Business Commentary: The fluffy money meltdown—Part I

Editor’s Note: This is the first of a two-part series. Part II will appear in the Sunday edition of the Green Valley News and Sun.

The subprime fiasco and the resulting financial meltdown, currently at play, are likely to go down in history as two the most vital issues in the early part of this century.

While it is too early to tell how deep and how long the economic effects will last, they have already caused worldwide financial chaos.

Only widespread government actions and assurances have so far averted total catastrophe.

There seems to be no shortage of blame, but that does not relieve the suffering of those who have lost their jobs, homes, health insurance coverage, all or some of their retirement nest eggs or material possessions.

Rather than pointing fingers, it makes more sense to talk about fundamental causes.

When the housing and financial markets turned gluttonous, rational business policies and procedures were set aside.

To meet rising expectations and demand, an anything goes mentality set in.

Real estate brokers sold homes to those who could not—by any rational measure—afford them and arranged short-term mortgages with escalating interest rates that set the mortgagees up for failure.

While the frenzy of the real estate bubble provides a partial rationale, there were many complex components.

Greed was an important factor.

Over a period of years, the financial services industry initiated several practices that came to dominate the industry: Derivatives, Arbitrage, Securitization and Hedging (DASH).

Volumes have been written to explain these complex and over-reaching practices, but simplified descriptions follow for the purposes of this essay.

Derivatives are financial instruments that derive their value from underlying assets with definable (theoretically assessable) value.

Examples include stocks, bonds, home mortgages and investment contracts.

As originally introduced into the financial world, the object of derivatives was to provide an additional layer of investments for professional traders, investors and speculators.

Arbitrage is the financial technique of trading in financial instruments or on financial market segments for which—depending on the market—the same investment carries different values.

Arbitrageurs trade on these differences to make money.

Currency exchange differences are an example.

In theory, such investing and/or speculation was risk free because the trading was done on an electronic basis and prices were set at the time of trade.

Securitization is the process of mixing different kinds of financial instruments (e.g., stocks, bonds or mortgages) into bundles and building markets for those bundles.

This is effective when trading individual pieces making up the bundle would be cumbersome, time-consuming or non-rewarding in terms of time or cost.

In theory, securitization and bundling simplified trading, allowed for more trades of greater value and added to market volume without undue, added risk.

Hedging has a long history.

It was initially used in modern times to provide financial insurance against losses in the commodities markets, where volatility is the norm.

In essence, traditional hedging acted as insurance against severe losses due to seasonal or market-demand price swings.

For example, gold typically goes up in price as the stock market goes into freefall, so an investor could hedge against a probable stock market decline by buying gold futures.

This isn’t a guarantee, of course, but it is a hedged bet that may substantially reduce risk.

One problem with DASH practices, individually and collectively, is that they came to dominate modern financial activities.

Instead of fulfilling special, limited functions, they rapidly and excessively grew to a disproportionate percent of global financial activity.

Finally, they overshadowed more traditional and —some would say—legitimate financial activities, such as direct stock and bond trading.

A second problem with DASH activities is that they became dependent upon and driven by leveraging, which is a fancy word for debt.

Many institutions whose trades dealt in DASH activities did so with debt instruments carrying many times the presumed (often optimistic) value of the underlying cash, stocks, bonds, mortgages or other instruments of value.

In some cases, the leverage factor was ten, twenty or forty times the underlying value as assessed with acceptable practices.

The enormous role that leveraging played in DASH activities was no different than the role of debt in the real estate market, where loans far in excess of rationally derived value became commonplace.

At an individual level, families were incurring massive debts for ever-larger, more expensive vehicles and mountainous credit card debt with little thought to consequences, much less saving or investing.

Debt incurred as DASH and inflated real estate and expensive consumer credit is Fluffy Money.

Little real equity (sometimes just 1/40th of the presumed value of DASH instruments) and highly leveraged and unrealistic debt across the board were the building blocks for a worldwide financial house of cards.

It took the collapse of just one sector—the housing bubble—to begin the collapse of the entire Fluffy Money pyramid.

Author Note: Harold Mansfield was born in Fort Collins, Colo. After serving in the U.S. Army, he graduated from Colorado State University in 1958. He received his Ph.D. from the University of Denver in 1974. In 1993 he retired from Fort Lewis College, where he taught psychology, statistics and writing for 18 years.

In addition to fiction writing, part of his retirement regimen includes researching, thinking through and writing about critical contemporary social issues.

After a “lifetime” in Colorado, including 31 years in Durango, he moved to Green Valley in 2005.

Some of his writings have appeared in The Durango Herald, Solar Age Magazine, crimemagazine,com and Crossroads: A Journal of the Southwest.