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During any financial meltdown, whether personal or national in scope, there's always going to be finger pointing. People look for elaborate reasons why things happened ranging from mass hysteria to unscrupulous profiteers. People will list dozens of reasons, nearly all of them orchestrated by people outside of their crisis-defined group. But the primary driver of all of these fiascos can be abbreviated with three letters: OPM. Someone asked me my thoughts on how the housing market could have gotten so out of whack and my simple answer was OPM.
Is it really that simple that everything from stock crashes to our housing bust to people filing for personal bankruptcy and governments teetering on the edge all have the same root case? I think so and its name is Other People's Money (OPM).
The fact is that people will take enormous risks or spend recklessly if they have no "skin in the game". The Great Housing Bubble of 2002 - 2007 has so many examples of the abuse of OPM that it would fill an entire book.
The simple and obvious example is unqualified buyers were able to take out zero percent down loans giving them unlimited potential upside with zero financial downside. But what is lesser known is that this was enabled because the ratings agency made a quantitative determination that defies any logical understanding of human nature. They determined that the risk profile of an 80% mortgage with a 20% second mortgage was exactly the same as one with 20% down. Some bright quantitative analyst, perhaps encouraged, determined that in either case, the loan to value was 80% and therefore, they had the same risk. This allowed the underwriting of a massive amount of zero percent down loans. Anyone having any understanding of human nature knows that in one case, the potential loss is 20% and the other case its zero. It turned out naturally, that those who really put down 20% had much lower foreclosure rates that those with the piggyback loans.
Of course, it wasn't just the consumers using OPM. The banks had become masters of it too and they showed the same signs of risk taking that consumers did. Because they were able to securitize their loans, banks were not just leveraging the deposits of their customers, but increasingly utilizing capital from investors. The normal fear of loss that occurs for a banker when thinking about his depositors funds became completely absent. It was somebody else's money, in many cases from investors overseas, which fueled lower and lower loan approval standards.
And don't shed too many tears for the investment managers that were sold junk mortgage paper. They were using OPM also and on a massive scale. Most of these managers had increasingly smaller and smaller personal risk in their funds and increasingly they operated off a percentage of profits. Super-charged profits from buying higher yielding mortgages ensured them monster bonuses for years that far exceeded their personal risk capital. Whether it was a hedge fund or a pension plan, the investment managers from 2002 to 2007 took home a lot of cash.
Of course, there is another player in this, one that exemplifies the brazen use of OPM like no other: Government. Governments, at least the biggest of them, not only get to utilize OPM at an astonishing rate, they are in the unique position of using money from people that aren't even born yet! A trillion dollars is a mind-boggling number but you can spend it recklessly when the people that you borrowed it from didn't even know you took it from them. If nobody is clear who the "Other People" are, very few people object. Psychologists a long time ago recognized that humans would continuously exchange short term gratification even when the long term effects were devastating. Imagine the likelihood of the government bailing out banks or AIG if it told each American household that it would have to write a $4,000 check to cover the cost and that it was due in 30 days.
If OPM can wreck the world's largest economy, think about what it can do for your household. Everything from your credit cards to leasing that fancy new car operates on the extreme of OPM. Of course, if you use YOUR money, you can avoid the risk of abusing OPM and its inevitable downfall.
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