It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. The new competition brought down mortgage fees and spurred some useful innovation [including] subprime mortgages. Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s. Once bundled, different types of mortgages could be sold to different groups of investors.What are the lessons we can draw from this crisis?
Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. Home buyers did the same thing, by putting little money down on new houses. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.
All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher — so high that they were destined to fall.
And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit. Many of these bets were not huge, but were so highly leveraged that any losses became magnified.This toxic combination — the ubiquity of bad investments and their potential to mushroom — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. The conservatism has gone so far that it’s affecting many solid would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Streets fears.
(1). Don't Assume. You all know what happens when you assume. Homeowners, speculators, lenders, and investors all assumed real estate would just keep going up forever, just because it had in the past. Look at fundamentals for an investment, not trends. Hear that, commodities bull market?
(2) Don't Panic. When everyone panics, runs happen, and prices get driven down to nothing. Institutions shut down. So take a deep breath. Like George Harrison said, all things must pass. And this financial crisis is within the set of "all things."
(3) Be Informed. People knew this kind of thing was going on years ago. If you were stoic and avoided irrational euphoria, read and kept up with the markets, then you probably got out before this became a problem (around last August). Foresight is bred by observance.