Warren Buffett once said, “You don’t know who is skinny dipping until the tides go down”. Well, toward the end of 2008 financial tides did go down after years of prosperity. There are several theories about what caused the down turn. The leading theory appears to be the risky practices of mortgage lending institutes. I wondered how could such debacle happen at such large scale and why? So I begin to search for answers. I wanted to understand what conditions and decisions lead to this major tragedy. My mother taught me to always look through the rubbles of a bad experience and pick up the lessons that I just paid dearly for. Otherwise, she said, it would remain a net loss.
The bait:
In the 1990s banks learned to convert home loans and interest income from them into thousands of mortgage backed bonds and bond funds. It was not as profitable as if they kept the loans to maturity. But this way they were able recycle their assets more quickly. Plus, let’s not forget about the profit that comes from all the various origination and processing fees. Soon, the practice of lending money turned to practice of “lend, repackage, unload, and repeat. They even convinced AIG to insure these bonds. For this concept to work however, volume must increase. How does one increase the number of loans issued? By promoting, marketing, and lowering the requirements for lending. The down side of lowering requirement standards would be a higher default rate. Ordinary that would be a major drawback unless lending institutes pass it on to investors as well. That was exactly what happened. They even categorized these bonds based on their risk potentials.
The bubble:
The new concept appeared a win win situation. Lenders were able to recycle their assets more rapidly. More renters were able to realize the American dream of owning their own home. Builders were able to build more. Suppliers of the home material saw a sharp rise in orders. Realtors were able to sell more. It was almost too good to be true. Somehow a lot of smart people failed to factor in the demand and supply principle. The new lending practices created more demand for residential real estate (by design). The home prices started to go up sharply to keep up with the new artificially created demand. A bubble began to form. It continued to inflate due to constant increase in demand. In some states it turned into frenzy. People rushed to buy home before the prices went up even more. Lenders, which by now have become just loan processors, continued to lower the requirements and blindly accepted the new unrealistic appraisal values which were based mainly on recent sale prices.
The big bust:
It did not take long before a combination of overvalued housing market (which was moving much faster than average household income) and irresponsible lending practices created an unsustainable platform. When the ride was finally over and the housing prices finally peaked, the reality kicked in. Millions of people who purchased homes (that they couldn’t afford) in the hope that the upward trend will continue found themselves in a new position, upside down. Defaults were inevitable. It was simply a matter of time before this house of cards come down. As the foreclosures began, the security mortgage bonds and bond funds began losing value.
The big Bang:
Devaluation of the mortgage backed bonds spread the housing crisis to Wall Street and caused a massive financial institutes failure which lead to the largest financial rescue mission in recorded history. It led to devaluation of everyone’s stock, 401K, and retirement portfolio. It nearly brought the whole house down. Luckily we survived as we often do when faced with a natural or manmade disaster. The American Spirit and resiliency prevailed until the tides came back up again.
The Lesson:
We were reminded once again to always consult with our inner wisdom before making a major decision. Sometimes it is very difficult to ignore all the hype. Nonetheless, we must trust our instincts and common sense and not allow any external hype or rosy glasses influence our better judgment.
About the Author: Dr. Farid Noie has been in private practice in the Bay Area since 1996. He is a Diplomate of International Congress of Oral Implantologists, Fellow of Academy ofGeneral Dentistry, and Assoc. Fellow of American Academy of Implant Dentistry. He has completed his surgical training at New York University as well as Medical University of South Carolina, Temple University and Wright State University School of Medicine. He completed his oral Anesthesiology training from University of Alabama at Birmingham. He is a member of the American Academy of Cosmetic Dentistry.
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