When we talk about today’s financial crisis, we unanimously agree that the root cause is “greed”. But the take aways from such situations are the very lessons that have come our way in previous recessions such as the Great Depression of 1929 which all started with the stock market crash.
So what are the Lessons ?
The 20s were fuelled by an unprecedented number of Americans gambling on WallStreet – not bankers and traders, but everyday Americans. Why? Because of something known as “Margin”. You could buy stock on credit, purchasing a $1000 worth of shares with just $100 down. Once the stock went up which it usually did upto 1929, you could sell it at a huge profit and pay off the credit. So money was made as long as the market kept going.
Eventually, stocks went down. There was a mass “magin call” – time to pay up for the stock you bought for 10% down. But no one had the cash to pay up for such a huge loss. Thus the margin call accelerated the collapse of the market and the banks that funded all that buying. When the banks began tightening under the weight of all the unpaid debt, people anxiously started bucking out their money.I’m sure this is something we’ve been witnessing even to this day. Eventually banks began falling and left millions of people broke. What arose out of the crisis was the FDIC, insuring individual deposits up to $100,000 in all commercial banks.
Whats all this got to do with today’s financial crisis?
Houses became investments instead of places to live and were bought on margin. People bought a house or two or three or more for 10% down or less. Now that rings a bell! You could buy a million dollar house with just $100,000 and guess what, they’d even let you borrow that money! What came out of all this was that people turned out to be enormously rich by buying pre-construction assets and sold them even before completion. The profit of course didn’t go waste, it was further used to buy larger properties. The “greed” kept going on.
At some point which was inevitable, the prices of homes sky rocketed, which although seemed like a good thing at first because of the easy availability of money, backfired. The banks started offering “exotic” loans with little or no money which meant you could buy anything by just paying the interest. Talk about having free lunches! In fact, people were opting for Adjustable Rate Mortgages even when the rates where on an all time low of less than 5% for a 30 year fixed rate mortgage. The “greed” kept going on.
Now, everyone wanted his share of the pie, so eventually the banks decided to go easy on the loan approval rules. Behold the ‘sub primers’! If you don’t have enough income or have got many defaults on your card, no fear the banks are here! You’ll probably just have to pay higher interest rate 5 years down the line.The incentive for these banks were that the sub prime market seemed profitable because of these higher rates. Again the “greed” kept going on.
When the average American started reaping profits and started smoking their Cuban cigars, the investment bankers (the not so fortunate people of today) wanted a piece of this action and so started dismantling their mortgages and repackaging them into De..wait for it.. wait for it.. “Derivatives”.(I’ve been watching a bit too many ‘How I met your mother’ episodes). Investors felt they could rely on this tried and tested, brick and mortar based housing domain. The “greed” just keeps adding up.
And just like that everything came to a standstill; the prices jst stood still, it didn’t drop nor rise.People started getting worried! No, not about losing their houses, but their profits, the ones they earned over a couple of years. As a result, plenty of homes were out on the market, enough to disrupt the demand supply with more buyer power. Yes, the “greed” kept adding up.
Of course, it would be foolish to think that anything would be in an equilibrium when external factors play a high hand and that too factors such as greed. The home prices dropped like an anchor. It was a mayhem. More “For Sale” signs started sprouting up than the greenery as home owners tried to sell the roof over their heads before prices hit the basement. What’s more interesting is that the timing could not be worse. Yes, it was time for those Adjustable Rate Mortgages to have a peak in interest rates because most of them reached their 5 year point. Neither could the property be bought at the new rates nor could it be sold. A perfect deadlock. And we all know what caused it; “greed“.
So there we have it, our economic downturn.
Banks gave ultimatums to pay up or face foreclosure time. Many lost their only homes, the ones they could only afford. But you know the saying, there’s always some good that comes out of anything. Yes there was an innovation, the innovative “jingle mail” :). People just dropped their keys into the mailbox and walked off!
Suddenly those derivates didn’t seem so great. Our great Fannie Mae & Freddie Mac (hence referred to as the BROs) and other banks couldn’t sell & raise enough money from those mortgages to cover the inflated loan and huge home equity lines. 3/5 top investment banks either shut shop or were bought over.
This is where the BROs came into the frame of things; to create liquidity. Banks gave loans on mortgages which were fixed assets which inturn was sold to the BROs to infuse fresh capital to generate more loans.
But when the BROs gave up buying those mortgages, it disrupted the cycle and reduced liquidity in the market causing a credit crunch; the financial equivalent of visiting starbucks only to realize that they are out of coffee!
The lesson: Don’t mess with things you can’t afford to lose especially if its your home!
Shameer Notes 