Financial Crises

Behind the more recent financial and economic crises beginning in 2007 lies the fact that banks and investors forgot the principle of the conservation of value. Let’s see how. First, individuals and speculators bought homes—illiquid assets, meaning they take a while to sell. They took out mortgages on which the interest was set at artificially low teaser rates for the first few years but rose substantially when the teaser rates expired and the required principal payments kicked in. In these transactions, the lender and buyer knew the buyer couldn’t afford the mortgage payments after the teaser period ended.

But both assumed either that the buyer’s income would grow by enough to make the new payments or that the house value would increase enough to induce a new lender to refinance the mortgage at similar, low teaser rates. Financial Crises

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities, too, were not very liquid, but the investors who bought them—typically other banks and hedge funds—used short-term debt to finance the purchase, thus creating a long-term risk for whoever lent them the money. Financial Crises

When the interest rate on the home buyers’ adjustable-rate debt increased, many could no longer afford the payments. Reflecting their distress, the real estate market crashed, pushing the values of many homes below the values of loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll over those loans, prompting the investors to sell all such securities at once. The value of the securities plummeted. Finally, many of the large banks themselves owned these securities, which they, of course, had also financed with short-term debt they could no longer roll over.

This story reveals two fundamental flaws in the decisions made by participants in the securitized mortgage market. They assumed that securitizing risky home loans made the loans more valuable because it reduced the risk of the assets. This violates the conservation of value rule. The aggregated cash flows of the home loans were not increased by securitization, so no value was created, and the initial risks remained. Securitizing the assets simply enabled their risks to be passed on to other owners: some investors, somewhere, had to be holding them. Yet the complexity of the chain of securities made it impossible to know who was holding precisely which risks. After the housing market turned, financial-services companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one another. This was the start of the credit crunch that triggered a recession in the real economy. Financial Crises

The second flaw was to believe that using leverage to make an investment in itself creates value. It does not, because—referring once again to the conservation of value—it does not increase the cash flows from an investment. Many banks used large amounts of short-term debt to fund their illiquid long-term assets. This debt did not create long-term value for shareholders in those banks. On the contrary, it increased the risks of holding their equity. Financial Crises

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