Turmoil in the Financial System - How it started, What it means, Where are we headed?, by Shobhit Mathur
News about the turmoil in the financial system has occupied the headlines for the past few weeks. America is facing the worst financial crisis since the Great Depression and it is getting worse by the day. So far, as a result of a rapid succession of events, the Investment Banking business in the US has come to an end, the world’s largest Insurance company needed a bailout and several commercial banks have filed for Bankruptcy. The day I am writing this article (29th Sep), the Dow Jones Industrials Index had the biggest fall in its history and just a day earlier, Washington Mutual was the largest bank to fail in the nation’s history. When we are inundated with such news on a daily basis, we are distracted by the details and miss the big picture. In this article, I attempt to describe the financial crisis in simple terms and outline a plan to brace ourselves for the future. In an attempt to make the article understood by majority of the audience, I have abstracted out the details and minimized the use of finance jargon. I hope everyone, from novices to finance pundits find some useful information from what follows.
The Current Situation
The nation faces a financial emergency. There does not seem to be any easy solution and the ramifications though not clearly understood seem very dire. If you haven’t been following the financial news, here is a recent event which will give you a flavor of the crisis we are facing. A couple of weeks ago, Lehman Brothers, one of the largest investment banks in the world, filed for bankruptcy. Lehman Brothers was founded in 1850. It survived the Civil war, the two World Wars, the Great Depression and several business cycles. In its great history, it never filed a loss until the beginning of this year and went bankrupt by the end of it. Many financial institutions as prestigious as the Lehman Brothers have gone bust since the beginning of this year and many more are expected to follow. The financial crisis seems to be spreading into the rest of the economy. Surely these are unprecedented times, and as always, such situations have great lessons for mankind.
How did we get here?
The roots of the current financial crisis lie in the flawed monetary policy followed by the United States for several decades. However, for the sake of brevity, I will focus on the events in this decade, as this was the period during which the financial health of the country deteriorated the most. The decade started with the spectacular bust of the dot-com bubble in March 2000. Following this, the US economy started to shrink. The dot-com bust was followed by the 9/11 attacks in 2001. After recovering marginally, the economy was hit again in March 2002. In November 2002, when the US economy was officially in a recession, Alan Greenspan, the then chairman of the Federal Reserve, cut interest rates to 1% and held them there. Interest rates can be understood as the cost of borrowing money. Central banks set interest rates to control the flow of money in the economy. When interest rates are set too low, as Greenspan did in 2002, people tend to borrow more and consequently the economy is stimulated by the consumer spending. However after the bursting of the dot-com bubble, people had lost hope in the stock market. Combined with historically low interest rates, promotion in the media towards home ownership and the inherent belief that real-estate is more reliable than the stock market, the cheap money people borrowed flowed into real estate and housing.
From a banker’s point of view, the way to make money when credit is cheap is by taking more risk. Riskier loans yield a higher interest rate. Sub-prime mortgage loans are the riskiest of all and consequently the ones with the maximum potential return for the banks. Sub-prime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. In an attempt to get higher returns, banks started encouraging such individuals to take up sub-prime loans. Various incentives were given to encourage home ownership. However, the banks did not keep these loans to themselves. They packaged such loans through a process called securitization and sold these securitized loans to financial institutions all around the globe. With rising home prices (the collateral behind the loans) and promised high yields, other financial institutions were willing to accept these loans easily. Realizing that there is a booming market for these securitized loans, American banks relaxed their lending standards, took greater risk, gave out more loans, securitized them and sold them to other financial institutions. With easily available home loans, the demand for houses went up and the housing prices went to the moon. The banks were happy and so were the home owners. The mania continued for about 4 years. However, this entire market was based on the belief that housing prices would continue to rise forever. The bubble finally burst in late 2006. Houses were not affordable anymore. The prices had risen way beyond income levels. Housing prices came crashing down. Moreover with a slowing economy, rising oil prices, rising unemployment and high inflation, people who were given these cheap loans could not afford to pay their installments. Houses started to foreclose, the market had a glut of empty houses while the demand fell. As the houses foreclosed, the securitized loans which they backed lost their value too. Realizing that these loans were not as safe as they assumed it to be, the rest of the world was unwilling to buy anymore of these loans. The home loan market froze. The existing loans went worthless as they did not generate any monthly installments. Consequently, the institutions holding these loans went into heavy losses and many faced bankruptcy as we have seen. By now however these bad loans had found their way into the accounts of several financial institutions all around the world. The dominoes started to fall and continue to this day. One should note that this is a simplified portrayal of the crisis, but gives the big picture.
