Some thoughts on the financial crisis
I’ve been doing a bit of research as of late in an attempt to understand the incredible mess our economy is in now. I’ve researched a decent amount of US history to try to get a sense of the general patterns our economy goes through, and what events have precipitated the problems we’ve run into. And while that’s been helpful, the mess we’re in now seems to be a combination of unique effects. A significant portion of my current understanding comes from a conversation I had the other day with one of my friends, who happens to work in the financial sector.
That said, I think the current financial situation stemmed from three mistakes made. If any one of them hadn’t been made, the crisis would have been averted, or at least would have been significantly less severe.
1) The Federal Funds Rate was lowered from just over 6% in 2001, to a near record low of 1% in 2003, only to be subsequently raised back up to over 5% by 2006. Since the Fed loans out money to the largest banks at this rate, all other interest rates are based off the Federal Funds Rate. The dramatic decrease suddenly made mortgage interest rates very cheap, but only for a short period of time. It was enough to encourage a large amount of enthusiasm in the housing market.
2) A number of lenders around the height of the resulting housing bubble practiced extremely lax lending standards. People were essentially allowed to get mortgages providing nearly no documentation proving income to the lenders. These loans are referred to as “no doc loans”. I believe standards were gradually pushed to new lows in order to stay competitive in an exploding market and to entice more people to purchase property. I think the fact that housing prices continued to rise dramatically also helped encourage these practices because the risk of a default was lower if the prices continued to rise. These low lending standards allowed people to lie about their income and/or take mortgages they weren’t going to be able to afford in the long run.
3) Bundles of mortgages from a variety of areas around the country were gathered together and resold to larger banks and investment firms. At the time, people seemed to view these securities as diverse and didn’t see the dependencies between them. When housing prices started falling and people began defaulting, all areas were hit hard, and these giant securities suddenly became very toxic. The problem is that hardship in one area started spreading to other areas of country, dropping housing prices all around and making it much more difficult for people to keep up with rising interest rates on their mortgages.
Looking at that financial crisis from this perspective, it can be a bit difficult to assign blame. First and foremost though, the government overreacted in 2001. Mind you, in 2001, the economy was still reeling from the Dot-Com bubble / burst and that, combined with the 9/11 attacks, put us in a bad financial position. The fear that we could enter a depression pressured the government into acting. At the time, the government must have figured that lowering the Federal Funds Rate would stimulate the economy, and continued to cut rates many times. By the end of 2001, the Federal Funds Rate hit 1.75%, only to drop to 1% by 2003. A rate of 1% hasn’t been seen since the early 1950s. It’s clear that the government overreacted and in doing so, spurred a great deal of interest in the housing market. It became very lucrative to borrow money to pay for housing.
Because everyone was buying up property, prices of course went up. It was a self feeding cycle. As prices continued to rise, people were making even more money off the mortgage deals, and it became even easier for people to afford housing. Then, a number of factors really made things tumble. One, the Fed couldn’t possibly keep such low rates forever, so rates increased. In addition, I believe there were other effects hurting the economy, such as 8 years of Bush’s overwhelming spending and the war in Iraq. All these factors put pressure on people who essentially lied about their income and took mortgages they really couldn’t afford, except by virtue of the raising housing prices. And as the cycle fed itself to build up momentum, the system fell apart just as cyclically. Defaults started occurring across the country and big financial firms found themselves with giant portfolios that no one wanted to touch.
Now, while the government should have never took such an extreme action toward the economy, lenders should have never gotten to the point of having such lax lending standards. Fact is, if you ask someone to tell you their income and you don’t ask them to prove it, some of them will lie. This is a huge financial risk you’re taking on. But the enthusiasm in the market at the time perhaps made people blind to this basic fact. Perhaps some of them just wanted to make a quick buck, securing the loan, taking their share, and selling the loan to a larger bank. Then, there’s the mistake of the larger investment firms and banks, viewing these massive bundles of mortgages as a relatively sound investment. Someone was clearly not doing their job.
We’re in a position now though where these toxic securities are scattered throughout the economy. Many banks have money invested in this stuff that could potentially go under any day now. And no one wants to buy them or back them in any form. With good reason. So our economy is almost frozen. Banks have a lot of money in investments that could become worthless any day now. So, they’re forced to keep money on hand in case they lose these investments. As I understand it, it’s become very difficult to borrow money because of this. So what are we to do?
