The 10 worst assumptions of 2008

By U.S. News & World Report

An old military saying has become popular on Wall Street: "Amateurs study the plan. Professionals study the assumptions."

It's too bad that nostrum wasn't in fashion a few years ago, when it seemed as if nothing could go wrong in the go-go economy.

An epic housing boom fueled by low interest rates was turning ordinary Joes into real-estate magnates, and everybody wanted in. Home equity materialized out of nowhere, helping everyday Americans buy fancy vacations and luxury cars. When Henry Paulson was nominated to be Treasury secretary in 2006 and came to Washington for confirmation hearings, nobody even brought up the topic of subprime loans or a housing bust. What, us worry?

We know what happened, of course. Investors seeking the highest possible returns badly underestimated the risks of exotic securities linked to doomed mortgages. Things that couldn't possibly go wrong went very wrong. Financial geniuses on Wall Street ran computer models showing what would happen if their own risky bets went sour -- but not if everybody else's did, too, at the same time. And then, the unthinkable: the collapse of Wall Street titans such as Bear Stearns and Lehman Bros. (LEHMQ, news, msgs) and an earthquake in the financial system.

Behind all of those meltdowns were bad -- sometimes awful -- assumptions. Here are some of the most egregious:
Real-estate values always rise over time. That was true for most of the past century, until they rose too much in too little time in the middle of this decade. We know now that housing values nationwide peaked in 2006 and have been falling ever since. So far, prices are off about 20% from the peak, with a further decline of probably 10% or 15% ahead.

Assuming that home values would keep going up was a catastrophic miscalculation for Citigroup (C, news, msgs), Merrill Lynch (MER, news, msgs), Fannie Mae (FNM, news, msgs) and millions of homeowners who now can't afford huge assets that are falling in value.

Lesson: Never bank on outsized gains that haven't materialized yet.

The mighty consumer will keep spending. Remember when economists kept marveling at the willingness of Americans to get out their wallets, no matter what their debt load or job prospects? Well, the economists aren't so impressed anymore. During the second half of 2008, retail sales, for example, fell nearly 8%, the steepest decline on record.

The good news is that consumers are paying off debt and saving more, but for an economy in which consumer spending accounts for two-thirds of gross domestic product, the pullback signals a dramatic realignment that will be painful for an overspent nation.

Lesson: You can't spend your way to greatness.

A buyer will always emerge. But at what price? All those bidding wars over homes in 2005 and 2006 were driven by the belief that somebody else would pay even more for the house in a couple of years. But when home values started to fall, buyers evaporated, because nobody wanted to buy a big asset that could be worth less the day after you closed the deal.

It wasn't just homes: Lehman Bros. CEO Richard Fuld was convinced that a last-minute buyer would emerge for his troubled company -- right up to the moment Lehman declared bankruptcy. Bear Stearns and American International Group (AIG, news, msgs) foundered because suddenly there were no buyers, at any price, for vast amounts of troubled securities that had been as good as cash a year earlier. General Motors (GM, news, msgs) has been trying to sell its Hummer division for the better part of the year, but it turns out nobody wants to pay real money for a division that represents the conspicuous consumption of a bygone era.

Lesson: An asset is worth only what somebody else is willing to pay for it, not what you think it should be worth.

Banks will be careful with their money. Ha! Once upon a time, bankers were conservative investors whose first responsibility was to make sure they didn't lose their principal. That led people such as Alan Greenspan, then the Federal Reserve chairman, to assume that the mere risk of losing money was plenty of incentive for banks to make smart, careful investments.

Greenspan was wrong. Here's what he said in October: "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity . . . are in a state of shocked disbelief."

So are bank shareholders: The S&P 500 Index ($INX) is down about 40% for the year, but the financial sector is down about 60%.

Lesson: Never underestimate people's ability to screw up.

Continued: The smartest guys are on it

 1 | 2 | next >