How did we get here?

Sorry the posts have been a bit inconsistent. I am still trying to figure out the best way to communicate my thoughts/ideas in a well laid out format.

Today I will give an overview as to how we got into the position we are in today. I will elaborate on this in the next few days to give you a more detailed summary to show how embedded this problem has become in our daily lives.

First off I'd like to start off with a few Boston sports tidbits.

-Celtics had an unbelievable comeback in game 1 on Monday. Plain and simple - they didn't deserve to win. Rondo played the sloppiest game I've seen in while, Ray couldn't hit a shot, we had a ton of careless turnovers and looked very tired overall. With that said, I still believe the Celts will win this series.

-Bruins played with no energy in game 2. You cannot win a playoff hockey game by just showing up. Still think the B's win in 5.

-Sox are beat the Yanks last night. That should make us all happy, but their pitching is worrying me. Absolutely love the lineup though. Ortiz needs to start hitting or I want a mega deal for Miguel Cabrera by the all-star break. Honestly, we have playoff basketball and hockey right now, so I haven't followed the Sox as faithfully as I should. Can't knock that.

I can only imagine what some people's take is on the financial crisis. It's scary food for thought. Some people have the wrong idea as to how we got here, some people have a few correct thoughts as to how we got here and some people simply don't care. I for one, care deeply because this situation effects my life, my family and friends, and will no doubt have a major effect on the future generations of this country.

This will be the first of a series of posts which detail how we got here.

Causes of the current financial crisis can be traced back as far as twenty years or so. Imbalances in the banking sector have been growing since the mid to late eighties. Fast forward to 1998 when the Federal Reserve bailed out Long Term Capital Management. This was when the idea of "too big to fail" was born. Then Fed chairman, Allan Greenspan, believed LTCM posed serious systemic risk to the financial markets and therefore must be bailed out to avoid a collapse. Irony runs deep in this issue and in the financial markets as a whole. LTCM was run by a man named John Meriweather, for those who have read Liar's Poker may remember, was the head of bond trading at Saloman Brother's in the 1980's. Saloman Brother's pioneered the trading of mortgage backed securities, otherwise known as "toxic assets" which are a major reason our banks are insolvent today, which we will get to later. This bailout was the first seed to be planted into the psychology of investors and CEO's across the country. If a company got so big that it was important to the "system", than if shit hits the fan, it'll get bailed out.

Next we had the dot.com boom of the late 1990's. This was when companies that had no way creating revenue/earnings went public and their stock prices went soaring through the roof. It made absolutely no sense, but the prevailing bias of market participants was that because they were a dot.com stock, they had unlimited earnings power in this new age of the internet and technological advancement. We saw the NASDAQ (see chart below) rise from 1500 in mid 1997 to 5000 in March of 2000.

This created bubbles within the capital markets and would later trickle down into the economy. Lots of new wealth was created in this short time. Most of it was caused by the rise of financial assets, which is not backed by anything tangible. Many people did not know how to handle this new found wealth. They went out and bought multiple houses, cars, luxury items (jewelry, clothing, vacations, airplanes, boats, you get the picture), which only exacerbated our problem of having capital misallocated. The longer capital is wrongfully invested, the larger a bubble will grow.

Think about giving a kid money while his/her parents are away. If the kid has $10 a day to spend on food, the money will mostly be used on pizza or candy. Now since the pizza and candy companies are making more money, they will produce more. Since the kid doesn't want fruit and vegetables, the apple and the carrot companies have less profits and therefore produce less. This isn't healthy for the industry as a whole because they all count on one another for healthy and sustainable growth. So as you can see, allowing someone with new found wealth to spend freely, will create imbalances which lead to bigger problems.

Once the dot.com bubble popped in 2000, markets were sent crashing down and recession was imminent. Recession is actually a good thing, contrary to popular opinion. It means that businesses were growing too fast for their own good and need time for a healthy pause to almost re-balance themselves. Recessions allow the poorly allocated capital to be reallocated to productive businesses which foster economic growth. Think energy, infrastructure, utilities, semi-conductors, things that will improve our daily life and allow both people and businesses to become more efficient. A tool that can used to make investors allocate capital more productively is interest rates. An interest rate is simply the cost of money. If you have a $100 loan with a 1% interest rate, you owe the lender $1 for each interest payment. If you have a $100 loan with a 10% interest rate, you now owe the lender $10 each interest payment and must therefore invest your money wisely in order to come up with enough to cover your interest payments.

In 2000 Allan Greenspan clearly did not want the U.S. to enter recession. As I said before recession is good because the private market will reallocate capital to more productive businesses. In order to avoid recession, Greenspan lowered interest rates, with the benefit of hindsight, was one of the worst possible moves he could have made.

Here is a chart of the Federal Funds Rate from 2000-2006.

As you can see rates were cut in half in the following year and half and eventually stayed below 2% from late 2001 all the way until early 2005. Now some of you may ask why is lowering interest rates such a bad idea. Well when we had a giant bubble build up in the stock market which led to the misallocation of trillions of dollars, why would we further exacerbate the problem of misallocation by making money cheaper to borrow? Makes no sense to me.

This created the world's largest credit bubble. The credit bubble acted like a cancer, spawning new bubbles in other sectors. The most dangerous bubble, which I will write about next, was real estate. Rather than investing in stocks, which may cost anywhere from $1/share to $500/share, overnight millionaire investors could now speculate in the biggest market in the U.S. Why flip stocks when you can flip houses? Why flip houses when you can flip mansions? Tomorrow I'll go into the boom and bust of the real estate market in the U.S. and show you how that factored into this financial mess.