This is Part II of a three-part series on understanding a financial crisis. Click here for Part I.
Systemic Risk:
By early 2008, investors and the rest of the world were starting to lose confidence in the world's largest banks. News was starting to roll out about banks' heavy investments in sub-prime mortgages and risky derivatives and people were beginning to see just how interconnected all these banks had become. In March of 2008, rumors began to swirl about risky investments and a looming failure of Bear Stearns, one of the largest banks in the world. The stock began to drop, people were calling the bank asking to withdraw their money, and the bank was scrambling to meet all the demands and stop the pandemonium.
As Washington had gotten word of this, the president of the Federal Reserve, Tim Geithner, was called to assemble a team of investigators to determine how bad the books looked at Bear Stearns. In their investigation they discovered what central bankers fear more than anything: systemic risk. Systemic risk is easy to understand. Since all these banks owed each other money, if even one bank were to go bankrupt who would pay all the banks they owed money to? Then, if the banks who were owed money were not getting paid, how would they pay off the banks that they owed money to? Systemic risk is feared because it puts you in a situation where if one piece of the system fails the entire system goes down. In this case, the system was the global economy.
A Way Out:
Upon the completion of the investigation Geithner's team conducted at Bear Stearns, Geithner called Ben Bernanke, then Chairman of the Federal Reserve, and informed him that he believed Bear Stearns was "too big to fail" (in other words they were too interconnected with the rest of the world in order to be allowed to go bankrupt). Bernanke knew that if Bear failed it would bring down the entire financial system, so he suggested to Henry Paulson (then Treasury Secretary) that they "bail out" Bear Stearns by allowing another bank to buy their assets. In this way, Bear would be able to pay its creditors and avoid bankruptcy. Henry Paulson was very free-market in his way of thinking and called this a ridiculous idea, telling Bernanke that the market rewards and the market punishes. Paulson originally believed that Bear should be allowed to fail because they were in trouble due to their own greed, but changed his mind after he realized how bad the situation was. The Federal Reserve agreed to give JP Morgan $30 billion if JP Morgan would agree to buy Bear Stearns, and they did. Bear was sold for a mere $10 a share, only 7.5% of their 52-week high stock price before the crisis.
Average, hard-working investors who owned Bear Stearns stock lost more than 90% of their investment.
Paulson warned America of moral hazard. Moral hazard basically asks "if you bail someone out of a problem that they created themselves, what incentive do they have to not do the same thing again?" Paulson warned the major banks that the $30 billion Bear Stearns bailout was a one-time deal and that they were on their own and needed to manage their risks accordingly.
The Summer of Assurances:
After the Bear Stearns bailout, President George Bush gave control of the management of the spreading financial crisis to Henry Paulson. Paulson realized that in order for the system to continue to function and avoid failure, they had to keep money flowing into the banks. Since the main source of the banks' money was people, the Bush administration spent the summer of 2008 trying to reassure Americans and the rest of the world that everything was fine in the financial system and that they should trust the banks. They should continue to keep their money in the banks and trust that the situation would work itself out as long as confidence stayed high.
This reassurance campaign became known to some as the summer of assurances. Unfortunately no matter how much Paulson and the Bush administration reassured the world, a disaster was already inevitable. In the fall of 2008, it became obvious that Lehman Brothers, one of the United States largest investment banks, had become so riddled with toxic debt in sub-prime mortgages and risky derivatives that they would need to file for bankruptcy since they simply couldn't pay their bills to other banks and their investors.
The Aptly-named Dick Fuld:
Dick Fuld was the CEO of Lehman Brothers. While his bank made billions of dollars trading derivatives and collecting interest on loans, he took massive bonuses, lavish vacations and bought excessive material things. This was the kind of guy who would buy a yacht just because he could. Dick Fuld truly is, well, a dick. Anyway, Dick Fuld remembered that Paulson had bailed out Bear Stearns, and he knew that Lehman Brothers was in a similar if not worse situation. He tried to call Paulson's bluff and believed that the government would bail them out. He did nothing to mitigate the risk posed to the global economy and showed zero remorse for his lavish spending and ignorance of clear issues on Lehman's books. Paulson would stand firm though (as he rightfully should have). In early September on a Monday morning, Lehman Brothers announced that it had filed for bankruptcy and the Dow Jones Industrial Average plunged over 600 points.
Paulson was sitting on an incredibly difficult situation. He knew that since Lehman Brothers had failed, AIG would be right behind it since AIG had credit default swap agreements totaling over $400 billion with banks that Lehman Brothers owed money to. The financial crisis was starting to become uncontrollable. Paulson again switched teams in an effort to save the economy and the Federal Reserve reached an agreement to bail out AIG for over $180 billion. These inconsistent signals Paulson was sending (while somewhat understandable) had investors unsure of what to expect from the banks and from the Fed. People knew the problem was bad, but they didn't know how bad and they didn't know how long it would go on or what the government and the banks were doing to fix the problem. While Paulson and other members of the Bush administration tried to reassure Americans and the rest of the world that the crisis was under control, they all knew it really wasn't.
