Even the pros could benefit from Finance 101

The economic slump has roots in faulty logic and unwise moves by the financial elite, analysts say. Congress has designated April as Financial Literacy Month.

from the April 30, 2008 edition

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Some mortgage-finance companies have failed. The financial companies in the Standard & Poor's 500 index, despite all the fees they generated during the housing boom, have about the same collective stock-market value today that they did at this time in 1999. Even General Electric, long seen as a bastion of earnings stability, recently fell victim to an embarrassing turn for the worse in its finance businesses. On April 11, chief executive officer Jeff Immelt had to report a rare quarterly loss, barely a month after he had forecast a solid year for the conglomerate.

At the center of today's financial woes is the surge in "securitized" finance of home loans. Mortgage-backed securities often paid great income to the investors, but many were also very complicated. The investments were sliced into so-called tranches, some of which bore the heaviest risk if loans to subprime borrowers started going bad. The theory was that even with subprime loans, only a small share would go bad, so that "senior" tranches could earn a triple-A credit rating.

When defaults soared, that myth was shattered. And it is big banks, as well as hedge funds and other investors, who bear the losses.

"There's no turning back the clock on the new financial technology," such as securitization, says Zvi Bodie, a Boston University expert on finance.

But making this new world of finance work better requires "a higher form of literacy," he says. And in cases when it's hard to know the value of complex assets, he says, bank regulators may need to be more vigilant in supervising banks.

"That translates into higher capital requirements," Mr. Bodie says. By mandating capital reserves, regulators can help control the risk of leverage. The less capital that financial firms hold in comparison to the loans or investments they make, the more leveraged they are.

A recent report by analysts at JPMorgan Securities predicts significant changes in the aftermath of the current financial crisis. Authors Margaret Cannella and Jan Loeys foresee greater regulation of investment firms, since they now play a big role alongside traditional banks in the credit markets. And they predict that securitized lending will become "less leveraged, better disclosed."

• Interested in learning more about financial literacy? The government has prepared a primer on many everyday issues: www.mymoney.gov.

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