A-Train Finance

Now that we are officially in a recession, the worst one of my short life and what could very easily end up being the worst one since the Great Depression, it is important to take a step back and try and figure out how we got here. We would like to believe that another great depression could never happen again because our financial system has become so much more sophisticated and protected than we were back then, however the causes of the economic strife of the 1930s and what we are going through today is in many ways frighteningly similar.

The plain and simple reason we are in a recession is leverage. Leverage is when you buy more than you can with your money so you borrow somebody else’s money to buy things with. In many cases investment banks and hedge funds will leverage up to 80 to 1 so for every dollar they actually hold they will hold $80 worth of some asset class. In boom times this equates massive gains for traders at these firms, imagine for every 1% that you made on your portfolio you were actually making 80%, of course the guys that ran these firms were making 8 and 9 figure bonuses. Even in flat times and small pull backs these firms remained profitable using techniques like short selling. During the roaring 20s there was a similar sentiment about leverage, firms overleveraged and when the market turned even a small splash caused a huge disruption that turned into a storm of selling.

Today we can trace back several small splashes that turned into the hurricane that we are in today. The first two major splashes occurred all the way in 1999. First, a major piece of the Glass-Steagall act was effectively repealed. This was an act that was put in place in 1933 to prevent large corporations like Citigroup from existing. This legislation was put into place with an eye to prevent what occurred in the Citigroup bailout, it aimed to prevent companies becoming to large to fail. The reason that Clinton signed the bill to allow this is the second major reason we are in the predicament we are in today. Within the same bill there was an order that if companies were to become such large money making machines that they would give back to the country by strengthening the Community Reinvestment Act which allows people with weak financial footing buy houses.

All in all this seemed like a great compromise where everybody got what they wanted without giving up to much. Corporations would be able to grow very large and profitable and in turn they will help out the less fortunate by bumping up home ownership from 65% to 70% in our country. The problem with this is that every time home ownership levels increase by that much it has lead to a housing bubble and a subsequent recession, usually these are the bad recessions too (see early 30s, early 70s). Now this was the ground work that was laid for this recession, but it was the engine of growth in the early part of this decade, home building took off infrastructure took up and consumer purchases took off since there were so many people now owning homes that could finance against those homes, and since more and more people were buying homes the prices kept going up so people could take out more and more money against them. In fact you could have taken out a loan in 2001, paid only interest on it and then in 2005 you could have had it reappraised and chances are it went up 15% and you could take that money out again and pay only interest.

This is where Bush and his policies come into play. A greater level of home ownership is not a bad goal in and of itself, as long as there is some restraint and control on the process. Interest rates were simply kept too low for too long and this allowed for the bubble to fester longer and longer, this allowed the economy to grow despite a very expensive war while the countries manufacturing base effectively crumbled. Our problems were masked by the housing markets effects on our financial institutions and the low income people that could pull equity out of their houses for cheap. Homes were reach ridiculous prices but many felt that they would be worth 20% in 5 years so just keep buying.

Then it happened, there were many causes to what triggered that first wave of foreclosures, but there were two main causes, first and foremost was the way that the mortgages were structured, many had rates that reset after a grace period in which people only paid interest or a small amount of the principle. People went into these loans thinking in five years they would get the promotion and be making six figures, for the most part, that didn’t happen. The other cause was mostly unforeseen, the commodities boom. In an effort to make American exports more attractive the dollar was purposely devalued. This also had the added benefit of lowering our debt level since our debt is held in dollars. The unseen consequence with this was metal, food and fuel prices, already on the rise started to skyrocket. Wages could not keep up with this rise and as more people felt the pinch at the pump they chose to fill up their SUVs to get to work at the expense of paying their mortgage.

This caused the suffering on Main Street, but surely Wall Street would have known better, these guys are a bunch of Harvard MBAs, they could make money faster than the government could print it. Well back in the boom times as banks were forced to hold all of these bad mortgages by the CRA they figured might as well make lemonade out of lemons and make some money with these high risk assets. They in turn leveraged them selves and sold securities back by these risky mortgages diversified in location (i.e. backed by bad mortgages all over the country). The worst offenders of this were Merrill and Lehman followed closely by Citi. Due to the way these were structured and sold if even half as many foreclosures occurred as what has happened then these companies would be on the hook for billions of dollars that were tied up in leveraged assets. To pay for these losses the big hedge funds and Banking entities started to deleverage driving the cost of everything down (this is major evidence that the price of oil was completely fixed by hedge fund oil trading desks) including stocks and commodities. These companies started to go under and since other companies had invested through them and lost a lot of money they also went under causing more unemployment and the further erosion of the economy.

So when does it stop? Hopefully soon, the actions that the government has taken have been costly and will be a burden on this country for most likely the rest of my life time, but they should dampen the effects of this recession and prevent an all out depression. Hopefully this time we will learn our lesson that major short term gains are temporary, there is no 100% safe way to invest and that if we want to prevent painful events like 2008 then we should keep both eyes on the long term and forget about short term gains.