Sunday, October 19, 2008

Faith in the Finance System

I had my first taste of how the finance system works when I graduated from university in the USA, and got my first job. My first application for a credit card was rejected even though I had a decent salary as an engineer. The reason was I had no credit history - a record of borrowing and repaying money. It was only when I told them that I had took out a loan from the university and was beginning to repay it, then I got my first credit card. So I learned two things. Firstly, the banks were quite cautious. Secondly, a person who owes money was considered more trustworthy than someone who owes nothing. The second lesson is still true, but not the first one.

The operative word is confidence (faith, belief, trust, ...). The banks have to have faith that when I borrow money from them, buy a book using my credit card, take out a loan to buy a car, or take out a mortgage to buy a house - that I will repay them.

When the housing prices keep on rising, people believe it is safe to buy a house that costs 10 or even 20 times the money that they actually have. When people have difficulty obtaining mortgages, the government encourages banks to lend to them, believing the rising market will make the lending safe. Thus is born the subprime mortgages and loans. Banks become more aggressive in lending. Banks then devise ingenious ways to get other people to share the risks in such shaky lending.

The now infamous mini-bond is actually a kind of insurance. The investment banks were afraid that the risky loans may not be repaid. So they created an instrument which is essentially an agreement that the investment bank will pay the buyer a certain amount of money if the risky loans do get repaid, but the buyer gets less money (or in the worse case, nothing) if the risky loans do not get repaid (defaults). Most people did not realize they were providing insurance to the multi-billion dollar investment banks. They were essentially betting against someone defaulting their subprime mortgages and loans. Now they know, but it is too late.

Suddenly someone realized that the loans were much too risky and the faith they had were not justified. So they stopped lending money and asked for loans to be repaid. Once that started, everybody lost faith, and the system collapsed.

It turns out much of our faith in the finance system, and the people who operate it, have been misplaced.

By the way, if you cannot identify it, the photos are both of San Francisco. On our way back from Los Angels this August, the plane was hugging the California and the cloud cover happened to break when we passed by San Francisco. The cluster of tall buildings in downtown San Francisco is one of the financial centers of the USA. On the ground, they look very solid and impressive. From high in sky, they look more like models and much less solid.


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