A Once in a Century Credit Tsunami

Posted: Tuesday, Nov 04, 2008 - 12:55:33 pm PST
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That is what Alan Greenspan, former Chairman of the Federal Reserve, told Congress last week. He explained that the catalyst for this crisis was the unbelievable number of mortgages that were given to people who simply could not afford to make their monthly payments. These sub-prime mortgages are the ones that were originated by banks and then purchased by Fannie Mae and Freddie Mac, the two mortgage giants that have now been taken over by the federal government. He said that, as bad as these loans were, the problem was magnified many times over by the securitization of these mortgages. The short explanation is that these derivative securities, called credit default swaps (CDS), were leveraged up to 30 times the original mortgage security value, thus greatly magnifying the problem. It was all based on a house of cards that fell when the real estate bubble burst.

He made one point I found of special interest. He said that the model for pricing these securities came from a Nobel Prize winner in economics “about 20 years ago.” He didn’t mention his name, but his name doesn’t really matter. What matters is that Greenspan said the data this economist used to construct his model for pricing security derivatives was based on roughly the previous 20 years of credit data leading up to his Nobel Prize. The problem, according to Greenspan, was that the 20 years he used was a relatively good time for credit markets around the world. Had he included a time frame that encompassed bad credit markets as well as good ones, his pricing model would have made these derivatives much less attractive, lowering demand for them, thus lowering and minimizing their prices, rather than maximizing the credit crisis.

If you have ever listened to Alan Greenspan, he sounds like an economics textbook, which to most of us sounds something like Chinese. During his hearing before Congress, in a rare moment of lucidity, he said, “I still do not fully understand why it happened.” As one who can’t quite get his arms around all of the causes and effects of this credit crisis, I don’t feel so bad now.

By the way, the word “credit” comes from the Latin “credere” which means to “believe” or “trust.” So, in that sense, all significant financial market downturns are really crises of credit. At this point, most investors around the world simply have lost much of their trust in the global financial system. But this intrepid wealth manager believes that through this crucible we will build a better financial system. Of course, it will take time and it will be difficult, but life’s harshest lessons are often the ones we learn from the most and, in the end, result in greatly improved lives and stronger social systems. I fully believe we will look back on this time, breathe a sigh of relief that it’s over, and continue to build the growing global economy that helps us all. Keep the faith!

The Author

Les Atchley is the founder of Atchley Financial Group, a national wealth management firm headquartered in Coeur d’Alene, Idaho that specializes in retirement, investment, and estate planning. He and his team of experts help clients make intelligent decisions with their wealth in order to realize their goals and achieve financial independence. You can contact him directly at 208-664-1900 or learn more about the firm by visiting their website at AtchleyFinancial.com.