The federal government is proposing to raise $700 billion dollars to buy up these toxic securities from banks and firms on Wall Street. The plan is for the Treasury to essentially take these loans, and hold on to them until the economy recovers. If the defaults continue and some of these securities implode, that’ll be money lost. However, if the market recovers, these securities could potentially be resold at cost or for a profit. In addition, the government will appoint oversight committees to oversee the investment, and study the soundness of the economy. The companies from which these securities are purchased will also be likely punished, in order to try to ensure no one profits off the intervention.
Personally, I’m worried about three things with regard to this plan. First of all, it sets a terrible precedent. If you mess up, the government will fix it for you. This will greatly reward people who ought to have suffered as a result of this mess. Granted, the government will try to avoid rewarding people through the plan, but I feel confident they’ll still benefit. In general though, establishing such an unprecedented safety net for bad business decisions could have serious long term effects. Second, I think it’ll create a lot of tension between tax payers and the Wall Street. If people view the businesses as so reckless that the tax payers will have to clean up their mess, people will want more say into the affairs of Wall Street. This outcome seems fairly inevitable and could potentially be extremely harmful. I don’t see the government as being anywhere near as capable as Wall Street in terms of managing money, and having the government become even more involved could really cripple the economy in the long run. Third, I have no idea where we’ll be getting the $700 billion to pay for these securities. I know the argument is that we could resell them, but if Wall Street doesn’t want to go anywhere near them, that probably implies that they constitute an extremely unwise investment strategy. I wouldn’t want my $700 billion going into the riskiest investments on Wall Street. So, if we lose a significant portion of that money, where is it going to come from? Thanks to Bush, we’ve spent around that much on the Iraq War, and we’ve racked up close to $4 trillion in public debt. Can we really just keep borrowing so much money without consequence?
In many ways, I feel that the government’s initial interference with the economy helped breed the conditions that led to the current financial crisis. In spite of how bad things appear right now, unless we’re literally in the situation where the market WILL collapse without our help (and in that case, I would only invest as much money as is ABSOLUTELY necessary to avoid that collapse), I would do very little. I would make sure that the government keeps any promises it made previously to any company, so as to not screw anyone over, and I would make it clear that the government will avoid interfering with the economy as best as possible. The message I would send to Wall Street is, you guys are on your own. Figure out a way to fix this. And I think they will, if they’re not hampered by the government in the process. Maybe getting the government to spend a bit less would help too. Any other alternative looks pretty bleak in the long run. We are going to need to be willing to take risks in life, and not act on fear. Otherwise, I’m not sure how we’ll ever break out of this vicious cycle.
That said, I think the current financial situation stemmed from three mistakes made. If any one of them hadn’t been made, the crisis would have been averted, or at least would have been significantly less severe.
1) The Federal Funds Rate was lowered from just over 6% in 2001, to a near record low of 1% in 2003, only to be subsequently raised back up to over 5% by 2006. Since the Fed loans out money to the largest banks at this rate, all other interest rates are based off the Federal Funds Rate. The dramatic decrease suddenly made mortgage interest rates very cheap, but only for a short period of time. It was enough to encourage a large amount of enthusiasm in the housing market.
2) A number of lenders around the height of the resulting housing bubble practiced extremely lax lending standards. People were essentially allowed to get mortgages providing nearly no documentation proving income to the lenders. These loans are referred to as “no doc loans”. I believe standards were gradually pushed to new lows in order to stay competitive in an exploding market and to entice more people to purchase property. I think the fact that housing prices continued to rise dramatically also helped encourage these practices because the risk of a default was lower if the prices continued to rise. These low lending standards allowed people to lie about their income and/or take mortgages they weren’t going to be able to afford in the long run.
3) Bundles of mortgages from a variety of areas around the country were gathered together and resold to larger banks and investment firms. At the time, people seemed to view these securities as diverse and didn’t see the dependencies between them. When housing prices started falling and people began defaulting, all areas were hit hard, and these giant securities suddenly became very toxic. The problem is that hardship in one area started spreading to other areas of country, dropping housing prices all around and making it much more difficult for people to keep up with rising interest rates on their mortgages.
Looking at that financial crisis from this perspective, it can be a bit difficult to assign blame. First and foremost though, the government overreacted in 2001. Mind you, in 2001, the economy was still reeling from the Dot-Com bubble / burst and that, combined with the 9/11 attacks, put us in a bad financial position. The fear that we could enter a depression pressured the government into acting. At the time, the government must have figured that lowering the Federal Funds Rate would stimulate the economy, and continued to cut rates many times. By the end of 2001, the Federal Funds Rate hit 1.75%, only to drop to 1% by 2003. A rate of 1% hasn’t been seen since the early 1950s. It’s clear that the government overreacted and in doing so, spurred a great deal of interest in the housing market. It became very lucrative to borrow money to pay for housing.