The blame game
Observers of the meltdown have cast blame widely. Some have highlighted the practices of subprime lenders and the lack of effective government oversight. Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing sub-prime mortgage securities without verifying the strength of the underlying loans. Borrowers have also been criticized for entering into loan agreements they could not meet. However, the root cause of the problem is availability of cheap credit which started in the Greenspan Era and continued under the current Fed Chairman, Ben Bernanke. You cannot give a carrot to a rabbit and expect it not to eat it. Here is a question for all the finance pundits among the readers: in a supposed free market like the US, why is the Federal Reserve allowed to set the price of the most important good in the economy: the price of money. This is the root cause of the problem - availability of artificially cheap credit.
What it means to us?
As described above, during the past decade, these worthless mortgages were bought by several financial institutions all around the globe. This is the reason, we see European banks failing while they never directly lent money to the American people. The problem is widespread and amounts to several trillion dollars in bad debt. It threatens to bring down the world’s financial system. Financial markets swing between greed and fear. When the people get greedy the market enjoys a boom time. Finally when the bubble bursts, fear sets in. Today, banks are unwilling to lend money to each other. Each bank is unsure of the financial health of the other. For all practical purposes, the flow of credit or liquidity in the financial system has frozen, also called as a credit crunch. This is the reason, the government is forced to bailout banks as nobody else is willing to help these ailing banks. However, this is all being done with trillions of dollars of tax payer’s money. When flow of credit freezes, it has disastrous consequences on a credit driven economy like the US. Fear now rules the financial world. Cheap credit was available to the Americans for too long and they made the most of it. The process is unwinding rapidly and there is no short term solution in sight. The problem has now spread to prime mortgages, student loans, credit card debt, corporate debt, municipal bonds etc. The magnitude of the problem is so huge that we might see a situation like the great depression if not worse in the coming decade.
How to prepare for the future?
The crisis is bound to spread further, resulting in slowing growth and high inflation, also known as stagflation. Typically such periods are accompanied by high unemployment. In such a situation, where your future income is not guaranteed, the first step which you should take is to start saving and reducing any discretionary expenditure. You need to prepare yourself to live beneath your means. The days of living off credit cards and refinancing your homes have come to an end. Pay back any loans you have as you may not be able to do so later. If you have any excess cash, keep it liquid, in the form of treasury bills if possible. Gold is an investment of choice during such periods of crisis and uncertainty. It has been a store of value for several centuries. Most importantly, don’t ignore the crisis but rather educate yourself about it. By the time this crisis ends, it is going to envelope each one of us in some form. The more we are informed the better we are equipped to deal with it.
Shobhit Mathur is a software engineer at Amazon.com, Seattle. He can be reached at shobhit.mathur@gmail.com. Shobhit keenly follows economics and geo-politics. He maintains a blog of interesting articles at http://shobhitmathur.wordpress.com.
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October 1st, 2008 16:13
An enlightening article on the present american economic scenerio affecting banks in the world. Awakening article for every individual.
good work
October 1st, 2008 17:34
Getting the facts correct is the first view of the failed USA BUSH GOVERNMENT:
Factual statistics contained at Harvard Business School library: show: Total expenditure of more than $3.5 trillion dollars in Afghanistan and Iraq wars in the last eight years by Bush Administration.
If “Watergate” was bad, this “Bush” administration over the last eight years has ruined U.S.A. completely; not only AMERICA but U.K. as well!
U.S.A spent on Iraq and Afghanistan through March 2008 approximately USA $700 BILLION– A DEFICIT OF FATAL DISASTERS across the levels unrecoverable.
Based on assumptions set out in our book, the budgetary cost to the UK of the wars in Iraq and Afghanistan through 2010 will total more than £18 billion. If we include the social costs, the total impact on the UK will exceed £20 billion
Before the 2003 invasion, oil cost less than $25 a barrel and futures markets expected it to remain around there. That is nearly $100 a barrel now.
