Unreasonable Haste is the Direct Road to Error

I don't understand everything involved with this economic crisis, but I do know that my son's college fund has lost value recently. Earlier this year, it was stagnant, but at least I was acquiring more shares with my monthly deposit and not losing money. I will not need this fund for another fifteen years and I feel fairly secure that I will get the money that I need from it when Noah heads off to college. I don't have that same sense of security for my parents who will be looking to retire soon or for my nephews and nieces who will hopefully be enrolling at universities and colleges within the next five to seven years. I began researching past legislation and market cycles and reading as much as I could on this current catastrophe and I hope that this blog will help you understand this quagmire (at least as well as I can understand it and explain it).

In an effort to increase profits, mortgages have been packaged into exotic securities, sliced and diced and sold as bonds purchased by investment banks and hedge fund operators. It was widely assumed that the housing market would never see a reduction in value, so there was no fear in making mortgage loans. Traditionally, the value of a house increases approximately 3% every year, so if a person defaulted on a $300,000 mortgage after a two years, the bank would still have a house worth around $318,000.

Hedge fund operators and investment banks loaded up on leverage, generally referring to using borrowed funds or debt to attempt to increase the returns to equity. For instance, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. Leverage helps both the investor and the firm to invest or operate. This proved to be very successful and things were booming until the housing market began to falter.

Unfortunately, the housing market got turned on its head when supply was higher than demand. Many subprime borrowers, people with low credit ratings who could not qualify for traditional mortgages, found out that their houses were worth less than their mortgage. These people then got slammed by the rise in their adjustable rates, which initially begin as fixed rates and then convert to a floating rate based on a specific benchmark like the LIBOR (London Interbank Offered Rate) average (derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year). Many of these subprime borrowers defaulted on their mortgages.

This revelation did not stop anyone from trying to turn even more profits. Investors demanded more newfangled collateralized debt obligations (CDOs), which are complicated securities based on pools of other mortgages. These CDOs are often rated highly and considered safe, but the credit raters who parlay these opinions are paid by the borrowers (the investment banks and hedge fund operators). Couple this with mortgages handed out to undeserving parties and even more foreclosures, and we have an impending crisis that nobody noticed or could predict (sans Warren Buffet who called these derivatives "weapons of financial mass destruction" in 2003; and now Buffet and his Berkshire Hathaway group are buying up America on the cheap) because of the massive deregulation efforts by a Republican Congress and President Clinton.

It turns out that all of these investment banks and hedge fund operators had over-leveraged themselves. For example, Lehman Brothers borrowed at 35 times its capital, so it was no surprise when they had no money to cover their losses. Where does AIG fit into this mess? Well, AIG provides insurance for these seeking to hedge their bet by selling credit-default swaps (CDS). For instance, if you buy $10 million worth of General Motors bonds, you can hedge your bet by buying $10 million in CDS from AIG so that you get $10 million should GM have an event of default on its obligations. AIG did not have the capital to cover these CDS and if AIG would have gone under, all the institutions that bought those CDS would probably have failed too.

How does this affect you? Here are some examples:

• The most recent Federal Reserve survey of loan officers showed a plurality of banks tightening credit standards across the board. Bank of America is now declining to increase lending to McDonald's franchisees even though the two companies have a long-standing partnership. In August, 67% of small-business owners said they'd been affected by the credit crunch, compared with 55% in February, according to surveys by the National Small Business Association.
• Since the summer of 2007, 137 lenders have stopped funding federal student loans and 33 have suspended private programs, according to Mark Kantrowitz, publisher of FinAid.org and other financial aid websites. Part of that had to do with a cut in federal subsidies, but part was directly related to the credit crunch — issuers that pulled out tended to be those that packaged and resold loans, a market that has evaporated.
• Although crops are set to have a record-setting year, the livestock sector is expected to experience a $750 million reduction in net earnings compared to 2007.
• The amount you can expect from a top-yielding certificate of deposit has fallen from about 5.5% to 4.25% over the past year, according to Bankrate.com.
• The average 60-month new car loan is priced at 7.10%, not much different than in the spring, according to HSH Associates, Financial Publishers — and the average rate on a 60-month used car loan, 7.54%, has actually been drifting downward. (Those 0% financing deals still exist, too, from struggling car companies desperate to move inventory.) The difference is, you're probably not going to get that rate (or any at all) unless your FICO score is north of 700, whereas six months or a year ago, a score as low as 620 would have gotten you behind the wheel.

I agree that something had to be done, but I don't necessarily think that this economic rescue plan is the best way to go about it. Both of the candidates reluctantly voted for the passage of this bill. I've seen a lot of commentary about how the government should stay out of it and let these greedy and irresponsible companies fail, but the job losses alone are too large to fathom.

How does this affect the presidential election? Here's what Paul Krugman, professor of economics at Princeton and staff member on the Council of Economic Advisers for President Reagan, said "both Mr. Obama and the Congressional Democrats are surrounded by very knowledgeable, clear-headed advisers [including Warren Buffet], with experienced crisis managers like Paul Volcker and Robert Rubin always close at hand." He went on to say "We’ve known for a long time, of course, that Mr. McCain doesn’t know much about economics — he’s said so himself, although he’s also denied having said it. That wouldn’t matter too much if he had good taste in advisers — but he doesn’t."

Neither of the candidates, or almost any politician in Washington for that matter, has the experience to fully comprehend and deal with this crisis. Obama, however, has shown he will listen to his advisers and ask poignant questions. He has been prudent and thoughtful throughout this ordeal.

McCain, on the other hand, used this crisis as a political ploy. He went to Washington and didn't aid the legislation at all. He then blamed Obama when the bill it didn't pass through the House of Representatives. He said "This bill failed because Barack Obama and the Democrats put politics ahead of country." Really? Obama didn't thrust himself into the negotiations and aid in the initial bill's failure. He was content to monitor and aid the process outside the limelight through communication with key members of both parties and the administration. He tried to avoid inserting presidential politics into this process. He ended up going to Washington at the request of President Bush because McCain manufactured the situation. And when Obama arrived, he participated in discussions while McCain said nothing. McCain has been jumping from one side of the fence to the other on every issue over the past month trying to gain some sort of standing, but only appearing more and more foolish. He has proved his own statement, "I make decisions as quickly as I can. Often my haste is a mistake, but I live with the consequences without complaint" (excerpt from his book Worth Fighting For) true time and time again. I don't want to be forced to live with the consequences of his haste and you shouldn't want to either.