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Understanding the Financial Crisis

Understanding the Financial Crisis

In retrospect, there are many things which led up to the financial crisis which hit home in the last quarter of 2008. You certainly have heard about Wall Street abuses, "toxic mortgage securities," frauds perpetrated by previously well respected investment advisors, and the collapse or near collapse of many companies such as Lehman Brothers, Merrill Lynch, and Citibank. It will literally take years to unravel all that went wrong, but suffice it to say that taking on excessive risks led to the problems we face today.

Returns on Investments are Generally Directly Proportionate to the Level of Risk

Most of the failed or troubled firms we have read about turned a blind eye to risk and sought unreasonable returns by investing and trading in securities which offered little or no accurate means to measure risk; actions fueled by greed. The major investment instruments involved in this debacle were various forms of mortgage securities. Wall Street investment bankers developed strategies whereby they could buy up billions of dollars worth of home mortgages from banks and mortgage companies, and package them into bundles which they would then resell to investors. They usually bought these mortgages at attractive prices as the banks and mortgage companies had already profited from the initial fees related to the mortgage, and were anxious to “cash out” so that they could repeat the process and lend the money again.

The investors included everyone from high net worth individuals to pension funds to bank investment divisions who were using the bank’s funds to essentially invest in mortgages the bank had sold! Within these bundles of mortgages which were packaged and sold were every type of credit risk; from those with the very best credit ratings and up to date on their mortgage payments, to those who one would question as to how they qualified to be granted a mortgage in the first place. The bundles of mortgages with a greater proportion of risky loans often paid much higher rates of return to investors because of the more risky nature of the mortgages included in the bundle.

The Fed’s "Cheap Money Policy" Added Some Fuel to the Fire

About two years ago, when the Federal Reserve Bank adopted a policy of lowering interest rates in response to the first signs of a slowdown in consumer spending (particularly in the housing market), these higher risk securities offered an even more attractive alternative to investors because their rate of return remained high. However, to many investment professionals this was an early warning sign. Overall interest rates were falling, yet these mortgage backed securities continued to pay steady or even higher rates of return!

For many years the US economy has been driven by consumer spending. Housing and automobiles are the biggest ticket items and that is why these markets are very good economic indicators which can help us to anticipate future economic conditions. As we witnessed the real estate values climbing to higher and higher levels over recent years, there was some faulty analysis as to the reasons for the price increases. Often we can simply attribute price changes to changes in "supply" and "demand." However, if the supply and demand balance is artificially altered, then the resultant higher or lower prices are less reliable indicators. For example, when interest rates were steered lower by the Federal Reserve Bank, more and more people could afford to buy homes, because the monthly mortgage payments were within their budgets due to lower interest rates. As more and more people bought homes, that in turn reduced the supply of homes and home prices continued to rise higher and higher.

The Real Estate "Bubble" Bursts

As home prices went higher, many people who already owned homes were enticed to tap into the equity (the excess of market value over the mortgage balance still owed) of their homes, and home equity loans and mortgage refinancing exploded in popularity. In turn, these newly available funds provided both more and more of the risky mortgage securities to be sold by Wall Street, and the funds necessary to keep the consumer spending engine driving the economy. The process continued to repeat itself over and over again as home prices continued to rise.

Saving to accumulate a down payment, buying a home, and enjoying the appreciation in value of that home are at the root of the American dream. Utilizing the increased value in your home by taking a home equity loan or by refinancing your mortgage so that you could make home improvements or purchase an automobile for example, has often been a sound financial strategy. However, in the past, most people had paid down their mortgage balances somewhat and in addition enjoyed some market appreciation as a cushion prior to tapping into their home equity through refinancing or a home equity loan. In today’s environment, many refinanced their homes based solely on the increase in market value, having paid little or nothing on the original mortgage balance.

When the demand for homes began to soften, real estate values began to decline to levels below the mortgage balance still owed by many homeowners. Next, the value of all of these mortgage securities created by the investment banks began to be called into question. As investors holding these securities began to panic since their investments were worth less and less as housing prices declined, there were fewer and fewer new buyers for these securities at any price. The fact is however that many of these bundles of mortgage securities contained mortgages which were still performing, and which would eventually be paid. Nonetheless, the panic caused many of the holders of these securities to dump their investments at any price; action fueled by fear.

In Summary

Just as the large investment banks failed to monitor risk when they rushed to buy many of the mortgage securities described earlier, individuals failed to act prudently by undertaking new mortgages which left them with very little room to meet all of their monthly expenses. The billions of dollars in new mortgage debt from home purchases at or near the "top of the market," the refinancing of existing mortgages based on unrealistic home values, and the home equity loans taken based on the same circumstances have all contributed substantially to the current economic downturn. Greed and fear, two of the most powerful market forces, have combined to cause a huge decline in the confidence levels of investors, lenders, and consumers. An economic recovery will depend heavily on the restoration of that confidence.

©Patrick J. Catania 2009
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

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