TARP:
As Lehman Brothers filed for bankruptcy and AIG was bailed out, shockwaves of financial panic began to rip through the market. There was no end in sight and no one knew how deep the roots of the problem went. Because of this uncertainty, Ben Bernanke recommended that Paulson go to Congress and establish a bailout "fund" which would allow them to relieve the pressure on the markets by setting money aside that the banks could use if they needed it to pay each other off. The idea was to restore confidence to the financial system so that banks could lend each other money again in a healthy way. Of course Congress was split down the middle on this, with some people believing that a bailout was the only way to resolve the problems and others believing that a bailout just sent a signal to the banks that they could do whatever they wanted, make billions, and taxpayers would pick up the pieces.
After much debate a program was finally created called TARP - or the Troubled Asset Relief Program. This was a $700 billion bailout "fund" that would be divided up amongst the banks that had the biggest financial problems. While it seems like this would take months to resolve, you should understand that the speed at which this whole situation happened was such that Paulson was only able to get the bill passed by telling congress that if they didn't pass it, the financial system of the world would melt down in a matter of days.
And it would have. The entire process happened in a matter of weeks.
After TARP was established, Paulson called the leaders of the largest investment banks together in New York and told them that they needed to take the money or they would face severe ramifications. While one CEO tried to deny receipt of the money because he believed it was wrong (Dick Kovacevich of Wells Fargo), they were all ultimately forced to sign the agreement that day and over $125 billion of the TARP fund was divided up between them. The money came with no stipulations. No regulatory changes, no limitations on bonuses or salaries, nothing. The banks were paid billions of dollars and received no punishment for their terribly risky and greedy behavior.
Friday, June 22, 2012
Thursday, June 7, 2012
Understanding a Financial Crisis - Part I
Between 2008 and 2011 the debacle that took place in the American banking system cost Americans 8.5 million jobs and erased over $11 trillion of their net worth. Headlines both old and new have instilled fear and raised questions, and still do, over whether this "crisis" or that "crisis" will soon be the end of the world. As an investor, I wanted to understand whether I should care about any of this or if it was just useless drivel designed to improve the news agencies' ratings. While much of it is indeed (in my opinion) useless drivel, the underlying theory and the danger of a financial crisis is real, and as an investor, a home buyer, a saver, or even a spender, you should care because it can directly affect the amount of money you possess.
This is part one of a three-part series that will detail in easy-to-understand terms how the 2008 financial crisis started, how it affected the global economy, what could have been done to prevent it, and how it is or is not still affecting the world (and your wallet) today.
A Little Background:
The first thing to understand is how a bank works. When you put your money in a bank, the bank doesn't just keep it there. It loans it out to others. If you put your money into a savings account that earns interest, the bank loans that money out to others who want to buy homes and cars or start businesses. Banks charge interest on their loans, and logically, more than they pay on things like savings accounts, CDs, and other interest-bearing accounts. This is how banks make money. They "buy" money from people and pay in the form of interest rates, and "sell" it to others as loans which they charge higher interest rates on. Additionally banks charge fees for various things and make investments in stocks, bonds and other investment vehicles. These practices all exist so the bank can pay you a fair interest rate and still make money by loaning your money out to others.
Today, most banks in developed countries function under a system called fractional reserve banking which basically means that they can loan out a set percentage of the deposits they have on hand and the rest they have to keep available in cash in case the depositors (you and I) want their money. The amount they must keep on hand is known as the reserve requirement or reserve ratio, and in the United States it's set by the Federal Reserve (aka the Fed). If you clicked the link above, you'll see that if you deposit $100 into a bank, at a reserve rate of 10% it would keep $10 and loan out $90. The person who gets that loan will either buy something with it or put it into another bank. If they buy something, the seller will put that money in the bank. Ultimately it will just end up in another bank. The second bank then has $90 and they must keep 10% on hand, so they keep $9 and loan out $81. The money is spent again and the next bank loans out $72.90 and keeps $8.10 on hand. This continues until the supply of the original $100 is exhausted. Theoretically, this system will never break down as long as the people that the banks are loaning money to continue to make their payments. The problem is that the system is entirely built upon trust, and this is where a financial crisis begins.
