“The world has changed quite drastically – and our view of the world has changed quite drastically.”

I found that stunning statement buried deep in a news story about the arcane maneuverings that exposed the world’s largest investment companies to massive losses in what we now know as the subprime crisis. It came from a director of one of the world’s biggest bond rating services – the people who are supposed to keep everybody rooted in reality.

If there is a New Year’s resolution worth making, it is to recommit ourselves to some fundamentals of how the world works. I won’t even try to explain the arcane world of collateralized mortgage obligations and credit default swaps and their complicated cousins. For one thing, I don’t pretend to understand it. If I did, I’m pretty sure I couldn’t explain it in English, because as far as I can tell, nobody has done so yet.

For those of us who have seen the rubble of the S&L failures, the dot-com craze of the late 1990s and other “bubbles,” today’s crisis feels like “déjà vu all over again.” If we zoom out for the big picture, we see a few common threads:

• Forgetting the “real world” purpose. Practically everything we do in the world of finance has (or once had) a function that actually helped people. Commodity futures gave farmers a way to hedge the inevitable risk of crop failure. Mortgages provide people a way to buy homes. Stock markets permit companies to raise capital to create goods and services (and jobs). From time to time, all of these have pulled free of their moorings and become twisted into vehicles for what can only be called gambling. Even condominiums suffered this fate a couple of years ago, with the buying and flipping of units that hadn’t even been built yet.
• Redefining value. For almost anything of tangible value you can buy or sell, there are time-tested standards for what it is worth. Because we all have our own “axes to grind” in real estate, I’ll use the stock market as an example. Individuals who buy shares in a company are buying a right to part of the company’s earnings. But what happens when there are no earnings, as was the case in the 1990s when anything ending in dot-com was a surefire winner? Analysts switched gears and started talking about “sales” and “J curves.” When it became clear that people were spending fortunes for stock in companies that were unlikely to ever earn anything, values collapsed. Of course, we’re seeing the same thing now with the collapse in value of exotic products loosely based on mortgages.
• Changing standards. Once values are redefined, the changing (read: lowering) of standards is always close behind. When there was a shortage of buyers at high price points, lenders simply relaxed their standards, and the subprime market was born. The old standards of “risk” didn’t seem to matter any more, because the notes would be passed on to new investors (read: speculators). In the end stages, mortgage originators were pushing so-called “liar loans” that required no proof of income and assets.

Fortunately, the laws of value eventually assert themselves. If you lend money to people who can’t pay it back, everybody gets hurt. If you pay too much for a short-term speculation, you’ll lose money when you sell it. If you gamble, you’ll lose at least half the time. We’re not seeing a crisis because things are going wrong. We’re seeing it because things are returning to normal.