Panic of '08 - Part 2

Everything began to unravel with the increase in prime rate. In June 2003 it was 4.00% and it nearly doubled to 7.25% by December 2007. Mortgage rates shot up correspondingly. People with subprime and ARMs (adjustable rate mortgages) who could barely afford their new homes when they purchased them suddenly had their monthly mortgage payments skyrocket. These customers could no longer afford their homes and defaulted on their payments.

The higher rates discouraged potential new buyers. People who needed to sell their houses were forced to lower their sales price. This trend is continuing to spiral down resulting in a collapse of the housing market and devaluation of home prices. Today we have people who had once paid 4% on a $275,000 loan for a $300,000 house who are now paying 7% on their $275,000 loan for a house which is now valued at $225,000. In other words their loan is more than the value of the house. They’ve lost what they initially put into the house and can’t afford to make their house payments with the higher interest rates. So they are simply walking away, leading to the highest foreclosure rates in decades.

If all this wasn’t bad enough, add in Wall Street. Investors recognized the problems that financial institutions were in and began to sell their stocks short. Basically, buying short means you determine the sales price today even though you don’t own the stock yet. Let’s say stock for Company A is $50. You agree to sell it to somebody for $50 in one week. A week later the stock is $40 and so you buy it at $40 having already agreed to sell it at $50 and you made $10. Of course if the stock is higher then you would lose money. But Wall Street helped insure that their shorts would be profitable by simply buying short. Much of Wall Street is psychological. If other investors see that people are buying a company short then they figure those people know something you don’t. So they start selling their stock now before it goes down thus almost guaranteeing that the stock will fall in price.

The last piece of the puzzle is that happened after Wall Street began to sell short. Other people and companies watched and listened and began to lose confidence in a company. Then the domino affect begins. One by one companies began to withdraw their funds from an investment firm and worse, refuse to loan it any money. For example, look at the demise of Bear Stern. There were rumors that the firm didn’t have the cash to keep going. In the next 10 days Bear Stern shares dropped 40%. After Wall Street started to sell it short, companies such as Goldman Sachs stopped doing business with them and others followed. More rumors abounded in Wall Street about the potential collapse of Bear Stern in spite of the firm’s efforts to counter them. But it became hopeless and towards the end in one half hour period their stock dropped 40%. That was it for Bear Stern.

Bear Stern is just the tip of the iceberg. In the past week we’ve seen a number of other major companies who we never would have thought vulnerable suddenly disappear. If they were lucky, like Merrill Lynch who were bought by Bank of America. Other investment firms started to fall into bankruptcy with no last minute buyers. And then came the US Government which bought AIG rather than let it go bankrupt and lose all of its customer’s money.

So that is a (somewhat) brief overview of the Panic of ’08. This isn’t the first and won’t be the last financial crisis we go through. Yes it is serious but it isn’t fatal. And 100 years from now people may not even remember it. For example, do you recall the Panic of ’07? According to Wekipedia, “The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis in the United States. The stock market fell nearly 50% from its peak in 1906, the economy was in recession, and there were numerous runs on banks and trust companies.” Sound familiar?