The Setup:
As we noted above, when a bank loans out money it is required to keep a certain amount of cash on hand in case of a default on that loan, but banks don't want a lot of cash; They want to loan out money so they can charge interest on it and make money for themselves (like any other business). In the early 90's, a group of young JP Morgan bankers (mostly in their 20s) were tasked with finding a way to reduce the risks associated with loaning out money, since if the risk on the loan were lower the fed wouldn't require the bank to keep as much cash on hand and they would have more money to loan out and charge interest on. The idea that they came up with to reduce risk was called a credit default swap. It was sort of like an insurance policy protecting against the possibility of default on a loan. Basically, the bank would loan out money and then turn around and say to another bank "we want to make another loan, so if you guarantee us that you will pay us if the person defaults, we'll pay you a monthly payment for that protection." Of course other banks agreed to this because they were being compensated with money they could then loan out and charge interest on, making more for themselves.
The Growth of a New Kind of Banking:
At first, credit default swaps were only made on very secure loans (those that the bank made to companies that they trusted would pay back what they borrowed). The first major credit default swap involved JP Morgan, ExxonMobil and the European Bank for Reconstruction and Development (EBRD). After ExxonMobil spilled 11 million gallons of oil off the coast of Alaska in the Exxon-Valdez oil spill, they took out a multi-billion dollar loan from JP Morgan to handle lawsuits and reconstruction/fallout costs. JP Morgan knew this was risky but they trusted ExxonMobil so they agreed, loaned them the money and then turned around to EBRD and made a deal to pay them if they would agree to assume the multi-billion dollar liability if ExxonMobil couldn't pay it back. This type of credit default swap quickly spread as banks realized that they could make a lot more money by reducing their reserve requirements through using credit default swaps. It allowed them to loan out way more money than they could ever repay if there were a string of defaults on the loans or a run on the bank in which everyone wanted their money at once. Still, this practice was accepted and utilized for a long time, mainly with big, well-known companies that the banks trusted. Companies like Johnson and Johnson, Proctor & Gamble, Microsoft, Apple, and WalMart. But there was a problem with all of this.
Obviously, for the banks who were obligated to pay another bank's loan back should the borrower default, the credit default swaps were a form of risk. If ExxonMobil defaulted on their loan, for example, JP Morgan would stop making payments to EBRD and EBRD could potentially owe JP Morgan billions of dollars. Of course EBRD and JP Morgan would have agreed to terms they both thought were favorable in terms of risk to reward, but it was still risk for EBRD. JP Morgan realized that they could offset more of their loan risk if they pooled the loans together and split them into different risk levels. For example, there might be a pool of very low risk loans to companies like Microsoft, Apple and ExxonMobil, and a pool of loans with more risk (i.e. the borrower was more likely to not be able to pay it back) to smaller, unknown companies or businesses that had poor earnings or credit ratings. Likewise, it would theoretically be less risky for EBRD to agree to pay out on a collection of low risk loans than it would for them to agree to pay out on a collection of high risk loans. And so JP Morgan pooled their loans together into things called CDOs or Collateralized Debt Obligations and split them into different risk levels, then tried to make deals with other banks to offset the risks of the various CDOs. Other banks ate it up because it basically gave them the ability to say "If you want us to agree to pay you if these high-risk loans default, you'll have to pay us more each month." Cha-ching! More money.
This form of "risk reduction" spread like wildfire throughout the financial world. Banks everywhere were starting to become more and more willing to give credit to riskier and riskier borrowers, because they could slap high interest charges on the loans and make more money. The goal, obviously, was still to charge a high interest rate on the high-risk loans and pay other banks slightly lower monthly payments to assume the risk if the borrower defaulted. In this way, the banks giving out the loans could make a profit and have more money to loan out and continue the process. For them, the sky was the limit. In theory, there is absolutely no limit to the amount of money that can be made with this system.
Unless the borrowers start to miss their payments.
Warnings:
As this process began to spiral out of control, Washington started to get wind of it and a fierce battle ensued. The argument was over whether or not the trading of these financial instruments should be regulated (like the stock exchange is regulated by the SEC) or not. Up to this point, all of these transactions involving loans, credit default swaps and CDOs occurred in what is known as a dark market, or a market that is not regulated by any federal or international agency. In the dark market there were no reporting requirements. The banks weren't obligated to tell anyone, not the SEC, not the federal reserve, and certainly not the public how much risk they were taking on or how much money they were making on it. So congressional representatives (the smart ones, if there are any of those) lobbied for more regulation. Unfortunately for Washington, money is power, and the banks had no problem at all funding the campaigns of the political representatives who would side with them and vote for no regulation.
Ultimately, the banks would win because they had the money and the power. The chairman of the Federal Reserve at the time, Alan Greenspan, argued that regulation was not required because the transactions were being carried out by seasoned professionals who could manage their own risk and regulate themselves. To him establishment of a regulating agency for these types of markets would be a waste of taxpayer money. The lack of regulation continued, and banks soon learned that they could apply the same principles they had used on corporate loans to consumer loans. They began pooling together groups of mortgages and trading the CDOs amongst themselves.
