With the Treasury and the Federal Reserve desperately throwing in unprecedented sums to stem the ongoing financial crisis, ordinary people have a right to ask, ‘How did these big financial institutions lose all this money? Where did it go?’
The money went various places. Losses on residential mortgages are the precipitating factor in this crisis, a fancy term for “the straw that broke the camel’s back.” They are far from the only cause. But let’s start there.
Mortgage lenders made loans liberally at low rates of interest, lower in retrospect than the levels needed to cover the risk of the loans. Easy money boosted housing prices, motivating builders to construct more and bigger houses than was sustainable in the long run.
So real resources, such as building materials and construction workers’ time, went into houses that were not needed or that were bigger than their owners would be able to afford if the economy soured. This is part of where the money went.
Cheap refinancing induced people to take equity out of their houses and buy boats, go on cruises, pay down credit card debt (and then go out and charge more) or simply buy clothes for the kids or pay medical bills. As a society, we consumed more than we should have relative to what we produced and to long-run prospects for our personal finances. This is a second chunk of money.
Financial firms packaging mortgages or investing in them booked big profits, often before the profits were actually realized. They paid big dividends to shareholders or partners and big bonuses to CEOs and traders.
These people bought Jaguars, built mansions in Connecticut and bought vacation homes around the globe. Some of the money went for cocaine and hookers, although probably much less than legend would have it. Prudent ones socked much away. (Treasury Secretary Henry Paulson, a former CEO of Goldman Sachs, has an estimated net worth of $700 million.)
Some of the losses may be only on paper. Someone bought a mortgage-backed bond for $10,000 and if they tried to sell it now, they might only get $2,000. They have “lost” $8,000.
It will be a real loss if they have to sell now. If they don’t, the value may go back up. But the bond may never be worth $10,000 again and with a sour economy, tighter credit and expected high inflation, it may not regain much at all.
For a highly leveraged hedge fund or investment bank that bought $1 million in such bonds using $50,000 of company money and borrowing $950,000, a 5 percent decline in the value of a bond wipes out all of their equity.
Such “leverage” means that even moderate drops in the value of these securities can break an investment bank.
Such losses in a financial sector that we allowed to take on enormous leverage outweigh actual write-offs on bad mortgages several times over. But knowing that doesn’t help much right now.
There are other places the money went, but, like 500 hedge-fund managers in the bottom of the ocean, it is a start.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.