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.

SOURCE: JPMorgan Securities/Rich Clabaugh–STAFF

When Congress designated April to be Financial Literacy Month a few years ago, the goal was to address a dearth of money smarts among the general population. But a funny thing happened on the road to financial enlightenment: It turns out that even the pros have a lot to learn.

"Illiteracy" isn't quite the word for it, but some analysts say that America's current economic slowdown has important roots in flawed logic and unwise behavior among the financial elite.

In short, America is getting some unplanned financial education this year that extends to boardrooms as well as schoolrooms. The hard lessons will probably weigh upon the credit and housing markets for several years.

But how well will those lessons be learned? It's an open question whether banking is destined to remain a source of instability in the economy, or whether leaders in business and government can learn to better manage financial risk.

"The reality is that finance is a complex business," says Peter Morici, a University of Maryland economist at College Park. "There has been no monopoly on foolish behavior."

In some cases, the lessons for financial sophisticates are the same ones that some programs for schoolchildren have been teaching this month: Be careful how much you borrow; if the return on an investment is higher than average, then its risk is probably higher than average, too.

A few examples of where the professionals have gone astray recently:

•Mortgage companies popularized loans where the buyer put no money down, a risky practice that helped fuel a housing boom – and now a bust.

Wall Street banks relied on complex mathematical models to gauge the value of their investments, but they misjudged how far those values could plunge when times got tough.

•Regulatory agencies, critics say, put too much faith in the ability of financial institutions to safeguard their own interests. Now, those regulators have to clean up damage such as an expected rise in bank failures.

A central problem is the cyclicality of lending and real estate activity. In the euphoria of a boom, professionals successfully reap big profits, but they also tend to commit lapses that set the stage for a bust. They forget basic principles or push into new activities they don't comprehend.

"In many cases, they didn't understand the risks they were taking," Mr. Morici says.

And their mistakes can have big repercussions. Although many factors are at work, financial-industry missteps are one reason for an economic downturn that may be turning into an outright recession.

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:

of 5 stories this month > Get unlimited stories
You've read 5 of 5 free stories

Only $1 for your first month.

Get unlimited Monitor journalism.