Last week’s article generated a lot of feedback on tradingtutors.com, which has prompted me to write a follow-up piece dissecting the root-cause of the protests. The Global Financial Crisis triggered the worst market downturn since the great depression. And ‘triggered’ is a wholly appropriate verb because the US in particular was well on its way to economic implosion anyway. The financial processes that fuelled the GFC had been building for years and the crash was a stark reminder that irresponsible actions have consequences.
Of course, most of us were kept in the dark and it soon became apparent it wasn’t just the US financial institutions that weren’t playing fair. In fact, a number of other countries were heading for a similar fate. And we all paid the price. Every one of us has felt the effects of the Global Financial Crisis. Some saw their investment portfolios halve in value, forcing them to work a few more years before retiring.
So what was behind the Global Financial Crisis? Well, without going into too much detail, (entire books have been written on the subject) let’s take a look at how it all started. Like most great down-turns, the GFC started with a bubble. In the US, housing prices were booming, unemployment was low, credit was easy and the government was encouraging the debt binge. More and more people were borrowing, housing prices began to rise, the economy was doing well and the share market was booming, as illustrated below:
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The US wasn’t alone. England, Ireland and many countries in Europe were on the same track. The problem in the US was the way this debt was on-sold. The initial loans were profitable but that wasn’t enough. Loans were packaged-up to make more money and sold again, spreading the risk across more and more stakeholders. Even today, debt is a highly-traded instrument and there are many ways of doing this. The value of debt depends on risk - the higher the risk, the higher the return. The lower the risk appears, the easier that debt is to sell.
It was the selling of these complex financial instruments, packaging what began as simple home loans, that drove the global economy down the dark, one-way street to financial melt-down. Perhaps the high-level executives who were responsible for this didn’t realise the magnitude of what they were doing. Perhaps they did and just didn’t care.
Mortgages were the most popular debt commodity traded by the major banks. They were easy to value, easy to assess into different ‘ratings’ and easy to sell. The credit ratings agencies got carried away with the collateralised debt market and didn’t adequately evaluate the associated risks. Finally, it was the rapid and contagious devaluation of these packaged risk investments that saw the GFC spiral out of control so quickly. The two most widely used instruments were Mortgage Backed Securities and Collateralised Debt Obligations and many major US investment banks were heavily invested in these. Over a number of years, the US government had relaxed the standards for these institutions and encouraged their competitive activities as they were contributing to a booming economy.
The GFC has happened and we cannot re-write the history books. A small number of people made a lot of money from the actions that led to the GFC and we have all paid the price since.
Occupy Wall Street shouldn’t be a case of “make someone pay” as much as it should be about “what can we do to protect our future?” How can every American, Australian, Greek or other nationality change the way we live, govern and conduct business to ensure future generations aren’t effected by the irresponsible actions of others? We must establish a system to ensure we can recognise, manage and avoid the pitfalls of greed, power and deregulation.
In next week’s Trading Tutors Newsletter, I will explore the instruments of debt in more detail and take a look at the banks that were caught out when the value of these instruments plummeted overnight.
Until next week,
Stay ahead of the game,