Clearly, abuse of credit has done serious damage to the American economy, but the sky isn’t falling. While bond insurer Ambac disappointed investors today, at least the poor saps who took directional positions, it has been “bailed out” and will use its incoming assets to move forward. Money will change hands, ending up with the financial “war profiteers” who fearlessly capitalized on the panic of the masses. Banks will reorganize, businesses will continue to operate, and life will go on.
I always wondered why banks were giving loans to people who could not afford to pay them. It seemed asinine to me, but I reasoned that bank executives must be smart people with fancy degrees and sophisticated thinking that would only confound my tiny mind were I to hear it. I now see that banks were indeed far, far more foolish than their debtors. After all, I have some small amount of sympathy for a nave person who trusts the bank to give him an appropriate loan. “Surely,” says the potential homeowner, who is blinded by desire to own a luxury home, “the bank wouldn’t make a bad investment! They have smart people. And lots of computers, and fancy software, and guys with MBA’s. They wouldn’t give me a loan I can’t repay, because that would be stupid!”
As it turns out, banks do make bad investments, and while even a smart individual can be wiped out investing, there is no excuse for a bank to have such problems. I have a small amount of capital to invest, so I can only open a limited number of positions. When fluctuations in prices drop my buying power, I occasionally have to make a position adjustment just to keep from getting another margin call. I bought out of a very good position today at a small loss. I had to make a decision, and although that position would have been profitable in the long run, right now, I see that it is better to focus on shorter term positions that will offer returns in a better time frame. In order to keep my great positions, I sacrificed a good one, which is annoying, though not devastating.
Banks should not have such issues! Also, while I have to pay commissions to my broker, they do not, as they can handle their own stock and options transactions. With their prodigious capital, they can afford to invest in a variety of positions and should be able to “ride out” a few rough spots here and there, never forced to do a buyback because of margin.
Giving a few loans to high-risk debtors is fine as a speculation, but why banks made consistently poor lending decisions eludes me. The pay off is not any greater than that of lending to a more reliable individual. By offering low interest rates and special “interest only loans,” they allowed people to pay negligible amounts when it was abundantly clear that those people would never be able to make the balloon payment or refinance at the end of the term. At least if they had issued a “regular” mortgage, they could have collected some interest before the individual defaulted. The banks’ strategy is comparable to selling an in-the-money naked put for a smaller credit than a you would get on an iron condor. Gee, low risk, low credit or high risk, low credit? Let me think about that. Apparently, the banks didn’t.
This mortgage crisis will go down in history as one of mankind’s greatest follies. Like the Holland tulip bulb market or the .com boom, it will be a source of amusement to new students of finance. They will snicker at the silly banks, solemnly declare their intellectual superiority, and go on to find a way to make a different, equally stupid mistake. Credit is not leading to the downfall of society, because society has always had its ups and downs. Stupidity is ontological. If Charles Darwin had been a trader, he undoubtedly would have coined the phrase, “survival of the least unfit.”
I have my own personal badge of stupidity when it comes to finance, so I know where from I speak. I believe I can move on from my mistakes, and I believe that the American economy will do the same. Stupidity is chronic and debilitating, to be sure. But it isn’t a terminal illness.