A Looming Disaster:
As banks pooled more and more mortgages and corporate loans together, stranger and stranger derivatives of these securities began to appear. Consider the JP Morgan/EBRD/ExxonMobil example from above. EBRD could offset the risk of having to pay JP Morgan by paying Citigroup or another bank monthly premiums to assume the risk. In this way, if ExxonMobil defaulted on the loan, JP Morgan would activate its agreement with EBRD, and EBRD would activate its agreement with Citigroup. Citigroup would pay EBRD, who would then pay JP Morgan, and ExxonMobil would go bankrupt. Just like banks bundled groups of loans together, they learned that they could bundle groups of credit default swap agreements together and trade them as synthetic CDOs. The problem with all of this is that the risk of ExxonMobil defaulting (no matter how small it was) never actually went away. It was just passed from JP Morgan to EBRD and then to Citigroup. Because these markets were not regulated, banks could simply pass the risk along to anyone else who would agree to take it. And why wouldn't you agree to it if you could get paid for it and then just pass it off to someone else?
The system seemed to be working perfectly. Stocks were booming, the financial world was experiencing heavy growth, housing prices were rising, and all was well. As banks became more and more greedy though, they started to write mortgages to riskier and riskier borrowers. Some borrowers made very little monthly income, had low credit ratings, a history of not paying their bills, or simply couldn't afford what they wanted to buy based on their income. This didn't matter to the banks because the more money they could loan out the more money they could make by trading the derivatives of the loans such as credit default swaps, CDOs and synthetic CDOs. These mortgages that were given to people sometimes had extremely high interest rates or very long payback terms, some rates as high as 42% and terms longer than a person's lifespan. Many regulators and banking professionals now admit that there were a slew of mortgages handed out that they knew didn't make any financial sense. These mortgages were known as sub-prime mortgages and were the main ingredient in the "sub-prime mortgage crisis" we hear so much about.
The Inevitable Crash:
As time went on, some banks, particularly Goldman Sachs, began to realize that something wasn't right. Because they realized that a crash was coming, they decided to "prepare" by taking advantage of it. Goldman is now known to have pooled together collections of CDOs backed by sloppy sub-prime mortgages and sold them to their customers, then bet against their own customers by issuing credit default swaps against the CDOs! As Goldman knew that the mortgages would never last, they made agreements with other banks to pay them attractive fees in exchange for a payout if the borrowers defaulted. One of these banks was a German bank called IKB. They continued to assume Goldmans' "risk" (which was at this point almost a certainty) because they assumed it was unlikely that all the loans would default at once and Goldman was paying them attractive fees for the protection. Their assumptions were wrong. In 2007, IKB was the first bank to fail because it couldn't pay off its credit default swap obligations when the underlying mortgages and loans started to go bust.
As the news of the IKB crash spread, other banks quickly (and cleverly) began attempting to write off their risk to each other, but it was too late. Housing prices were plummeting and defaults were everywhere. Because of the string of defaults (which should be been forseeable since these borrowers were known to be high-risk!) a chain reaction of credit default swap payment requirements was initiated. Basically, everyone in the world owed everyone else in the world money. In 2008, AIG was on the hook for over $440 billion in credit default swap payments and there was no conceivable way they could pay it.
In Part II:
We'll talk about how the failure of IKB led to a loss of confidence in the global financial system and what happened to AIG with that $440 billion in debt. You'll also see how the crisis really became a crisis and how it affected average investors. Read on!
This is part one of a three-part series that will detail in easy-to-understand terms how the 2008 financial crisis started, how it affected the global economy, what could have been done to prevent it, and how it is or is not still affecting the world (and your wallet) today.
A Little Background:
The first thing to understand is how a bank works. When you put your money in a bank, the bank doesn't just keep it there. It loans it out to others. If you put your money into a savings account that earns interest, the bank loans that money out to others who want to buy homes and cars or start businesses. Banks charge interest on their loans, and logically, more than they pay on things like savings accounts, CDs, and other interest-bearing accounts. This is how banks make money. They "buy" money from people and pay in the form of interest rates, and "sell" it to others as loans which they charge higher interest rates on. Additionally banks charge fees for various things and make investments in stocks, bonds and other investment vehicles. These practices all exist so the bank can pay you a fair interest rate and still make money by loaning your money out to others.
