Financial Crisis: How Did We Get Here?

We are on the verge of the biggest financial crisis since the 1930's. So much has happened in the last few weeks that I felt it was important to step back and try to get a handle on what has transpired. We experienced a real estate bubble. Most bubbles throughout history result from too much of a good thing. Since 2003, credit is that thing. At the time, it all seemed so wonderful. More and more people were living the American dream of home ownership. Those already owning homes were pleased to see their value rise and happy to tap into the equity to purchase cars, vacations, and bathroom remodels. This story played out in many countries.

But ingredients were coming together in the financial markets that made for a bad recipe. Too many people were getting loans that they would likely never be able to repay. The big financial institutions were lending more and more money to questionable borrowers as a route to quick profits. They could "package" these mortgages and sell them to someone else, and they were sold, across the globe.

This makes me think of a Warren Buffet quote, "Only when the tide goes out do you discover who's been swimming naked. " The tide in our case is home prices. As home prices decline, these packages of mortgages depreciate in value. Then, the financial institutions holding these risky packages have to devalue them on their books.

Now the pendulum of easy credit has swung too far back in the opposite direction. Every player in the markets has gotten more conservative, in fact down right tight, with lending. We need qualified buyers to step up and buy homes, thus supporting prices. But lenders have become so strict that this is not happening and home prices continue to decline. Mortgage securities decline in value, the strength of the financial institution weakens, so they lend less, and home prices continue down in a self-perpetuating vortex.

This reluctance to lend is what brought us to the current crisis. Credit and lending are the red blood cells in the financial circulatory system. Think of them as carrying needed oxygen and nutrients to sustain the body. What Fed Chairman Bernanke and Treasury Secretary Paulson saw this week was a credit contraction of unprecedented proportions. The recent take over of Fannie and Freddie, the bankruptcy of Lehman, and the "rescue" of AIG, were supposed to restore some sense of order and keep credit flowing. But it wasn't enough and markets were at a tipping point.

The decisions made in this month of September will be questioned, analyzed, and debated for years to come, but I believe the actions of Messrs. Bernanke and Paulson were needed to avert a global crisis. It was clear the stopgap measures and band aid solutions were not having enough of an effect. We were at the point at which taking no action was a huge risk. I am breathing a cautious sigh of relief.

What Can We Do Now?

In these times of turmoil and uncertainty it is easy to become emotional about our investments. It is times like these that we discover how much risk we really can or cannot tolerate. We may feel the need to "do something." When your emotions are high because of stressful market conditions, you should NEVER make financial decisions.

However, now is a good time to review things. The first thing is a "gut check." How are you feeling on these days of wild market swings? When you see a huge drop in the market does your stomach turn? Are you afraid to look at your financial statements? These are signs you are taking too much risk.

Second, do you have an investment plan? People with a plan have investments suited to their needs, to their goals, and objectives. Their assets are positioned for the long term. If they have needs in the near term, these are taken care of with only the safest of investments. These are the people who will be better able to handle financial crises without losing sleep.