I understand that many people think our government should be less involved in our lives (i.e., they want a smaller government), but it just doesn’t work in the world of finance. Greed is the driver when money is involved, and we have plenty of examples to learn from in recent history.
In mid-November, we watched FTX — one of the world’s largest crypto exchange platforms—implode and file for bankruptcy. Initial reports suggested the collapse was caused by Sam Bankman-Fried (CEO of FTX) transferring billions of dollars from customer assets at FTX to his crypto hedge fund, Alameda Research. Additional factors were later identified. In late November, crypto lender BlockFi filed for bankruptcy, and it is too soon to predict how widespread the economic damage will be.
I never recommended Bitcoin or cryptocurrencies to any of my clients, and I would never invest in them myself. The risk is too high for my conservative investment philosophy. However, I know several people (even financial advisers) who have invested. Cryptocurrencies are digital assets, and many early investors reveled in the fact that there was limited oversight by U.S. or global authorities.
The FTX collapse is being compared to the 2008 bankruptcy of investment bank Lehman Brothers, which was a major factor in the 2008 financial crisis. Let’s review the factors that almost brought down the U.S. and global economies. A lack of oversight was definitely involved.
In approximately 2005, the mortgage industry began encouraging people to buy larger houses than they could afford — with hefty mortgages. The old rule of thumb to not spend over 30% of a person’s gross income on housing was discarded, and “low-doc” or “no-doc” paperwork became common. Often, no deposit was required to buy a house. The mortgage industry argued that housing prices would continue increasing, thereby justifying the excessive mortgages they were selling to vulnerable homebuyers.
Everyone seemed to forget that real estate values are cyclical. According to a white paper by the U.S. Federal Reserve (containing data from CoreLogic), housing prices in the U.S. declined by about 33% from 2007 to 2009 as compared to their peak in 2006. This led to many mortgage holders being “underwater” and owing more than their home was worth. Many people walked away from their mortgages and lost their homes.
The U.S. economy may have tolerated the housing correction, but the banking and investment industries exacerbated the problem by bundling “subprime” mortgages into “collateralized debt obligations” (CDOs). The CDOs were bundles (or “pools”) of risky mortgages that the mortgage industry had sold to unsuspecting home buyers, knowing they required excessive monthly payments when compared to the buyer’s income. (Clearly, the bundles should have been categorized as high-risk or subprime). The next unethical step was that rating agencies gave the CDOs (absurdly) double A and triple A ratings. Fraud was widespread, and the CDOs were marketed to investors in the U.S. and abroad as safe, low-risk investments.
I’ll never forget the phone calls I received in 2008 from large investment firms and banks, trying to convince me to recommend that my clients buy their CDOs. Although I ran a very small financial planning firm, the banks and investment firms were desperate to “unload” (i.e., sell) the low-quality CDOs to investors, and I was seen as a gatekeeper. Thankfully, my rule of waiting three years to see if a new investment proved to be worthy, prevented me from ever recommending CDOs to my clients.
Greed was in full swing, and a cascading set of events were about to occur.
In 2007 and 2008 investment firms decided to use excessive leverage to buy and sell more CDOs. Selling CDOs was very profitable, and the investment firms chose to ignore the enormous risk they would face if housing prices declined and the underlying mortgages defaulted. Lehman Brothers was reportedly leveraged 35-to-1 in 2008, meaning its debt was 35 times the amount of its capital.
This was incredibly risky, because as it became obvious that the mortgages in the CDOs were poor quality—and housing prices were declining significantly—the CDOs (which they owned and had not yet sold to investors) declined in value. A reduction in value of only 3% was all that was needed for Lehman Brothers to…