Today, most banks in developed countries function under a system called fractional reserve banking which basically means that they can loan out a set percentage of the deposits they have on hand and the rest they have to keep available in cash in case the depositors (you and I) want their money. The amount they must keep on hand is known as the reserve requirement or reserve ratio, and in the United States it's set by the Federal Reserve (aka the Fed). If you clicked the link above, you'll see that if you deposit $100 into a bank, at a reserve rate of 10% it would keep $10 and loan out $90. The person who gets that loan will either buy something with it or put it into another bank. If they buy something, the seller will put that money in the bank. Ultimately it will just end up in another bank. The second bank then has $90 and they must keep 10% on hand, so they keep $9 and loan out $81. The money is spent again and the next bank loans out $72.90 and keeps $8.10 on hand. This continues until the supply of the original $100 is exhausted. Theoretically, this system will never break down as long as the people that the banks are loaning money to continue to make their payments. The problem is that the system is entirely built upon trust, and this is where a financial crisis begins.
The Setup:
As we noted above, when a bank loans out money it is required to keep a certain amount of cash on hand in case of a default on that loan, but banks don't want a lot of cash; They want to loan out money so they can charge interest on it and make money for themselves (like any other business). In the early 90's, a group of young JP Morgan bankers (mostly in their 20s) were tasked with finding a way to reduce the risks associated with loaning out money, since if the risk on the loan were lower the fed wouldn't require the bank to keep as much cash on hand and they would have more money to loan out and charge interest on. The idea that they came up with to reduce risk was called a credit default swap. It was sort of like an insurance policy protecting against the possibility of default on a loan. Basically, the bank would loan out money and then turn around and say to another bank "we want to make another loan, so if you guarantee us that you will pay us if the person defaults, we'll pay you a monthly payment for that protection." Of course other banks agreed to this because they were being compensated with money they could then loan out and charge interest on, making more for themselves.
The Growth of a New Kind of Banking:
At first, credit default swaps were only made on very secure loans (those that the bank made to companies that they trusted would pay back what they borrowed). The first major credit default swap involved JP Morgan, ExxonMobil and the European Bank for Reconstruction and Development (EBRD). After ExxonMobil spilled 11 million gallons of oil off the coast of Alaska in the Exxon-Valdez oil spill, they took out a multi-billion dollar loan from JP Morgan to handle lawsuits and reconstruction/fallout costs. JP Morgan knew this was risky but they trusted ExxonMobil so they agreed, loaned them the money and then turned around to EBRD and made a deal to pay them if they would agree to assume the multi-billion dollar liability if ExxonMobil couldn't pay it back. This type of credit default swap quickly spread as banks realized that they could make a lot more money by reducing their reserve requirements through using credit default swaps. It allowed them to loan out way more money than they could ever repay if there were a string of defaults on the loans or a run on the bank in which everyone wanted their money at once. Still, this practice was accepted and utilized for a long time, mainly with big, well-known companies that the banks trusted. Companies like Johnson and Johnson, Proctor & Gamble, Microsoft, Apple, and WalMart. But there was a problem with all of this.
Obviously, for the banks who were obligated to pay another bank's loan back should the borrower default, the credit default swaps were a form of risk. If ExxonMobil defaulted on their loan, for example, JP Morgan would stop making payments to EBRD and EBRD could potentially owe JP Morgan billions of dollars. Of course EBRD and JP Morgan would have agreed to terms they both thought were favorable in terms of risk to reward, but it was still risk for EBRD. JP Morgan realized that they could offset more of their loan risk if they pooled the loans together and split them into different risk levels. For example, there might be a pool of very low risk loans to companies like Microsoft, Apple and ExxonMobil, and a pool of loans with more risk (i.e. the borrower was more likely to not be able to pay it back) to smaller, unknown companies or businesses that had poor earnings or credit ratings. Likewise, it would theoretically be less risky for EBRD to agree to pay out on a collection of low risk loans than it would for them to agree to pay out on a collection of high risk loans. And so JP Morgan pooled their loans together into things called CDOs or Collateralized Debt Obligations and split them into different risk levels, then tried to make deals with other banks to offset the risks of the various CDOs. Other banks ate it up because it basically gave them the ability to say "If you want us to agree to pay you if these high-risk loans default, you'll have to pay us more each month." Cha-ching! More money.
This form of "risk reduction" spread like wildfire throughout the financial world. Banks everywhere were starting to become more and more willing to give credit to riskier and riskier borrowers, because they could slap high interest charges on the loans and make more money. The goal, obviously, was still to charge a high interest rate on the high-risk loans and pay other banks slightly lower monthly payments to assume the risk if the borrower defaulted. In this way, the banks giving out the loans could make a profit and have more money to loan out and continue the process. For them, the sky was the limit. In theory, there is absolutely no limit to the amount of money that can be made with this system.
Unless the borrowers start to miss their payments.
