The Economy of Greed

photo credit: pfala (injured)

“Be fearful when others are greedy. Be greedy when others are fearful” – Warren Buffett

The present financial situation that the global economy is experiencing has had an effect on us all. While political and financial leaders look to fix the problem the rest of us ‘regular people’ are left to pick up the pieces and make sense of things. The question I hear day after day from customers is how did this all start? Another question I receive is “What should I do, I’m scared.” While I’m not an economist, nor am I an expert in these matters my job requires me to have a base understanding of what is happening in the economy. Provided below is an overview of the situation as it faces us.

I’ve quoted Warren Buffett at the top of this article as I feel these words by him are indicitave of how we arrived at our present situation and what we can now do about it.

So, how did we arrive at our present situation? Well from what I can tell it started with the well intentioned idea that all American’s should be home owners. In it’s own right this is a noble concept that I agree with wholeheartedly. As a home owner myself the knowledge of the equity that I’m building in my home is wonderful. As is the thought that every payment I make on my mortgage goes towards eliminating that debt, rather than a rent payment which only makes someone else richer.

The dream of home ownership for everyone is a great idea. However, when it coupled with poor or shady lending practices it’s a bomb waiting to explode as we’ve discovered. Some lenders dealt in what’s known as the sub-prime business. Many people taking sub-prime mortgages are those who really didn’t qualify for a mortgage in the first place. These lenders offered great introductory rates that would later reset at a higher rate. These initial low rates made the mortgage payment very attractive and few borrowers gave consideration to what their payments would be like when their rate reset at the higher amount. To further add to the problem these lenders were giving out what is now known as ‘NINJA’ mortgages. No Income, No Job or Assets. I’m sure you can see the problem this could cause. Heck, the problem this has caused.

Of course the problem didn’t end there, insert our first case of greed. Housing prices in America began to rise and home owners took advantage of this to borrow against the equity in their homes. The money was used for the new car, big screen TV, and any other item required to keep up with the Jones’. Understand that I don’t feel there is anything wrong with making these purchases. However, they were made on borrowed money. When the housing bubble burst and property values began to shrink people found that they owed more for their home than what it was worth. In many cases (not all) this was due to greed. This is the beginning of our problem, however it’s not the end. Nor is it the biggest part of our problem.

Enter the Asset Backed Commercial Paper situation. With all these mortgages being funded the banks and other lenders were eager to package them up into investments. This isn’t anything new, banks borrow money all the time. The simple way of looking at it is this: Banks sell an investment to customer A and provide a reasonable rate of return. Banks then lend customer A’s money to customer B to allow customer B to purchase a home. The bank charges a rate of interest on this loan. The difference between the rates is where the bank makes its money. However, when the investment is backed by sub-prime mortgages and the owners of those mortgages default the bank is then unable to deliver to it’s investors.

Investors were fooled by the idea of a high rate of return with no risk that was advertised with the ABCP investments. Unfortunately there was risk associated these investments. When the investments started crashing globally the problem spiralled. Common people lost confidence in their banks, which caused several major banks to fail for no really good reason. These banks were for the most part stable, with good balance sheets. However, word got out that they were going to fail, so people pulled their deposits and as a result the banks did indeed fail. The prophecy became self-fulfilling.

All of this leads us to the question of what next? The best indication of what to do next comes from Warren Buffett, America’s most well known investor. This article from The New York Timesby Mr. Buffett provides some great insight. The answer to which of course is buy now. Perhaps not all at once, but slowly start getting back into the market. Setup a pre-authorized contribution and put a little bit away each month.

Regarding investing remember these two pieces of advice:

“It’s time in the market, not timing the market.”

“If it looks to good to be true, it probably is.”