Financial outlook for 2009.

• Author: Boquist, John A.

November 2008

How times have changed. Last year at this time, we saw investment storm clouds on the horizon. But like other storms, we thought they would pass through and leave us unscathed in the end. Instead, like the Indiana storms of last spring, the damage has been substantial and it will take awhile to clean up. The origin of the storm was largely financial in nature in our view. In order to understand the prospects for next year, we must first understand the causes of the financial crisis.

How We Got Here

The origins of the crisis started in 2001. In the aftermath of the tech bubble, the Federal Reserve pursued a policy of keeping interest rates very low (under 2 percent) from December 2001 to November 2004. This policy proved successful at avoiding a prolonged recession, but it had another consequence: housing prices started to climb. Investors were nervous about stocks and the low rates made real estate very attractive. From January 2002 to June 2006, housing prices climbed rapidly, more than doubling in areas like Los Angeles and Miami.

At the same time, there was a shift toward lending to riskier borrowers. In comparison with traditional loans, Alt-A loans allowed borrowers with lower down payments and lower incomes to qualify for a mortgage. The price, however, was a higher interest rate and higher fees for the mortgage. Many of the Alt-A mortgages were for second homes (investment properties) and it was common for borrowers to overstate their ability to repay the loan. These loans were often termed "liar loans" within the mortgage industry. The shift didn't stop there. Subprime loans were available to borrowers who didn't even meet the criteria for Alt-A loans. Both subprime and Alt-A loans expanded rapidly between 2002 and 2007.

During this period, Wall Street became creative with subprime finance. A simple structure would look like this. A group of 1,000 subprime mortgages would be pooled together. From this pool of assets, three classes of bonds would be issued and sold to investors. The different classes of these bonds are stratified by risk. When the monthly payments are paid to the mortgage pool, the Class A bonds receive their payment first. After they are paid, then the Class B bonds get paid, and then the Class C bonds. Since the Class A bonds get paid first, they have very low risk and generally get a AAA credit rating. The Class B bonds have much greater risk. To make them more attractive to investors, supplemental insurance is added from firms like AIG so they can get a rating of BBB.

As long as housing prices were rising, everything was fine. If you...