As you may already know, our Congress is about to vote on legislation granting the United States Dept. of the Treasury the authority to buy up over $700 billion in assets, consisting mostly of subprime mortgages. The primary reason for doing this is to prevent the bankruptcy of any more banks and increase liquidity in the financial markets. Sooooooo, how did this debacle get started? Without getting too technical, here is the gist:
For years, lenders had been giving home loans to individuals and families with weak credit ratings that they deemed subprime. Most of them involved a teaser interest rate for the first few years of the mortgage, which was significantly lower then the actual rate they would eventually pay. The selling point was that the rising housing market would cause homebuyers to build a disproportionate amount of home equity in the first few years of ownership allowing them to refinance at a lower rate by the time the teaser rate had expired. For a while this worked, as housing prices seemed to have no ceiling.
In the mean time Wall Street caught on to the profitability of financing this venture and began buying up subprime mortgages in bulk. These loans were then packaged together into securities and sold off to investors. (It’s important to note this was done with not just home loans, but also student loans and credit debt as well as other things. They all fell under the title “Asset-Backed Securities.”) The risk involved in this type of investing was high because it banked on a strong economy that would continue to allow housing prices to increase rapidly. Unfortunately, this didn’t deter financiers who were attracted to high returns. As the housing market and overall economy took a downturn, a significant amount of people with subprime mortgages graduated to the higher interest rates and were unable to make the larger monthly payments, thus forcing foreclosures in mass. At the grassroots level of our economy, this translated into a huge decline of household wealth. Many people no longer had home equity to fall back on or a healthy credit rating as a result of loan default. At the corporate level, many banks were saddled with a gigantic amount of these subprime mortgages and foreclosed homes that they simply couldn’t sell because the risk had increased dramatically.
So what did the big wigs on Wall Street do? The right thing would be to immediately write down the value of these assets on the company’s balance sheet to give investors a clear indication of where the company really stood. Did they do this? HA, nope. CEOs are driven by incentive, not morality, and that incentive happens to be their company’s stock price, not the overall welfare of the economy. So the debacle was spread out over the past year with company executives valuing their assets liberally — overpriced — citing an overly optimistic view of the market’s future in order to keep stock prices high. Month by month, more and more of each company’s assets had to be written down until some could no longer meet their short-term debt obligations forcing them into bankruptcy.
Now, you would think that companies as large and successful as Bear Stearns, Lehman Brothers and AIG would be smart enough to diversify their portfolios to avoid putting to much risk in one place. This is where greed comes in. By investing so much money in the risky market of subprime mortgages, CEOs were executing the equivalent of a Hail Mary pass in football. The risk was high, but so was the potential reward. Did it end up sucking? Yes. Was it dumb in hindsight? Yep. But has it worked in the past? Of course. So I don’t necessarily think there is blame to put on financial insiders. Company executives get paid to create value for shareholders, not to serve as market regulators. In the words of Bill Bellamy, “Don’t hate the player, hate the game.” I tried hard to think of something from Tupac, but nothing came to mind.