In the Middle Ages, alchemists searched for a process to transform base metals into gold and silver. During the past decade, the financial industry thought they could transform poor credit risk into good credit risk, high risk investments into low risk investments, and increase total wealth through creative debt instruments.
For a while, everyone believed financial alchemy was working. Virtually, anyone could get a home mortgage. 0% down, 125% of equity, no proof of income mortgages all occurred during the past 5 years. Home owners and buyers believed, as housing prices boomed. Risk was thought to be minimized as mortgages were divided up and packaged into collateralized debt obligations (CDO) that were sold to investors. Investment banks believed, as fees grew exponentially. Investors believed and bought up securitize debt like they were government bonds.
Then, home prices stopped rising, mortgage defaults increased, and securitized debt became illiquid. Reality set in as people realized home prices wouldn't go up forever to support the growing debt. Credit markets froze and the stock market sank precipitously, having it's worse yearly decline since the 1930s.
For now, financial institutions, investors and main street are hunkering down and returning to financial basics with respect to risk and debt. While painful, the deleveraging will create the foundation for the next economic boom. However, I expect that memories will be short, and we will see financial alchemy rise again, leading to another bubble, and subsequent burst.
Hopefully, I will recognize the signs of financial alchemy when it occurs again in the next few years.
For more on The Practice of Personal Finance, check back every Wednesday for a new segment.
This is not financial advice. Please consult a professional advisor.
Copyright © 2008 Achievement Catalyst, LLC
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