breathing down your neck for payment. In the case of the financial firms they needed the cash to meet investor demands or perhaps because of regulatory requirements. Regardless of the reason the only solution they had was to sell something, and when they couldn’t get the price they paid for the asset, they were forced to sell it at a loss. That was the catalyst that started the down-trend in August 2007. Demands were being placed on firms to meet cash requirements and they didn’t have it and as previously mentioned, firms on Wall Street are tightly connected to each other and the need for cash became critical.
At that time the Feds stepped in and made cash available in the form of loans and other means to inject cash into the system. In simple terms the cash well had run dry, firms were thirsty and the Feds drilled a new well.
That worked fine for a while until the next crisis came along and the Feds kept injecting more and more money into the system and, by the way, where does that money come from? It comes from the taxpayers because the Feds create this cash by issuing more debt, which is often purchased by foreign governments.
Another problem in this particular liquidity crisis is that there are hidden bombs in the asset portfolios of these troubled firms, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly. By injecting cash the government holds these frozen assets (some of which are perfectly fine) and replaces them with safe, low risk or risk free assets. The plan is that now the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing. Theoretically, the problem is solved, disaster is averted and life goes back to normal.
The long term problem is that more government debt is issued, the federal deficit grows, interest payments increase, the value of the dollar falls and ultimately inflation comes back to haunt us.
This is a simplification of the current problem, but it is accurate. The best we can hope for right now is that the markets stabilize, stop dropping and then begin the long descent out. We may have more downside, but that will depend on how quickly the government can pull things together. I have no doubt they know the seriousness of the issue, by biggest concern is what part of our world they are going to sell to stop the bleeding.
This time around there needs to be a different solution and we will take a look at those scenarios as they unfold.
Mark G. Neil, ChFC, CLU
Northwest Wealth Advisors, Inc.
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