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Sunday, October 19, 2008

Financial Crisis

It's been called a market crash, a financial meltdown, fiscal Armageddon and more. It seems the media - and the government officials - can't find strong enough words to describe the financial industry in the western world. A presidential candidate has called it "the worst crisis since the Great Depression." (I wonder how many people alive today are familiar with the Great Depression.) Whatever it is, it is sobering for all of us. It strikes fear in our hearts.

But there are some truths about the current financial markets in the western world (led by the United States). Of course they are not the obvious. Truth is rarely obvious. It gets obscured by the circumstances. But let's be clear ... truth is relevant. That it is often obscure doesn't diminish its relevance. So it would seem that what's true is also what's important. It's sort of like the difference between the urgent and the important. Urgent isn't always true, but it is always demanding. And important isn't always apparent, but it is relevant. So let's take a look at some truths about today's situation.

To begin with, much of what we are seeing in the marketplace is hype. For example, it has been said that as much as $2 trillion worth of wealth has been wiped out in this recent crisis. That is not exactly the truth. Most of us haven't actually lost any real money. If you hold stock in a company, and the market suddenly decides that company isn't as precious today as it was yesterday - you still own the company. You just now own a company that the market doesn't seem to appreciate as much as it used to. But you haven't actually lost any real money. Unless you decided to sell that stock for less than you paid for it, you never actually lose the money. And let's be clear about one more thing: just because the market doesn't think the company is as precious today as it thought it was yesterday doesn't mean that the market is right today - or that the market was right yesterday! You have to look at the fundamentals of the company - it's business, it's market, it's leadership, etc. (And you should have done that before you bought the stock.) Business fundamentals rarely collapse overnight.

Secondly, much of the so-called "market crash" is occurring because people are making decisions in a panic-mode. They are making irrational decisions, and behaving irrationally. Dumping shares and taking losses because you are afraid of the future is irrational! Consider, for example, if your neighbors all told you they were selling at a loss, would that motivate you to suddenly "dump" your house for half its value? Would you suddenly be inspired to agree with the market and take 50% of the appraised value for your house? What if your neighbors brought you a professional looking appraisal, completed by someone perceived to be competent? Would you then dump your house for half its value? Most of us would not. And yet that's exactly what we do when it comes to the stock market.

Finally, let's talk about the mortgage market. It's an interesting subject. Many people are mad about Fannie Mae and Freddie Mac. Many more are angry about the supposed $700 billion bail-out bill that was recently passed. But what is true of this situation? For starters, the government chartered Fannie Mae back in the 1930's to facilitate housing finance. It operated effectively for decades. In the 1970's Fannie Mae was privatized and the government created Freddie Mac to provide competition for Fannie Mae! Again, both functioned effectively and housing finance was available.

In 1977, Solomon Brothers issued the first private mortgage-backed securities. This was the first time any mortgage financing was offered on the national or global markets outside of a government sponsored enterprise (aka "GSE"). It was an important milestone in that it moved us from a housing finance industry to a mortgage banking industry. There is an important distinction between the two. Housing finance facilitates a basic human need (housing). But mortgage banking facilitated basic human greed.

The mortgage banking industry fueled our nation's greed on all levels. The people who made the loans got greedy and pushed mortgages with wild abandon. They were racking up commissions that were unbelievable. For instance, loan officers with Countrywide Mortgage were making as much as $1 million or more - with no college degree, no particular skills, and not facilitating any human need. Wall Street also got greedy. In 2007, Wall Street paid more than $64 billion in commissions to men and women who traded mortgage securities in the global markets. And let's not forget the consumers who took out the mortgages. They financed boats, nose jobs, tummy tucks, cruises, mid-life crises, divorces and many other things besides any basic human need.

In light of this distinction between the housing finance industry and the mortgage banking industry, it would be wise to consider these realities. Perhaps the government intervention can get us back to the basics of housing finance - which functioned effectively for decades - without government bail-outs or subsidies. I'm sorry that shareholders in Fannie Mae or Freddie Mac appear to have been wiped out by the government's intervention (and the jury is still out on whether or not they were). But it if restores a market discipline that makes sense and helps our nation focus on financing fundamental human needs instead of fundamental human greed --- then I'm not so sure this is a bad thing.

There is no question that the chaos in the marketplace is unnerving. But a wise man (or woman) will stop paying so much attention to the urgent - and spend some time looking for and giving strong consideration to the important. After all, important is where the truth usually lives!

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