Warnings:
As this process began to spiral out of control, Washington started to get wind of it and a fierce battle ensued. The argument was over whether or not the trading of these financial instruments should be regulated (like the stock exchange is regulated by the SEC) or not. Up to this point, all of these transactions involving loans, credit default swaps and CDOs occurred in what is known as a dark market, or a market that is not regulated by any federal or international agency. In the dark market there were no reporting requirements. The banks weren't obligated to tell anyone, not the SEC, not the federal reserve, and certainly not the public how much risk they were taking on or how much money they were making on it. So congressional representatives (the smart ones, if there are any of those) lobbied for more regulation. Unfortunately for Washington, money is power, and the banks had no problem at all funding the campaigns of the political representatives who would side with them and vote for no regulation.
Ultimately, the banks would win because they had the money and the power. The chairman of the Federal Reserve at the time, Alan Greenspan, argued that regulation was not required because the transactions were being carried out by seasoned professionals who could manage their own risk and regulate themselves. To him establishment of a regulating agency for these types of markets would be a waste of taxpayer money. The lack of regulation continued, and banks soon learned that they could apply the same principles they had used on corporate loans to consumer loans. They began pooling together groups of mortgages and trading the CDOs amongst themselves.
A Looming Disaster:
As banks pooled more and more mortgages and corporate loans together, stranger and stranger derivatives of these securities began to appear. Consider the JP Morgan/EBRD/ExxonMobil example from above. EBRD could offset the risk of having to pay JP Morgan by paying Citigroup or another bank monthly premiums to assume the risk. In this way, if ExxonMobil defaulted on the loan, JP Morgan would activate its agreement with EBRD, and EBRD would activate its agreement with Citigroup. Citigroup would pay EBRD, who would then pay JP Morgan, and ExxonMobil would go bankrupt. Just like banks bundled groups of loans together, they learned that they could bundle groups of credit default swap agreements together and trade them as synthetic CDOs. The problem with all of this is that the risk of ExxonMobil defaulting (no matter how small it was) never actually went away. It was just passed from JP Morgan to EBRD and then to Citigroup. Because these markets were not regulated, banks could simply pass the risk along to anyone else who would agree to take it. And why wouldn't you agree to it if you could get paid for it and then just pass it off to someone else?
The system seemed to be working perfectly. Stocks were booming, the financial world was experiencing heavy growth, housing prices were rising, and all was well. As banks became more and more greedy though, they started to write mortgages to riskier and riskier borrowers. Some borrowers made very little monthly income, had low credit ratings, a history of not paying their bills, or simply couldn't afford what they wanted to buy based on their income. This didn't matter to the banks because the more money they could loan out the more money they could make by trading the derivatives of the loans such as credit default swaps, CDOs and synthetic CDOs. These mortgages that were given to people sometimes had extremely high interest rates or very long payback terms, some rates as high as 42% and terms longer than a person's lifespan. Many regulators and banking professionals now admit that there were a slew of mortgages handed out that they knew didn't make any financial sense. These mortgages were known as sub-prime mortgages and were the main ingredient in the "sub-prime mortgage crisis" we hear so much about.
The Inevitable Crash:
As time went on, some banks, particularly Goldman Sachs, began to realize that something wasn't right. Because they realized that a crash was coming, they decided to "prepare" by taking advantage of it. Goldman is now known to have pooled together collections of CDOs backed by sloppy sub-prime mortgages and sold them to their customers, then bet against their own customers by issuing credit default swaps against the CDOs! As Goldman knew that the mortgages would never last, they made agreements with other banks to pay them attractive fees in exchange for a payout if the borrowers defaulted. One of these banks was a German bank called IKB. They continued to assume Goldmans' "risk" (which was at this point almost a certainty) because they assumed it was unlikely that all the loans would default at once and Goldman was paying them attractive fees for the protection. Their assumptions were wrong. In 2007, IKB was the first bank to fail because it couldn't pay off its credit default swap obligations when the underlying mortgages and loans started to go bust.
As the news of the IKB crash spread, other banks quickly (and cleverly) began attempting to write off their risk to each other, but it was too late. Housing prices were plummeting and defaults were everywhere. Because of the string of defaults (which should be been forseeable since these borrowers were known to be high-risk!) a chain reaction of credit default swap payment requirements was initiated. Basically, everyone in the world owed everyone else in the world money. In 2008, AIG was on the hook for over $440 billion in credit default swap payments and there was no conceivable way they could pay it.
In Part II:
We'll talk about how the failure of IKB led to a loss of confidence in the global financial system and what happened to AIG with that $440 billion in debt. You'll also see how the crisis really became a crisis and how it affected average investors. Read on!
Tuesday, June 5, 2012
The Importance of Happiness
One of the things that many traders and investors take for granted is their happiness. Investing, and especially daytrading, can be extremely stressful and emotionally demanding. Thus as silly as it may seem, your success in this business is vitally dependent upon your health and your happiness.
