I have seen a rash of warnings about a new financial disaster in the USA. Funny, we have not yet understood the 2008 Great Financial Meltdown and the ensuing Great Recession of 2009. To prepare for the next blow to our financial structure we should review some basic concepts of finance and economics.
1. ”One man’s debt is another man’s asset.” The 2008 collapse was blamed on our having accumulated too much debt in the housing market. And indeed I have not yet seen an accurate accounting of this debt which was mainly in the form of mortgage backed securities, the so-called “toxic securities.” Regardless of the size of the debt one has to remember that it equaled a similar amount of assets, e.g $50 trillion in debt was also $50 trillion in assets.
2. Those rating these assets, the mortgage backed securities, did not base their ratings on the asset itself, but rather on prices in the housing market. In other words they did not value the asset itself but used a tangential asset. This was a very costly mistake.
3. I argued at the time that the mortgage based securities should have been valued based on themselves, i.e. the typical 30 year home mortgage will pay an amount in interest roughly equivalent to the loan principal or in other words a $300,000 home loan over the course of the loan will pay about $300,000 in interest as well as the $300,000 principal.
4. I argued against the rule of “marking to market” used to value mortgage based securities. There was no market to mark to, only algorithms based on home prices, again not the value of the asset itself.
5. I was proved right when the financial markets were stabilized in about six months by the “TARP” program and eventually ending the practice of marking to market. If we had had a real major financial catastrophe it would have taken much longer to stabilize it. The “TARP” and ending marking to market showed that the mortgage backed securities had been erroneously undervalued by huge amounts. The securities were an asset with value way more than the marking to market practice had indicated.
So let us hope that, if we face a new concern about debt and its impact on the economy, that we will face it with accurate accounting procedures and not allow algorithms based on exogenous factors to throw our financial structure into a new tailspin.