US Financial Crisis: Whose Fault Is It Anyways?

Yesterday Henry Paulson, US Treasury Secretary, announced a plan to spend $250 billion to purchase stocks in at least nine major financial institutions. This money infusion would give taxpayers ownership stake on these banks and guarantee a 5% return. It would also help banks build more reserves and in turn ease lending to consumers and businesses alike, at least that is what we hope banks will do.

The Emergency Economic Stabilization Act of 2008 H.R. 1424 is known in Main Street as the “Wall Street bail out” plan. However, in Wall Street it is known as the “rescue” plan. Regardless of the name; many people have voiced their concerns and anger about this plan. The reason why they are mad, besides not knowing for sure if it will work, is that most people don’t understand the financial markets.

First, to understand today’s financial troubles, everyone needs to stop panicking. Panic induces fear, which then creates paralysis in our thought process. And if we can’t think straight, we will make costly mistakes.

This past weekend I was at a Carlos Santana concert at the Shoreline Amphitheater. And he was right to say that we should not to panic in hard times because “Panic is not profitable.”

The second thing we need to do is understand how we got here in the first place. Today, people are too busy pointing fingers and listening to negative news. These distractions won’t allow us to learn from our mistakes. And if we don’t learn from our mistakes, we are bound to repeat history again in the future.

So let’s look at how we got here:

ILLUSIONS

Big part of what makes the American Dream is hope. However unrealistic, uneducated, and misinformed choices replace hope with illusions.

Buyers had the illusion that homes would always keep increasing rapidly in value. However, they failed to understand that the real estate market has cycles. Some of the factors that create a change in the market are increased amounts of supply or demand, deregulation of the financial industry, easy and available credit, low interest rates and much more.

People who bought homes they could not afford did it because they saw an opportunity to “invest” their life savings and achieve the American dream. They viewed this opportunity as attainable because banks made it possible, unscrupulous agents/brokers made them believe it was possible, and because they lacked the knowledge necessary to understand the responsibilities, risks and benefits of owning a home.

Other illusions buyers had was their wages. The had the illusion that their wages would go up enough year after year to cover their ever increasing debt due to a lavish life style. This illusion, the lack of financial education and self-control allowed for people to live well beyond their means.

Today people, banks, and our government are drowning in debt.

CREDIT

Competition in the market forces business to improve on their products and allows the consumer to purchase those products at affordable prices. However, competition between banks in a booming economy and low interest rates created a credit bonanza.

Instead of banks improving on their products and services, they began utilizing creative financial tools to attract more borrowers. They also lend money to risky borrowers with little regard of their qualifications. Anybody that had a pulse could literally get a loan.

Banks can’t accommodate the demand for credit only with their money reserves. So if they want to lend more money, they sell these mortgages to commercial banks and Wall Street lenders.

PROFITS AND GREED

In Wall Street, these mortgages are grouped together into “mortgage backed securities” (MBS). Some of the MBS are guaranteed by Fannie Mae and Freddie Mac.

Furthermore, these MBS are grouped, sliced-and-diced, and repackaged as Collateralized Debt Obligations (CDO). These CDO’s offered investors in the financial sector attractive returns.

According to the 60 Minutes report, rating agencies like Standard & Poor’s and Moody’s ease any doubt about CDO’s by assigning their highest credit ratings to some of these investments. This encouraged hedge funds, pension funds and other financial institutions to gobble them up. However, these CDO’s were not entirely safe.

The story does not end there.

Credit Default Swaps (CDS) are insurance-like contracts (emphasizing the word “like”). In this contract, one party (insurer) gives insurance to the other (insured) that he will be paid if certain financial instrument defaults or an institution fails. They typically apply to municipal bonds, corporate debt, and of course mortgage securities.

Because these CDS’s are highly unregulated, they can be traded (swapped) between investors. Without any oversight, the purchasers of the CDS’s don’t need to prove they have the resources to cover losses if the securities defaulted. Also, this instrument can be bought and sold by both the insured and the insurer.

According to Michael Greenberger in the 60 Minutes interview, the most notorious CDS’s sellers are Bear Sterns, Lehman Brothers, American International Group (AIG), and Citigroup. These companies were not only selling risky investment securities, they were insuring them.

To put it into perspective, imagine that you can purchase an insurance policy on your car and at the same time you can also be the insurer of your neighbor’s car. In order to make a profit, you trade (swap) these insurance policies with other people all without ever knowing the actual value of either your car or anybody else’s car. What a mess, isn’t it?

CDS’s were very profitable when no mortgages were defaulting. However, this is a different story today.

THE CREDIT CRUNCH

Borrowers began defaulting on their mortgages for several reasons. And without their “cash cows,” the financial markets began to feel the pinch. Banks stopped lending money amongst each other and began tightening their credit requirements.

The slow flow of credit hurt many business owners who now cannot finance their daily transactions. This has forced many businesses to lay off employees. Those who have lost their jobs are having trouble finding another job that will pay them enough to meet their needs and all their financial responsibilities. If these households have less income coming in, they can’t make their mortgage payments. And if they can’t make their mortgage payments, we are back where we started and begin the cycle of the credit crunch again.

So, should we place the blame solely on the stupidity of the financial sectors? Should we place the blame on the government for not regulating the financial sector? Should we blame Wall Street for their greedy capitalism? Should we blame banking institutions for creating a massive amount of credit available to unworthy borrowers? Should we blame unscrupulous agents/brokers who protected their own best interest instead of their clients? Should we blame speculators who gamble on their purchases? Or should we blame “Joe homeowner” who bought a home even though he was financially unfit to do so?

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I think it’s time for us to stop pointing fingers in any direction. What we need to do is take action now.

If you are a struggling homeowner, contact your lender and review your options. Educate yourself and don’t fall victim to foreclosure rescue schemes or loan modification schemes.

If you are a ready and qualified buyer, what are you waiting for? Who do you think is going to tap you on your shoulder and say “Hey Mr. buyer, the real estate market has hit its bottom today and it will begin to pick up value tomorrow; so you better buy today”?

If you are buying, be aware of how you are financing the purchase and be aware of your financial limitations as well.

Finally, always educate yourself before you make a decision.

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One Response to “US Financial Crisis: Whose Fault Is It Anyways?”

Federal Reserve Rate cuts: How Will It Impact You and Your Money? : San Jose-Santa Clara County Real Estate UNCENSORED on December 17th, 2008 10:06 am

[...] for 30-year fixed loans are set by the investors that buy these mortgages in bundles called “mortgage backed securities.” Although the fed rate cuts make it cheaper for lenders to borrow money, these savings are [...]

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