Because everyone was buying up property, prices of course went up. It was a self feeding cycle. As prices continued to rise, people were making even more money off the mortgage deals, and it became even easier for people to afford housing. Then, a number of factors really made things tumble. One, the Fed couldn’t possibly keep such low rates forever, so rates increased. In addition, I believe there were other effects hurting the economy, such as 8 years of Bush’s overwhelming spending and the war in Iraq. All these factors put pressure on people who essentially lied about their income and took mortgages they really couldn’t afford, except by virtue of the raising housing prices. And as the cycle fed itself to build up momentum, the system fell apart just as cyclically. Defaults started occurring across the country and big financial firms found themselves with giant portfolios that no one wanted to touch.
Now, while the government should have never took such an extreme action toward the economy, lenders should have never gotten to the point of having such lax lending standards. Fact is, if you ask someone to tell you their income and you don’t ask them to prove it, some of them will lie. This is a huge financial risk you’re taking on. But the enthusiasm in the market at the time perhaps made people blind to this basic fact. Perhaps some of them just wanted to make a quick buck, securing the loan, taking their share, and selling the loan to a larger bank. Then, there’s the mistake of the larger investment firms and banks, viewing these massive bundles of mortgages as a relatively sound investment. Someone was clearly not doing their job.
We’re in a position now though where these toxic securities are scattered throughout the economy. Many banks have money invested in this stuff that could potentially go under any day now. And no one wants to buy them or back them in any form. With good reason. So our economy is almost frozen. Banks have a lot of money in investments that could become worthless any day now. So, they’re forced to keep money on hand in case they lose these investments. As I understand it, it’s become very difficult to borrow money because of this. So what are we to do?
The federal government is proposing to raise $700 billion dollars to buy up these toxic securities from banks and firms on Wall Street. The plan is for the Treasury to essentially take these loans, and hold on to them until the economy recovers. If the defaults continue and some of these securities implode, that’ll be money lost. However, if the market recovers, these securities could potentially be resold at cost or for a profit. In addition, the government will appoint oversight committees to oversee the investment, and study the soundness of the economy. The companies from which these securities are purchased will also be likely punished, in order to try to ensure no one profits off the intervention.
Personally, I’m worried about three things with regard to this plan. First of all, it sets a terrible precedent. If you mess up, the government will fix it for you. This will greatly reward people who ought to have suffered as a result of this mess. Granted, the government will try to avoid rewarding people through the plan, but I feel confident they’ll still benefit. In general though, establishing such an unprecedented safety net for bad business decisions could have serious long term effects. Second, I think it’ll create a lot of tension between tax payers and the Wall Street. If people view the businesses as so reckless that the tax payers will have to clean up their mess, people will want more say into the affairs of Wall Street. This outcome seems fairly inevitable and could potentially be extremely harmful. I don’t see the government as being anywhere near as capable as Wall Street in terms of managing money, and having the government become even more involved could really cripple the economy in the long run. Third, I have no idea where we’ll be getting the $700 billion to pay for these securities. I know the argument is that we could resell them, but if Wall Street doesn’t want to go anywhere near them, that probably implies that they constitute an extremely unwise investment strategy. I wouldn’t want my $700 billion going into the riskiest investments on Wall Street. So, if we lose a significant portion of that money, where is it going to come from? Thanks to Bush, we’ve spent around that much on the Iraq War, and we’ve racked up close to $4 trillion in public debt. Can we really just keep borrowing so much money without consequence?
In many ways, I feel that the government’s initial interference with the economy helped breed the conditions that led to the current financial crisis. In spite of how bad things appear right now, unless we’re literally in the situation where the market WILL collapse without our help (and in that case, I would only invest as much money as is ABSOLUTELY necessary to avoid that collapse), I would do very little. I would make sure that the government keeps any promises it made previously to any company, so as to not screw anyone over, and I would make it clear that the government will avoid interfering with the economy as best as possible. The message I would send to Wall Street is, you guys are on your own. Figure out a way to fix this. And I think they will, if they’re not hampered by the government in the process. Maybe getting the government to spend a bit less would help too. Any other alternative looks pretty bleak in the long run. We are going to need to be willing to take risks in life, and not act on fear. Otherwise, I’m not sure how we’ll ever break out of this vicious cycle.