Seven lessons from the financial meltdown

John W. Schoen Senior producer • Profile • E-mail

House prices always go up. Buy stocks on the dips. Your 401(k) is going to pay for a comfortable retirement.

For most Americans, these core beliefs — heavily marketed by the financial services industry — have been widely held for decades. But the collapse of the housing bubble, Financial Panic of 2008 and Great Recession have upended much of the conventional wisdom most individuals took on faith.

The frightening events of the past year have left important lessons for those who lived through them.

Here are seven (once) widely held principles that turned out to be seriously flawed.

Home prices don’t go down.

It hadn’t happened in living memory. And because almost nobody remembered the last big slide in home prices during the Great Depression, it became easier to cling to the myth that it couldn’t happen again. That view was also bolstered by the housing downturn of the early 1990s, in which home prices slipped but saw nothing like the plunge they’ve taken in the past two years.

As the housing market soared toward a peak in 2005, analysts hotly debated whether home prices were headed for a fall, as we reported at the time. The theory being advanced by the real estate and mortgage industries was that as long as incomes kept going up, people could afford ever-bigger mortgages and pricier homes.

But that theory turned out to be wrong for several reasons. First, incomes didn’t keep pace with home prices following the recession of 2001. Second, to feed the bubble, loans were offered to home buyers based on ever-sloppier underwriting. In many cases, borrowers were approved without any proof they could pay the money back. And appraisers were pressured to keep the house price bubble expanding; the evidence of appraisal fraud during the tail end of the bubble is now unassailable.

Despite recent signs of life in the housing market — home sales have bounced off extremely depressed levels — prices are still falling in many parts of the country. It’s still far from clear when those prices will begin to level off.

Wall Street rocket scientists have tamed risk.

One reason lenders were lulled into giving mortgages to homeowners who couldn’t pay them back was that Wall Street convinced investors that the “science” of risk management had advanced to the point that default risk could essentially be eliminated. The mechanism was a series of complex “structured” products that mixed loans together, chopped them up into new investments, added insurance in the form of a credit default swap and — POOF!! — the risk of a homeowner defaulting on a mortgage went away. The pitch was so effective, purveyors of these mortgage-backed securities convinced bond rating agencies to give them their highest, Triple-A blessing.

It wasn’t until the house of cards began to fall and investors went scrambling to cover losses with those credit default swaps that the flaw in the “science” became painfully clear. No one had bothered to check whether the firms writing all that insurance had the money to cover the defaults. And no had bothered to check the theory to see if it stood up when housing prices were falling. Because these derivatives were completely unregulated, no one even knew which banks or investment firms were on the hook, or for how much.

More than any single factor, the unwinding of this CDS market was the spark for the inferno that consumed Bear Stearns, Lehman Bros., and many other firms, threatening the stability of the world financial system.

A 401(k) account is going to pay for your retirement.

American savers got an early warning about this one when the dot-com bubble collapsed in 2000. But following the dot-com crash, the market rebounded smartly enough to keep the hope alive that savings in a 401(k) account — or IRA for people whose employers didn’t offer matching contributions — would create enough wealth to retire on.

Today, despite the stock market’s recent rally from panic-driven lows, Americans facing retirement are likely to feel woefully unprepared to finance decades of leisure or philanthropic pursuit. Most of us will simply have to work longer.

Ironically, the shortcomings of the retirement system contributed to the housing bubble as many investors tried to supplement their savings by "flipping" homes or otherwise attempting to profit from the boom. Tales of easy money from early flippers helped spark the later-stage stampede that helped push prices to unsustainable levels.

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