Understanding the financial crisis
Bedford-based financial planner Ron Valpey explains how the country’s financial institutions got into trouble.
The Perfect Storm, so aptly described in Sebastian Junger’s book of the same name, told the story of three huge storms coming together to form one mammoth storm with dire consequences. The financial crisis is a perfect storm.
The storm began brewing decades ago with a well-intentioned mandate for the expansion of subprime lending, loans made to less fortunate people who generally could not obtain loans because their ability to repay was questionable.
Most subprime loans were properly transacted by all parties involved, but in past decade many were not. Among those that weren’t, there was plenty of deception on the part of lenders and even on the part of many borrowers. Bad loans not withstanding, the subprime loans and new real estate fervor led to more relaxed lending standards for all types of loans – making credit much easier to get.
The new climate of more lenient lending standards combined with more relaxed oversight was, unfortunately, a breeding ground for greed. Real estate speculators, most of who were not even subprime to begin with, got in on the action, by borrowing more money than they ever could have before to flip already overvalued properties for a profit.
Financial institutions joined the fray by packaging subprime loans and other mortgage-backed investments into complicated investment instruments that were precariously over leveraged (borrowed money, borrowed with borrowed money) with the promise of implausibly high returns.
Further compounding the already present greed, many Wall Street executive compensation packages became unjustifiably and treacherously generous. Many hedge funds and private equity firms took advantage of the new easy credit to buy up companies solely for the purpose of turning a profit, without regard to maintaining or growing the company. Three bubbles – real estate, lending and investment imprudence all growing exponentially with leverage fueling the fire.
The result was a speculative house of cards dangerously overvalued in the billions to trillions of dollars; the true underlying value, still unknown, is likely only a small fraction of what was the severely inflated value.
Then, slowly at first, the house of cards began to crumble. The real estate bubble, on which everything hinged, began to deflate. Some subprime borrowers were hit with new higher payments and others simply refused to make payments on properties now worth less than what had been financed.
The defaults and foreclosures ensued, with prime borrowers soon following suit. Many real estate speculators, owing far more than was owned, walked away or were foreclosed. Wall Street, seeing returns diminish, began to sell rather than buy the overpriced mortgage-backed investments.
At this time, Main Street was still largely unscathed but then the full fury of the storm began to hit. Foreclosures began to skyrocket and banks did not just tighten lending standards, they all but stopped lending – threatening a devastating credit freeze. The real estate bubble and the lending bubble burst together. The local businessperson, house buyer or consumer, who wasn’t even subprime-classified, suddenly found it very difficult to get a loan for anything. Lending is the fuel for economic growth; when people and businesses can’t borrow, the economy can’t grow.
Then, the third and final bubble to burst was the mortgage derived investment bubble upon which all of Wall Street’s imprudent excess hinged. Sure-thing subprime-based investment instruments, not only could not be sold, many were suddenly on the verge of worthlessness. Add expensive oil to the mix and the brakes were suddenly slammed on, ending what had been mostly a routine Sunday drive for the financial markets and economy.
In an unprecedented financial sector shakeup – banks, mortgage companies, investment houses, and insurance companies backing them, began to fall like dominos: Bear Sterns, IndyMac Bank, CountryWide, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual and AIG.
Subprime loans were only the tip of the iceberg. The real catalyst for disaster, greed aside, was government intervention, the lack of government intervention, the relaxation of lending standards followed by the contraction of lending standards, compounded with reckless real estate speculation and the subsequent real estate bubble that burst.
Add to that chaos, the dangerous leveraging of mortgage backed securities and Wall Street’s imprudent compensation and investment practices, and all told, the result was a real mess, a perfect storm, a bubble, stratospherically valued beyond reason… that simply burst.
What can you do if you’re one of the millions of Main Street Investors cringing at the news? Assuming you are properly diversified and allocated, don’t worry – sit tight, don’t panic or do anything rash, and don’t get scared into selling just because the market is down. Despite an unprecedented upheaval of the financial system, the market decline we have experienced thus far is not out of the norm for what we have regularly and often experienced in a bear market decline.
The securities markets will eventually recover, and when they do, always remember to balance risk with return specific to your time horizon and tolerance for risk; always invest prudently based on what you need, and never invest speculatively based on what is going on in the market.