Recently I found myself falling into a depression-like state of chronic boredom and general blasé. Of course I wasn't actually depressed, but if you know me you know that normally I'm a very upbeat person. I have a dry, sarcastic sense of humor, am full of energy and love to, for lack of better terminology, give people crap. That all started to change because I was working so hard at trading and at my full time job and trying to tackle a million things at once. I had stopped going to the gym, stopped eating healthy food, started staying up way too late and reduced the amount of time I spent doing things I am really passionate about, like playing keyboard and singing karaoke.
I found myself constantly listening to slow, ambient music when I got home from work, simply dimming the lights down and settling into a chair to read or review my trades for the day. I would keep telling myself, "I'm dead tired, I need to crash at like 8pm tonight" but I never would. Instead I would sit up reading or browsing Facebook or Twitter, or watching mindless TV shows on Netflix, until the next thing I knew it was 2am and I realized I needed to go to bed because I had to wake up at 7am for work the next day. I'd do this all week long until the weekend when all I'd want to do is sleep.
I live ten minutes from the ocean and I didn't even want to go to the beach.
Instead I'd sleep until 12 or 1pm because I was so exhausted from the week and when I got up, I'd literally walk around the apartment in my underwear all day putting off doing laundry, doing the dishes, cleaning my apartment and exercising. I would just sit around and read about trading or waste time on Twitter, Facebook or Netflix, using "I'm 100% focused on my desire to become a professional trader" as an excuse.
Then one of my good friends did something that started a chain reaction of rapid change - a return to the way I used to be - for me: he decided to boycott social networking for 30 days and committed himself to doing it by posting his farewell on Facebook, to his 100,000 Twitter followers, and on his blog.
Of course it seems like this would be completely unrelated to investing, but it wasn't. At least not for me. I had become a zombie. It's not that this is necessarily a bad thing sometimes. Sometimes you do need to cut everything out and focus 100% of your energy on one thing, but that lifestyle is not sustainable if you want to maintain happiness and good health over the long term. I decided to join my buddy in his crusade to exile the social networking scene from his life and I cut Facebook and Twitter out of my life entirely.
With the extra free time, I now suddenly had time to read all I wanted about trading and investing but still accomplish other things. Things as simple as cleaning my apartment regularly so I wasn't annoyed by having to wash a plate just to eat dinner since I had put off doing the dishes for 4 days (that is, if I actually had any decent food as I would have if I hadn't put off grocery shopping too). I had time to go to the gym. I could still go to bed at a reasonable hour and wake up feeling well-rested, strong and ready for work.
The point is that I had no idea how much time I was wasting and just how much I had neglected my physical health and my happiness and how it was affecting my ability to accomplish the things I really cared about in life (my career, my goal of going pro as a trader, spending time with my best friends, and generally being happy). My trading suffered because of it: I pushed through a period where almost every single trade I made was a complete failure. I would get annoyed at my failures because I was tired and overly irritable and caught myself overtrading in an attempt to recover losses, and this would only lead to more losses which would make me more irritable and give me an excuse to go home and fill my brain with new things to try the next day. It was an unhealthy path of destruction leading only to ultimate failure of my major goals if I had continued.
What I really needed to do was take a step back and fix myself.
I started going to the gym again. I went grocery shopping and bought healthy food. I bought tons of fresh produce and red meats. I cooked amazing dinners from recipes I had or new ones I found online. I started coming home for lunch to make fresh food instead of going to eat at Subway. I made a pact with myself to stop putting things off - stupid things like doing the laundry, doing the dishes and cleaning my apartment - until the last minute when I had to do them under stressful conditions since I had to do them all at once. I started doing karaoke again on Thursday nights with another good friend of mine, going out to grab a beer or two, and started jamming on the keyboard again with a buddy who plays guitar. All of this and I still managed to get to bed earlier so I would be well-rested the next day. Most importantly, I spent some money on me. I signed up for a daytrading bootcamp and bought myself a brand new laptop that will allow me to use all the expensive recording equipment I have to record some new music and throw it up on YouTube.
I can't tell you how much of a difference it has made.
Over the last month or so, my trading has improved exponentially. Lately I feel confident, strong and knowledgeable in all aspects of life. Because of this my trading and investing performance has improved greatly, which means money in the bank for me, the ultimate goal of any investor.
So be healthy. Be happy. Exercise. Eat well. If you are a newer investor, don't fall into the trap of becoming "over-educated." It's easy to do in this fast-paced world, so put yourself first. Don't become consumed by the chase of the almighty dollar. Benjamin Franklin said that the only things that are certain in this world are death and taxes. I disagree - I think there are three things: death, taxes, and the existence of the stock market. It will be here tomorrow if you need to take a break and go to the gym or go for a jog, so go do it. You'll be surprised how much being healthy and happy will benefit your investing performance.
