From the beginning of the last decade and through to 2008, the economy seemed to be moving like an unstoppable force. 2008 changed the view of economics in the USA and throughout the world. Two full years later and we’re still discussing what just happened. Who is at fault? And perhaps more importantly, what happens next?
How Many Fingers Are Pointing at You?
The answer to the question of who is at fault is simply, everyone. The Financial Crisis Inquiry Commission, a congressional committee, recently released its conclusion on the 2008 financial crisis. The bi-partisan commission faulted the Federal Reserve and other regulatory bodies for permitting poor lending practices and risky bets on securities backed by those loans. Included in the commission’s conclusion were accusations of greed against several financial institutions and found fault in policies of both parties.
I would go beyond this and say the borrowers (the general public in many cases, including those living on Main St.) should also be held accountable for going beyond their own financial means and being ill-prepared for anything but a bullish market.
Loans, Securities, and Risk Bets = Downturn
What exactly are these loans, securities, and risky bets that are at the center of the recent downturn, and how could they be better regulated? For starters, let’s examine the infamous “sub-prime mortgage” and its part in the crisis.
A sub-prime mortgage is a loan made to a borrower with a lower (poor) credit rating. Normally this individual would not be in a position to borrow because of the risk of default by the borrower. When a company or bank makes a loan, like a mortgage, the lender is compensated by charging interest. The riskier or more likely to default a borrower is, the higher the interest will be (simplified version).
Think of two well known companies, GM and Apple. Are they equal in credit ratings at this point? GM just went through bankruptcy and is in recovery mode. Apple, on the other hand, continues to pump out new products and post record earnings. Who would you prefer to loan your money to? Think of this in relation to a subprime mortgage. The riskier (GM) the borrower, the higher the interest, or the more the lender needs to be compensated to agree to lend money.
Something that surprises most people is what a bank does with a mortgage. Most people assume that banks hold onto those mortgages and simply collect the interest as the mortgage is repaid. In actuality, the banks bundle together large groups of mortgages and sell those to investors. Mortgages are often grouped by risk. So a bundle of non-risky mortgages and a bundle of subprime or risky mortgages are sold to investors. This bundle is called a mortgage back security. This means the money paid by the borrower to the bank ends up going to a group of investors. In return, the banks get a big pile of cash and can lend more money out. Everyone wins!
Except when borrowers start defaulting on loans and investors realize how worthless really risky mortgage back securities are. Because money was borrowed without the means to pay it back and because people bet big on these high returns (high interest means high returns, or high yields), everyone got caught with their pants down.
What Do We Do Next?
What can we do now? Learn. The biggest key to financial success, for companies, banks and individuals (Main Street residents), is to live within your means. It will make a difference down the road. If the public does not, we will once again face a crisis.
Andrew is a corporate finance consultant living in Los Angeles, specializing in distressed and bankrupt consulting. He helps clients review business plans and the general market and decide what steps to take next. He has a masters in finance.
Andrew enjoys running and biking in the San Gabriel mountains, cheering for the San Francisco Giants and eating (but trying not to gain weight).