25 September 2013
Years ago a Pastor in nearby Greensboro, NC, Pastor Jody Bullard, orated a message entitled "The Battle of Almost" and that title made me think about what almost brought this country to another depression worse than the first, and the current battle to keep us from reaching that fate again. What was it that brought us so close to an economic collapse? Our financial industry decided to bundle home loans together (mortgage backed securities) and sell a portion of that to investors. Well, big money was made from this endeavor so pressure was put on investment banks to lend more money to borrowers to secure home loans in order to make even more money. Greed! Loans were already given to people that had good credit (at least a 620 credit score with 20% to put down on a home) so where do you go after that? The bottom of the barrel! Investment banks began lowering their criteria; giving loans to people with bad credit (say a 500 credit score with no money down). Offering loans with this type of criteria increases the risk that the loan will be defaulted on. To guard against this, banks attempted to insure themselves with a type of insurance where if the borrower defaults, the insurance company pays for that default. Thus “Credit Default Swaps”. Banks insuring themselves against potential losses by moving these risks off of their books so they can invest more and make more money. Why would someone do this? Fees…100s of millions in dollars of fees. The potential for these fees would mean more profit for the banks. However, some companies (like AIG or Lehman Brothers) got in over their heads by obtaining too much risk than they could handle. AIG and Lehman Brothers thought that the housing market would continue to go up but it did the opposite…it went down…way down.
Those that purchased a home did it under the grounds of sub-prime interest rates. Sub-prime refers to the credit quality of the borrower who have weakened credit histories and a greater risk of loan default than prime borrowers. These loans were also adjustable which means that at some point in time, those interest rates would increase (for example, let’s say your rate starts at 6% and increases to 15 or 20%). The borrower can’t make the payments due to those higher interest rates and eventually defaults on the loan. Mortgage backed securities hit the bottom, companies like AIG has to pay off all of those loans: all over the world. But they can’t! AIG goes under. Every bank of the insured books massive losses on the same day…they too go under. As a result, the whole financial system comes down. This is what we call in the financial and business world systemic risk. Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to just one individual, entity, or group. This happens due to an interlink between the systems of market. The failure on an entity or group of entities can have a domino effect and bring down the whole market. Some banks thought they were too big to fail but banks like Lehman Brothers were allowed to fail.
Some investment banks that were going to fail were forced to join forces with commercial banks (i.e. Bank of America (commercial) acquiring Merrill Lynch (investment). An investment bank is different from a commercial bank. Commercial banks deal with loans and deposits. Investment banks deal with raising capital for certain projects. For example, if Pepsi wants to sell $5 billion in bonds to build a new bottling company in Asia, an investment bank will help them find buyers for the bonds and handle all of the paperwork; as well as get the lawyers and accountants together. Commercial banks don’t really like investment banks and some were not happy that they were forced to join forces with them. In essence, it created an atmosphere of bigger banks…too big to fail: or so they think.
The continued battle is one of discipline and true change; to live below ones means; stop the printing of money to stabilize the economy causing inflation that will at some point burst the bubble; cease borrowing and government spending that continues to increase debt. From my view, we did not stop anything from happening; we prolonged it!
