Television news tends to say the same words over and over again without actually discussing the real issues. This is called consensus. If you ask the typical man in the street, he will tell you that the subprime mortgage crisis involved banks and investment businesses losing a bunch of the public’s money, at which point, it was necessary to give them more public money in order to protect the public. Simple, right? The effects of the worst economic crisis since the Great Depression in a nutshell. As investors, we should know that simplistic explanations are rarely fully correct and we should take the time to dig a little deeper.
Near the end of 1994, the Mexican government was facing huge political and fiscal pressures, and worse yet, was running out of dollars to service its foreign debt. Prior to this point, the country’s capital controls had been liberalized almost overnight, resulting in massive capital inflows and the stock market rising 400%. It was possible to borrow money on the U.S. market at around 3% and invest in Mexican companies later the same day, which could be expected to yield 10% or more using OPM (other people’s money). These inflows led to a distortion in the value of pesos.
Of course, price point movements that don’t reflect changes in underlying value are doomed to correct at some point, which was where the looming Mexican default came in. The struggling peso was supported with a $50 billion dollar IMF bailout, most of which was funded by the United States. Essentially, foreign investors who had willingly taken a risk were being reassured that their money would be safe regardless of them ignoring the structural problems associated with their investment.The United States government would pick up the tab for now and the Mexican government would pay them back later.
This was one of the first currency crises of the globalized world, and the precedent had been set: institutional investors would be protected using taxpayer money regardless of how stupid or foolhardy they had been. If individuals and funds made enough bad bets to threaten a worldwide crisis, they would still be insulated from its effects. Paper profits would be maintained, even at the cost of destroying real value.
The State of Banking in 2007
The proximate cause of the credit crisis was the repeal of the Glass-Steagall Act in 1999, which, among other examples of deregulation, meant that banks that took deposits could now also engage in a wide spectrum of financial activities that were previously prohibited. The intention was to make American finance more competitive and it was presumably felt that the institutions themselves and the industry as a whole could be trusted to limit their own risks. Without this factor being in place, the crisis might still have occurred, but its scope would have been far more limited.
The second most important part of the situation was the widespread acceptance of the practice called subprime lending, meaning that mainstream institutions would now extend credit to individuals and companies with less than stellar credit. The prime reason for this was competition among mortgage originators for market share and returns; more conservative institutions saw their competitors surging ahead and didn’t want to be left behind.
Another reason was that banks simply became more predatory and even engaged in large-scale criminal behavior, which continued well after most of the dust from the financial crisis had settled. As a proportion of total mortgages, these risky loans doubled between 2004 and 2005/6. One of the effects of this was that the underlying asset, real estate, rose in price while its inherent value remained constant.
The third factor involved the increased use of extremely complicated financial derivative instruments: credit default swaps, mortgage-backed securities, off-balance sheet capital transactions and other kinds of mathematical voodoo. Afterward, some industry players estimated that no more than a hundred individuals worldwide really understood how all of these worked. Essentially, banks and investment houses couldn’t make sense of their own balance sheets, either in terms of assets or their associated risks, yet nobody realized this.
One day, HSBC Holdings announced that its losses to bad debts would be 20% higher than expected – bad for this one international bank, but not a train smash in itself. A little more than three months later, Ben Bernanke claimed that the increasing number of mortgage defaults wouldn’t seriously harm the U.S. economy. A month later, all hell started breaking loose: ordinary, financially responsible people lost their homes and pensions, companies that had done nothing wrong went under, public finances were messed up for the next decade, and banks are still “too big to fail.”
Takeaways for Personal Investors
It should be made clear at this point that the above analysis is only a blog post. The author doesn’t run a hedge fund, and many smart people still have very different ideas on what exactly happened in 2008. However, there are some definite lessons to be learned:
- The investment game is not exactly rigged, but nobody is going to tell you what the real rules are. It’s not as if congressmen were exchanging bags of cash in back alleys for their votes, but the effects were very similar in the end.
- Diversification means more than owning a bunch of things with different names. When structural risk is present, having a variety of assets – stocks, physical property, bonds – is a must, and none of those three survived the financial crisis with flying colors anyway.
- Contrarian views must be taken into account and accorded some degree of respect. For example, few people in the U.S. (even academics) take Austrian economics very seriously, yet it and other theoretical models tend to be right at least some of the time, under some circumstances.