Sunday, 30 April 2017

Perfect Storm

What Is The Perfect Storm?

What I mean by perfect storm is an accumulation of smaller events that combine together in just the right way to create one big heck of a catastrophic event. The catastrophic event we are most interested in, of course, is the 2008 financial crisis.

Threads of the Perfect Storm

I cant possibly list all the threads that came together to create the perfect storm of the financial crisis; but, here are some of them: Real estate myths, transparency, leverage, confidence in experts, other economic problems like labour surpluses and shortages etc. There of course, are many more than this. It takes many many problems hitting at the same time to take down the economy the way it did in 08.

It's not my intention or ability to go through every thread of of the 08 crisis. I will however pick a few examples just to illustrate my idea of how this particular perfect storm worked.

Confidence in Experts

In the case of the financial crisis experts, they created insurance tools they thought would be safe because it placed them and their clients on both sides of certain critical bets. That is, betting against their initial investment was thought of as a kind of insurance. If you bet against yourself, you can't lose right? The problem was this confidence, given by the financial experts, made the consequences of the financial collapse even worse when it came. This is the case because it made the crash less expected. If you think you are protected, and then in the middle of the disaster, find out you aren't, it leaves you with no sense of worry, which might have helped you when things went wrong.

Real estate myths

If there is one tenet that seems more salient than the others its this one. And it forever connects *everyone* to the crisis that eventually developed. Namely, the price of land will always go up. When I say everyone is connected, I mean everyone. We would like to think we can easily blame banks or politicians for what happened; but, our very own misconceptions played a critical role in this event. Small, in the context of the perfect storm; but, critical nonetheless.

Ninja loans

People assume loan making businesses were just criminal orgs or stupid. But, this assumption lets hatred of banks lead to biased analysis.  Loan making orgs, did indeed make mistakes; but, these mistakes were only identified in hind sight. The loans they made, they thought, were profitable; and, the reasons they had at the time for making them seemed good enough.

Even if the loan client had no job, and so on, they still had a HOUSE that could, from the loan company's perspective, be double in value than it was three years earlier. The institutions didn't mind getting the house if the client was unable to pay their mortgage. In the meantime, they would get the commission on making the loan. There was no way to lose...right?

Like all bubbles, real estate bubbles in particular raise a kind of confidence. Remember, this is combined with everyone and their uncle saying, buying and holding land is ALWAYS a good bet. You get stuck with a house with 1/3 lower value than it used to have? Don't worry. Land always bounces back.

Tools to avoid the trust laws lead to lack of transparency

Freddie Mac was instrumental in creating investment tools that were inspired by the idea of finding ways to invest in real estate across state borders. The bottom line is that the complexity of these investment tools made it difficult to quickly understand contracts based on them when the financial crisis hit. The system froze as the system tried to understand barely understandable contracts.

These are just a couple examples of the factors of the perfect storm that came together in 2008. Each factor hit the system a certain way to bring it down. Experts who were on the lookout for problems, in fact, made things even worse by the false confidence they brought to people who had spent their adults lives in the financial industry. People's exaggerated belief in the benefits of owning real estate, lead them to buy over priced homes. And those making the loans for those homes, discounted the personal finances of those seeking them, because they too, thought, getting the home in the worse case scenario wasn't that bad.

It was a confluence of events that we all contributed to; even if was just with our ultimately false beliefs.

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