History seems predictable in the aftermath.
The Financial Crisis of 2008 tore the American economy apart, disrupted daily life, and created financial hardships for families across America. But most crisis has a tendency to seem avoidable after we see the consequences. Why didn’t the government regulate the market better? Why were banks so risk-averse? We should have seen the housing bubble coming - nothing that good comes without a price. Although it is easier to comment 14 years after the incident, say you did see it coming. What would you have done differently? What could someone in their 20s do to get a handle on an upcoming financial crisis?
What Was The Crisis?
The financial crisis of 2007-2008 was the worst to hit the world since the stock market crash of 1929. Also known as the subprime mortgage crisis, it was the result of the collapse of the U.S. housing market that led to a severe contraction of liquidity (lack of cash) in global financial markets.
Like most human-induced disasters, it wasn’t an overnight problem, but one that built up over a decade. In the mid-2000s, housing prices in the United States began to rise because of cheap and easy-to-get financing. Why was this? Looking at the Economic situation of America between 2000 to 2003, interest rates dropped from 6.5 % to 1 % in response to the Dot-com bubble burst in 2000 and the 2001 attack at the World Trade Centre. This prompted people to take more loans. Further, new Government policies like income tax-deductibility of interest paid on home mortgages encouraged home loans. The demand for houses increased and in alliance with the Laws of Demand, so did house prices. From the Bank-side, the period of the 1980s to 2007 was one of low inflation, low-interest rates, and stable growth. Investors and Financial Institutes became complacent and were willing to take up more risks than ever. Therefore, lenders lent more and households borrowed more.
Banks thought they saw a promising market and started dispensing mortgages like Halloween candy and Wall Street firms began packaging all of those mortgages into bonds and selling them to investors looking for higher returns on what looked like safe investments: a stream of money coming from homeowners making their monthly mortgage payment. The underlying assumption was that prices will always rise, and if borrowers are unable to repay their loans, banks can sell the houses (collateral listed on the mortgage) and recover the loan. From here Wall Street essentially went wild — creating all kinds of securities essentially built on the mortgages that became increasingly easy to access, thanks to the banks.
Everything was peachy-keen as long as housing prices rose and homeowners made their payments on time. But in their stampede to hand out mortgages to feed into the Wall Street machine, banks didn’t try too hard to check whether the home buyers had a realistic chance of repaying the loans. In other words, there was a decline in mortgage standards and Banks began to lend to sub-prime borrowers (people with low creditworthiness). Reckless lending ushered more people into the housing market, which fueled prices further and increased the number of US households that became leveraged ( meaning they borrowed more relative to their income).
Fourteen years ago, not only was the global financial system on the verge of collapse, the prevailing notions about how the economic and financial worlds are supposed to function were similarly failing. Markets work. That is the basic idea that has governed economic thinking for decades. The right price will always find a buyer and a seller, and a world filled with buyers and sellers can determine the right price better than any government can. In the summer of 2007, however, the markets for some mortgage securities stopped functioning. Buyers and sellers simply couldn’t agree on a price because the House market became saturated. Between 2004 to 2006, the Fed steadily raised interest rates, making loans more expensive.
At this point, the supply of houses outran demand, and so housing prices started to fall. This caused mortgage default rates to soar in unprecedented numbers. So when home prices started falling and people stopped making payments on mortgages they couldn’t afford, it caused a chain reaction that nearly broke the financial system. Investors frantically began selling their securities, and they hit rock-bottom prices, erasing any potential gains investors would normally have. Widespread defaults in mortgages resulted in Foreclosure and banks reclaimed the houses kept as collateral to recover the loans. But, with the falling prices, banks suffered massive losses.
Credit froze and the banking system started to “deleverage” to pay for the losses. The “real economy” started to slow down, and that put additional pressure on housing prices, intensifying an already-strong crisis into "the" crisis.
Trust evaporated, and it wasn’t until governments jumped in, late in 2008, by initiating a massive liquidity injection into the world economy, that the financial markets settled down ( in five years' time)
That intervention seems to have prevented a second Great Depression — although in taking a global view, the inhabitants of a few unfortunate countries, such as Greece and Spain, might beg to differ.
The crisis represents the failure of an entire system. Of an economy of people and the government meant to mage and foresee risks. But is there a lesson to be learned on finding a gap in the system, that you can apply as an individual?
The Kink In The Finance Machine
I think the big aspect to think about when it comes to The Financial Crisis is the ethical business dilemma — there were people who were probably aware of the potential risks; however, they preferred to play unaware and avoid the truth.
So what if you foresaw the Crisis? Let’s go back to summer 07’. There are two consequent action parts to the above story that could apply to you.
Part A: Turning the prediction of a falling market into big profits, how?
Trigger Warning: It may not sit right with you. This is based on movies like The Big Short.
While many people were selling their involvement with the housing market, there were others who saw this as a chance to increase their positions in the market at a big discount. What would this have looked like?
At its essence, the stock market is a big gambling house. You make good bets, you make profits. It’s not just betting on how a company does, you can also bet for an economy doing well… or against an economy.
What if we bought insurance against the possibility that the housing market might collapse? This would mean taking a monthly loss while the crisis played out, but receiving a huge payout from all the losses when we reach the other side of the tunnel.
We would have to bet that the U.S. housing market will crash, using a process known as ‘shorting’. By doing this investors can make money out of products losing value, as well as gaining value, and successes can be made from the failure of others.
The 2000s saw financial innovation which quite frankly outstripped human intellect. The potential impact of new products, like derivatives, was probably not understood even by the quant jocks who created them. Instead of selling individual loans, banks grouped mortgages of different risk levels and sold them as a brand-new product called a Collateralized Debt Obligation (CDO). These products were complex making it difficult to grip how risky they were. Because of the deregulation in the financial industry, lots of financial players invested heavily in these securities which were exposed to the risk of mortgage default rates. Historically, the U.S. housing market has been a safe bet, and so the unflinching support for these products grew until the CDO market was worth $226 billion in 2006.
