by Scott Pape |March 26th 2009
Writing about complex economic problems is scary. It involves risk.
It’s risky because it’s difficult to work out who’s right, who’s wrong, and who’s going to end up sleeping in a cardboard box at the end of it all.
Which is why many writers err on the side of caution, filling their prose with words and phrases that no one really understands (in some cases not even themselves).
It’s safer that way.
Better to fool everyone than risk being labelled a fool.
But loyal readers know that Barefoot does not harbour these hang-ups. No one has the right answer. Not Obama, or Kevin – not even Malcolm.
So, perhaps for the first time, let me take you on a (grossly simplified) story on how we got into this pickle, and why I believe we’re all being set up for one hell of a sucker punch in a few years’ time.
No risk policy
Imagine that there’s a group of bean counters who are in charge of managing the world’s collective $US70 trillion dollars worth of savings. They’re nervous, risk-averse types. Jittery even. You may have dated one in high school.
Their job is to find a safe place for all the world’s savings without taking too much risk.
$US70 trillion is a lot of dough – they just can’t stick it in an ING account – so instead they loan their money to the US Government by buying Treasury bonds, traditionally the safest place to put your money (unlike ABC Childcare, the US Government isn’t going to go broke).
The interest rate the bean counters get on their bonds is (in part) set by the interest rate policy of the US Federal Reserve.
So the bean counters have traditionally had a pretty boring job (buying US treasuries bonds, and playing ping pong). Well, right up until the dot.com crash occurred in 2000 anyway.
The former head of the US Federal Reserve, Alan Greenspan, was worried that the share market drop would cause the US economy to slide into a recession – so he cut rates from 6.5 per cent to just 1 per cent between 2000 and 2003.
Crazy savers
For the first time in years the bean counters were forced off the ping pong table and back to the office. They were faced with two problems; firstly, China and India had been making a heap of dough over the past few years and were saving like crazy, shovelling even more money to the bean counters to find a home for. Secondly, and most importantly, with interest rates set at just 1 per cent (and, according to Greenspan, likely to stay there), they weren’t getting a good enough return on their savings.
What could they do?
“Why don’t we buy home mortgages? The banks charge 5 per cent, and if any borrowers go bust we have the security of the house, which has always been a safe, solid asset over the years”, suggested one bean counter.
“But we have $US70 trillion to find a home for. What are we going to do, buy every home from New York to LA!”, replied another.
Wall Street sniffed an opportunity. With interest rates at record low rates, they could buy up millions of individual mortgages from brokers and lenders, and then package them all up into one big basket (called a CDO, or Consolidated Debt Obligation) and sell them to the bean counters.
Everyone won. Wall Street paid themselves billions in fees for doing all the fiddly work of buying up lots of mortgages, and the bean counters found a safe place to invest the world’s savings at a decent rate.
Getting everyone involved
By 2003, demand for mortgages had started to taper off; everyone who wanted a loan had one. Yet the bean counters were only really just getting started – they still had a heap of the world’s savings to put in.
Wall Street wanted to continue making money, so, given that house prices were going through the roof, they decided to loosen their lending criteria by creating a subprime loan.
This was a good thing. When Bill was blowing cigars in the Whitehouse, he passed laws that encouraged poor people to get into their own pad, but not much had happened. Yet now with a never-ending demand from the bean counters, never-ending greed from Wall Street, and never-ending stupidity from homeowners, everyone got in on the game. And I mean everyone. Reference the infamous case of a Mexican strawberry picker with an income of $US14,000 who received a $US720,000 home loan.
I know what you’re thinking.
Surely these bright-sparks must have known that they were on a collision course. Yet there are four things that obscured their views:
1. Greed.
2. Ratings agencies stamped much of these bundles of loans as ‘investment grade’ (or to you and I, ‘she’ll be apples, mate’). In part because they were paid millions of dollars to do so (see Item 1) and in part because their complicated computer risk models didn’t factor in the (relatively) new, and risky, subprime loans.
3. Many of the bean counters had taken out ‘insurance’ (known as a Credit Default Swap) in the very unlikely event that the bundles of loans they bought would end up going pear-shaped. They took this insurance with an insurer called AIG.
4. Housing prices were going up, and there was a belief they’d never fall. So you could make a few loose loans and, even if the worst happened, they’d get a house that was rapidly appreciating in value.
Big losses
Then, everything went rotten. People stopped paying their mortgages and started sending back the keys – something that the wizards of Wall Street didn’t plan for. AIG, the company that made the bets that the baskets of loans wouldn’t go down, became a basket case itself. Billions have been spent bailing it out. More will be needed as more bets go bad.
Anyway, the bean counters lost a serious amount of money. In fact they still have no idea how much money they’ve lost investing in dud mortgages (they’re still trying to mop up the mess). Not surprisingly, they’ve gone gun shy and stopped lending their money to anyone and everyone, which in part is what caused the credit crisis.
Then you have the big banks that have all these toxic loans on their books that are worth much, much less than the money they lent against them. If they gave the true value of the losses they’d incurred on the loans, they’d be insolvent. Bankrupt. Kaput.
Banks lend credit, which is the lifeblood of the economy. And right now there’s no blood flowing. US politicians are trying to save the patient…but the treatment they use could be worse than the cure.
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Five years ago, when I wrote my first book the Barefoot Investor, I couldn’t have imagined how many people would take the message and use it to change their financial lives. With the impending recession there’s never been a better time than now to learn the financial lessons that will help you weather this storm.
Tread your own path!
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