Handling Finances

On the radio a few days ago, I heard an interview with New York Times economy columnist David Leonhardt on the state of the economy. The interview centered on his column from March 19, 2008 called “Can’t Grasp Credit Crisis? Join the Club.” The first line of the column grabbed my attention: “Raise your hand if you don’t quite understand this whole financial crisis.”

In short, the stock market is jumping around like a caffeinated jackrabbit on a hotplate because nobody really knows what’s wrong. Subprime mortgages and other subprime loans got sliced up, packaged together and sold in so many different ways that it’s been nearly impossible to figure out which investments are losing how much. And when people don’t know how bad it is, they tend to panic. That’s what happened to Bear Sterns — the major investment banker that is being sold for a small fraction of what it was worth a year ago… or even a month ago! They didn’t just lose all their money investing in risky subprime loans, but when the market panicked, people started pulling millions of dollars out of Bear Sterns (and other investments like mutual funds) to protect their money from further losses. The more people sold, the more Bear Sterns was forced to sell more and more failing investments — right when they were at their lowest. After a few weeks and months of selling more and more of their assets at lower and lower prices (desperate to repay those who asked for their money back) they were finally forced to admit that they didn’t have enough assets left to cover all their obligations. It’s really similar to a run on a bank where too many people ask for their money back, but since the bank has loaned most of it out, they can’t repay it right away and end up in big trouble with it’s patrons (though in the US, there are protections to keep this from happening).

So what caused the credit crisis?

So some of the trouble — and certainly the speed and magnitude of recent market declines has been caused by fear and panic among investors. To understand what set it off requires a bit more understanding of recent economic history.

After the real-estate slump in the early 1990’s, mortgage lenders were becoming increasingly national and international in scale rather than simply local. Instead of developing long-term relationships with their borrowers, they competed for loans nationwide and lowered fees while creating new types of mortgages like ARMs — perfect for people who aren’t planning to stay in their house for more than a couple of years and want to save on interest.

Everybody was sure that home values could never drop nationwide, and with the federal funds rate held very low to ward off a second recession in the early 2000’s, everybody from homeowners who took out mortgages with little or no down payment, to big-time investing firms were increasing their returns by heavily borrowing at a low rate and investing in the high interest-rate subprime loans. When betting with borrowed money, even a relatively small drop in investment value can wipe out the investor which explains why so many groups went bankrupt all of a sudden. To make it worse, since the investing firms don’t always know how much exposure they have to the subprime loans (since they’re all sliced up and packaged in many different ways), they’re now holding onto cash to avoid the same fate as Bear Sterns by running out of money as investors ask for their money back. More cash means less investing which just compounds the problem as those trying to sell have an even harder time finding buyers and are forced to drop prices even further.

It’s a highly complex issue with all sorts of ripples affecting what would normally seem like barely-related investments. My main goal through this whole mess is to follow it closely and learn as much as I can — this kind of perfect storm doesn’t come often, but it’s always a potential danger and understanding how bubbles grow and burst is the first step to recognizing them in the future.

This entry was posted on Monday, March 24th, 2008 at 7:16 pm and is filed under Debt, Economy, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.