It is around this point that we would realize that the housing market is being overvalued — with much of it based on risky mortgages. If you can predict that a risky product will fail, then you can make big profits from that prediction. It’s possible to transfer the risk surrounding what you hold to someone else — you just have to pay them for taking it on.
Part B: You want to get through it and keep going on with life as you know.
The reality of the situation is that there is always a potential recession looming around the corner. While we may not have the time or knowledge to sit around trying to predict when it may hit us, here are four steps you should take in your 20s to come out of any possible recession on top:
Build An Emergency Fund
Make sure you have enough cash reserves to pay for unexpected expenses, like a car repair or medical issue, especially as these costs continue to rise. There are many strategies to go about this. If you have a career going for you, direct deposit, say 10%, of each paycheck into a high-yield saving account to build your cash reserves. Financial advisors say your emergency fund should cover three to six months of living expenses.
2. Understand economic cycles
Recessions are part of the economy’s life cycle, which consists of five stages:
Peak
Recession
Trough
Recovery
Expansion
They are in this way healthy and expected. Stay tuned to the Visible Guide for a more elaborate expansion on the Economic Cycle and the consequences of each stage.
2. Positive outlook
I'm not saying stop reading Financial news, but stop reading Financial news. I do my best to read the newspaper and different journals but they never really paint a pretty picture. Recessions have a“doom and gloom” narrative around them but they do lead to innovation and economic growth. Fun fact, Uber and Airbnb were founded during the 2008 recession. Not just that - pick a big company - Microsoft, HP, General Electric, Warby Parker, Netflix, and Trader Joe’s - guess what? All were founded during earlier recessions. Additionally, although it is scary to enter a troubled economy career-wise, the recession markets historically have created careers and even industries that didn’t exist before. So, as terrifying as the news around the recession might seem, don’t let it get to you.
3. Find your ideal job.
People think a recession means high unemployment, but the two factors are not necessarily related. Recessions can cause stress about job security for young professionals, and there are certainly companies facing tough financial times that are either going through mass layoffs or filing for Chapter 11 bankruptcy. But the good news is the Great Resignation created a market that favors job seekers. As of July 31, 2022, there were 11.2 million job openings in the U.S., creating a “dream recession” for people looking to enter the job market. If the economy falters, you want to ensure that your biggest asset, your income, remains as steady as possible. Consider your marketable and transferable skills that can help keep you employed even in turbulent times.
4. An Investors Guide
What happens to the stock market in a recession? Prices go down. That might be bad news for those already in retirement or close to it — Americans lost about half a trillion dollars in wealth in the first quarter of 2022. However, for you my dear friends, the recession presents a discounted buying opportunity. Looking at the current stock prices, they are generally down across the board from the all-time highs experienced last year. That gives you a second chance at a discounted price to buy into equities and exchange-traded funds. As Baron Nathan Rothschild once said, “The time to buy is when there is blood in the streets.” He should know: He built one of history’s largest fortunes profiting from the post-Waterloo recession. Although this may be opposing Bill Gate's Philosophy. Stay tuned to the Visible Guide for more on that, by the way.
A slightly more advanced version: Short selling stocks is one way to profit from a bear market. Eonomists define a bear market as a decline of 20% or more of a major stock market index, such as the S&P 500, for a sustained period. A short seller borrows shares that they don't already own in order to sell them and, hopefully, buy them back at a lower price. Another way to monetize a down market is to use options strategies, such as buying puts which gain in value as the market falls, or by selling call options which will expire to a price of zero if they expire out of the money. Similar strategies can be employed in bond and commodity markets.
For those individuals seeking simply to protect themselves from a crisis and not necessarily bet on such an event occurring, owning a well-diversified portfolio, including positions in asset classes with low correlations, can help cushion the blow.
5. Keep in mind lessons from the 2008 Financial Crisis:
- Just because you can qualify to borrow money doesn't mean you should
- Stock prices can keep falling for a very long time. In a bull market, the smart investor's mantra is to buy when prices fall because they won't stay down long. But in bear markets, they do... can you afford to take the hit?
- You can't avoid risk by avoiding the stock market; everyone was impacted by the economy. With stocks, you lose money when the market falls. But thinking only about that risk is like looking only one way when you cross the street.
- Your job is your greatest asset; It's much harder to survive a major downturn without a paycheck.
Concluding Thoughts
There are many reasons to worry about a major economic collapse or stock market reversal. That is why so many people are talking about it. However, you can console yourself with the observation that almost every serious economic downturn in the past has happened suddenly at a peak of some euphoric enthusiasm for getting rich. Some people would say that is exactly the type of environment we are living in today, but there are a great many people who are becoming quite cautious.
The main problem for cautious people is that returns on normal conservative savings vehicles like bonds or savings accounts are abysmally low. They won’t even keep up with the modest inflation our government tells us we are experiencing, let alone the much higher rate of inflation our weekly shopping trips tell us we are experiencing. Add to this the impact of the pandemic and we have our economy of today.
The only way to make any kind of meaningful return on savings is to take risks. The fact that most of us know that those risks could easily bite us is uncomfortable, but it doesn’t remove the fact that every day your money sits on the sidelines it is losing purchasing power.
During this time of tightening budgets (more here), use your day job and side hustle to maximize your earning potential. You can separate yourself from your peers - it just takes small steps starting now. If you can see the potential recession as just another hurdle that happened in your 20s, you’ll have a solid foundation in your financial journey.
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