Recently I found myself falling into a depression-like state of chronic boredom and general blasé. Of course I wasn't actually depressed, but if you know me you know that normally I'm a very upbeat person. I have a dry, sarcastic sense of humor, am full of energy and love to, for lack of better terminology, give people crap. That all started to change because I was working so hard at trading and at my full time job and trying to tackle a million things at once. I had stopped going to the gym, stopped eating healthy food, started staying up way too late and reduced the amount of time I spent doing things I am really passionate about, like playing keyboard and singing karaoke.
I found myself constantly listening to slow, ambient music when I got home from work, simply dimming the lights down and settling into a chair to read or review my trades for the day. I would keep telling myself, "I'm dead tired, I need to crash at like 8pm tonight" but I never would. Instead I would sit up reading or browsing Facebook or Twitter, or watching mindless TV shows on Netflix, until the next thing I knew it was 2am and I realized I needed to go to bed because I had to wake up at 7am for work the next day. I'd do this all week long until the weekend when all I'd want to do is sleep.
I live ten minutes from the ocean and I didn't even want to go to the beach.
Instead I'd sleep until 12 or 1pm because I was so exhausted from the week and when I got up, I'd literally walk around the apartment in my underwear all day putting off doing laundry, doing the dishes, cleaning my apartment and exercising. I would just sit around and read about trading or waste time on Twitter, Facebook or Netflix, using "I'm 100% focused on my desire to become a professional trader" as an excuse.
Then one of my good friends did something that started a chain reaction of rapid change - a return to the way I used to be - for me: he decided to boycott social networking for 30 days and committed himself to doing it by posting his farewell on Facebook, to his 100,000 Twitter followers, and on his blog.
Of course it seems like this would be completely unrelated to investing, but it wasn't. At least not for me. I had become a zombie. It's not that this is necessarily a bad thing sometimes. Sometimes you do need to cut everything out and focus 100% of your energy on one thing, but that lifestyle is not sustainable if you want to maintain happiness and good health over the long term. I decided to join my buddy in his crusade to exile the social networking scene from his life and I cut Facebook and Twitter out of my life entirely.
With the extra free time, I now suddenly had time to read all I wanted about trading and investing but still accomplish other things. Things as simple as cleaning my apartment regularly so I wasn't annoyed by having to wash a plate just to eat dinner since I had put off doing the dishes for 4 days (that is, if I actually had any decent food as I would have if I hadn't put off grocery shopping too). I had time to go to the gym. I could still go to bed at a reasonable hour and wake up feeling well-rested, strong and ready for work.
The point is that I had no idea how much time I was wasting and just how much I had neglected my physical health and my happiness and how it was affecting my ability to accomplish the things I really cared about in life (my career, my goal of going pro as a trader, spending time with my best friends, and generally being happy). My trading suffered because of it: I pushed through a period where almost every single trade I made was a complete failure. I would get annoyed at my failures because I was tired and overly irritable and caught myself overtrading in an attempt to recover losses, and this would only lead to more losses which would make me more irritable and give me an excuse to go home and fill my brain with new things to try the next day. It was an unhealthy path of destruction leading only to ultimate failure of my major goals if I had continued.
What I really needed to do was take a step back and fix myself.
I started going to the gym again. I went grocery shopping and bought healthy food. I bought tons of fresh produce and red meats. I cooked amazing dinners from recipes I had or new ones I found online. I started coming home for lunch to make fresh food instead of going to eat at Subway. I made a pact with myself to stop putting things off - stupid things like doing the laundry, doing the dishes and cleaning my apartment - until the last minute when I had to do them under stressful conditions since I had to do them all at once. I started doing karaoke again on Thursday nights with another good friend of mine, going out to grab a beer or two, and started jamming on the keyboard again with a buddy who plays guitar. All of this and I still managed to get to bed earlier so I would be well-rested the next day. Most importantly, I spent some money on me. I signed up for a daytrading bootcamp and bought myself a brand new laptop that will allow me to use all the expensive recording equipment I have to record some new music and throw it up on YouTube.
I can't tell you how much of a difference it has made.
Over the last month or so, my trading has improved exponentially. Lately I feel confident, strong and knowledgeable in all aspects of life. Because of this my trading and investing performance has improved greatly, which means money in the bank for me, the ultimate goal of any investor.
So be healthy. Be happy. Exercise. Eat well. If you are a newer investor, don't fall into the trap of becoming "over-educated." It's easy to do in this fast-paced world, so put yourself first. Don't become consumed by the chase of the almighty dollar. Benjamin Franklin said that the only things that are certain in this world are death and taxes. I disagree - I think there are three things: death, taxes, and the existence of the stock market. It will be here tomorrow if you need to take a break and go to the gym or go for a jog, so go do it. You'll be surprised how much being healthy and happy will benefit your investing performance.
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