What Happened To The U.S. Financial System?

The situation in the U.S. financial system grew even more dire this week with the failure of yet another bank (Washington Mutual), and predictions of imminent disaster without a mammoth $700B government bailout. Only time will tell whether this bailout actually solves anything, and whether this is the end of the big surprises; somehow I doubt it. But to me, the more interesting question is, “how did the mighty American economy, which represents 25% of the world’s GDP and 50% of the world’s wealth, get itself into such a horrible mess?” The simple answer is: massive disregard for financial prudence, caused by greed and incompetence…

Tech Bubble

A good place to start the story is with the tech bubble of the late 1990s. Bubbles are created when the value of something becomes disconnected from its true intrinsic value, and value starts rising on momentum alone. Usually this is caused by exuberance and herd-mentality; common sense goes out the window. In the case of the tech bubble, marginal tech companies with marginal business models got bid up beyond any semblance of realistic or historical valuations. To keep the bubble going required bigger and bigger suckers to buy at inflated prices. But eventually, as with all bubbles, reality set in. Once there were no more suckers left the price stopped rising and the smart money started getting out. Slowly prices started to drop, and more and more people started to sell. This drove prices down faster and faster and the bubble popped. In the end, prices reverted to their mean, the mediocre companies went out of business, and things returned to normal.

But, as a result of the tech crash and all the associated doom and gloom, the U.S. Federal Reserve thought it prudent to lower interest rates to historic lows (1%) in late 2001 to help cushion the effect on the economy and avoid an economic depression, or so they said. Well, it worked. People and businesses borrowed lots of money, and the economy recovered. The problem was, the Fed was avoiding a relatively small problem and encouraging a much bigger one…

Housing Bubble

Through the first half on this decade, U.S. housing prices grew, on average, at an extraordinary rate of 15%+ per year, which is way above the long-term average of 2-3% per year. This created yet another bubble, this time in housing.

So historically low interest rates certainly helped create the bubble, but as with all bubbles, it was hype and exuberance that really drove it. For example, speculators who couldn’t invest in tech stocks anymore switched to real estate. Housing was the new “hot” investment. The signs were undeniable. Everywhere you looked, there were seminars, books, and TV shows about flipping houses and how to make millions in real estate. In 2005, 28% of houses were bought for “investment” purposes. Builders cranked out new houses, there were bidding wars by buyers, and the whole industry got caught up in the mania.

But people’s incomes weren’t increasing at 15% per year, so how could they afford these rapidly increasing prices? This is where the banks and lending institutions magnified the problem because they too got caught up in the mania. The mortgages being offered by some of these institutions were ridiculous:

• Variable rate interest-only for the first 2 years
• Variable rate with interest rates as low as 1% in the first year
• Variable rate with payments less than interest for the first 5 years, meaning that the principle outstanding was growing
• Piggyback loans that allowed the downpayment to be borrowed against home equity
• No downpayment
• Cashback home equity loans beyond the equity in the house

There are estimates that 43% of first-time homebuyers in 2005 made no downpayment. The goal was for everyone to buy a house, whether they could realistically afford it or not…

Well, it worked. Millions of people bought houses they had no business buying. But why people would assume interest rates would stay historically low is beyond me…

Inflation

The next wrinkle was rising inflation. Since 2000, energy prices have increased significantly. For example, crude oil has gone from $30 a barrel to $120 a barrel. Why? Because we’ve run out of cheap oil, and emerging economies like China and India are using a lot more energy than they once did. So, as you’d expect, rising energy prices caused everything to be more expensive to produce, thus driving up inflation.

The Federal Reserve, wanting to control inflation (since that’s its job!), quickly raised interest rates from 1% to 5% to cool the economy. The problem was that all those people with variable-rate mortgages they already couldn’t afford had their mortgage payments double or triple. And it wasn’t only the dubious borrowers, with the so-called subprime mortgages, that got into trouble, but many borrowers with prime mortgages as well. Too many people got overextended. Default rates grew, and housing prices crashed, or more precisely, reverted to normal. But as you can see from house price graph above, they may still need to fall even further to get back to normal.

The net result was that by August 2008 approximately 9% of all mortgages were either delinquent or in foreclosure. Oops…

What isn’t clear yet is how this caused the financial armageddon we now see. So what if 5-10% of your customers are defaulting on their loans? The other 90% are still paying.

Derivatives

The problem is these lending institutions don’t have sufficient assets to cover their debts; they’re using leverage. Leverage is a great way to make lots of money, but it’s also a great way to lose lots of money. But these lending institutions aren’t just leveraged, they’re highly leveraged, some 20 to 1, others more than 30 to 1. So now if 3% of their loans default, that represents a loss of 60% of their assets if they’re leveraged 20 to 1, or a loss of 90% of their assets if they’re leveraged 30 to 1. Oops…

So that explains why all the lending institutions are in trouble – they were under-capitalized based on their risk exposure. Fine, so what about insurance companies like AIG? The insurance companies provided insurance to these lending institutions in the form of credit swaps and other financial derivatives. So when lending institutions wanted to collect on these insurance policies, the insurance company had huge problems because they too were highly leveraged. What do you do if you don’t have enough cash to cover your redemptions? You borrow more money. The problem is no one has any money to lend (except apparently the American taxpayer). All the financial institutions went to hide in their holes to wait for the carnage to end. So if you can’t pay your debts, and you can’t borrow any short-term money to tide you over, what happens? You go bankrupt, plain and simple.

Worst of all, all these financial institutions are so co-dependent through all of these credit swaps and other derivatives they’ve sold to each other that it’s like a big game of dominos. Knock one over and bunch more fall. Throw in a little market manipulation to bring down a few companies (à la Bear Stearns), and there you have it. One massive financial mess…

Lessons?

So what can we learn from this fiasco? Greed is extremely dangerous. The desire to make lots of money, regardless of the cost, is pervasive throughout the U.S. financial sector. All of these problems we now face were foreseeable. But the government did nothing to stop it. The Federal Reserve did nothing to stop it. The financial institutions did nothing stop it. Not that I think they could have. They always seem to be 8 steps behind. They move too slowly…

There were some experts that sounded the alarm bells years ago, but they were largely ignored. We’ll eventually get through this mess, but this isn’t going to be the last bubble. Where there’s greed, there’ll be speculators. The speculators will be always be looking for something new; there’s way too much money sloshing around to do otherwise. The next bubble may be agriculture, or energy, or alternative energy, or tulip bulbs, who knows…

The question is, what are you going to do next time? Are you going to become complacent like everyone else until it’s too late, or have you learned your lesson? Did your financial advisor help you avoid this mess? Probably not. Mine didn’t. Why not? That’s an interesting question…

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