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Wednesday, April 17, 2024

How the economy died

Wall Street’s predicament is a lesson in overstretching limits. This is an institution that prides itself in creating wealth, moving and shaking markets, empowering people. At its very best traditions, Wall Street is a worldviewa belief that at its height, the possibilities of the human imagination are limitless.

But, in the pursuit of the prospect and promise of riches, they tested the parameters of what is possible and what is probable.

The first lesson in Finance 101 states that money, coupled with prudence, contains enormous potential for growth. It’s simple: Investing grows money. Fundamentally, balancing one’s cash flowbetween income and expenditurewith a positive net flow, then reinvesting the money, is the means to achieve this goal.

For many individuals, one common and primary method is through direct investment, the way students deposit money into a savings account. As the aggregate function of accrued, compounded interest over a period of time earns returns tailored to the investor’s objective, value is created.

Others invest in stocks and bondsrespective equity and debt instruments conceptually designed to guarantee phenomenal growth, a constant income stream, or both. These stocks and bonds are created to profit both the investor and the company. Then, using modern, sophisticated functions such as technical and fundamental analyses, they predict market movements and forecast earnings. All these acts are designed to gain maximal returns.

For companies, the investments from individual investors, in turn, are loans that provide necessary funds for financing profitable ventures. They subsequently identify and invest in projects yielding positive net returns using capital budgeting analysis. The entire process transfers and circulates money between individuals and corporationsearning individuals money and companies equity for investment.

Wall Street, however, took this philosophy and practice of investments to the extreme. In many ways, they engaged in, and perhaps underestimated, overwhelming risk.

By creating a class of exotic financial derivatives called the collateralized debt obligations (CDOs) – derivatives dependent upon valuation of other assetstheir intention was to make profit by lending loans to homeowners, recouping these through the balance from interest payments.

In doing so, they simultaneously assumed that interest ratesthe cost of lendingwould remain artificially low – hence taking on more risks by lending to borrowers even with poor credit history. It didn’t help that individual investors were attracted by the immediacy of borrowing and credit rating agencies gave high ratings to the investors.

Precisely because these loans were attached with variable rates, when those unable to pay defaulted and foreclosed, a cyclical interaction of fear and panic permeated, increasing rates and, subsequently, increasing defaults. In turn, this collective increment affected all participants.

The crime here is not the innovation of the derivatives itself, but Wall Street’s reckless acceptance of the associated risks. In lending, they were implicitly remarking a belief that loaners with questionable credit history would somehow originate funds to pay their debt. When this didn’t materialize, leading to a cascade of interlinked failures in several industries, the impact was severe.

What Wall Street demonstrated is myopia, an ignorance of the strategic focus of long-term planning. The derivatives they created were illusions of intangibles, imagined value. Lacking was substantive, actual value. Present was not wealth but a sentiment of wealth.

The fall of Wall Street reminds us that financial transactions are actual processes that implicate the livelihoods of many. Real people lost homes, jobs and savingsviolating the entire percept of trust and reinvestments.

Wall Street succumbed to the reality of hubris and excess. It broke its proudest traditionsthat while innovation is necessary, pushing the boundaries of imagination too far is dangerous.

Having said this, now is the time to invest in the market. E-mail ZACH HAN at zklhan@ucdavis.edu for investment tips.


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