Gold price nearing just under $1,000 per ounce that compared to 1998 was $300 per ounce.
Current average: USA Dollar $1.40 to 1Euro
Federal debts over 25 billion USA$ grown out of proportion.
U.S. dollar is headed for its intrinsic value
There being futile hope, all the lengthy advises and counsel remains extremely hypothetical and inappropriate even.
The world is short of liquid cash! How could one envisage even contemplate to save when nearly over seventy-five percent of the AMERICANS are re-mortgaging their properties? This is the truth bitter, as it may seem! Whilst it is true that USA citizens need to get together their resources, and finances, and strategies to ECONOMISE and to be more careful about expenditure, such crises are not of NORMAL economic standard suggestive scenario. We are witnessing a global breakdown resulting from wastage of scarce resources and depletion of real growth in industrial output!
One panel suggests that the worst is yet to come. Perhaps this is a time whence many American citizens will realise value chain in a different perspective. Preparing for hard times in the U.S. is one of the smartest strategic moves you can make in your portfolio right now before “value” takes yet another negative turn and causes more upheaval.
Dismally sad but truthful the future of USA is dire whichever way one looks at from whatever angle one contemplates.
It is one of the most complex, paradoxical and chaotic situation for USA.
October 2nd, 2008 09:28
Any economist who understands “SHAREHOLDER VALUE”, “TRUE COST OF CAPITAL”, AND “VALUE CHAIN” attributed to the STOCK MARKET share prices will comprehend in sympathy with the fact that there is no REAL “core dividend” or “liquid shareholder profit” other than those in “abstracts” and “balance sheet” equations of LONG TERM AND MEDIUM LIABILITY VERSUS MEDIUM TERM WRITTEN OFF ASSETS OF DEPLETING BANKS. Now, the bailout plan or the rescue package in reality does NOT benefit a poor AMERICAN. Let us be more realistic and acknowledge that it is a stimulus or catalyst to merely diminish a blazing flame, already in its sinking mode. How, if this dark truth, shall improve minimum family struck with poverty and dealing with higher even more imposing cost of living, inflation, and scarcity of resources not to mention redundancies, absence of jobs, and loss of INCOME. In which way would a poor American familuy be better off? Is the USA government bit enough or has the federal reserves of the USA even with the help of tax payers money the capacity to absorb in full a deficit of nearly $550Billion dollars plus, finance its current wars, plus on top of all these, encapsulate and embrace the sinking fund of the TRUE SHARE HOLDER VALUE of companies NOT PRODUCING real profits but artificial balance sheet values. What will happen when the real federal money will NOT be available in tranches at the right moment? Then what happens? Is there a PLAN B OR A PLAN C?
As such, I am not convinced enough that this is the manner in which the issue at stake will be resolved. However, on paper, in terms of balance sheet, and in terms of temporary measures, it will show artificial stock market. Any wise person would withdraw from speculating on the stock market shares. I am compelled to write this message with much compassionate sympathy and concerns for the poorest American families and American families that struggle hard to sustain survival on a tight monthly budget with increasing costs of maintenance, food, petrol, clothing, overheads, and double mortgages. Now, it seems too optimistic, and too good to be true but will this be another BUSH blunder just before he goes out of power or would this be the only right thing “BUSH” ever did? On paper it appears a common sense plan with core financial insurance creating answers across the board. What happens when the federal interest rates cannot be maintained at levels envisaged? I truly hope and pray that STOCK MARKETS whose apparent movements manifest in demand and supply of the shares of a particular company in speculation of the rising cost of oil and gold will sustain the rescue plan if anything for the poor American Citizens. All else are matters of ‘this, that and the other’ and everyone would wishfully want to be able to express thesis, antithesis and synthesis of an issue that is both ‘right’ and ‘wrong’. However, this so called “rescue plan” is an extra ordinary step up effort by the most experienced and skilled financial and economic experts and hence it appears to be a sound package. The “uncertainty” or the “risk” is does ANYONE know how stock market shares will trade in a month’s time? In a mamoth buy out of toxic assets, let us hope that they are at least bought of at “fair” prices or at least favourable prices. If that being the case, the infusion of capital will not imply pampering businesses but a blessing in disguise. God bless U.S.A.
October 10th, 2008 15:32
There are fundamental problems with the US economy. The US consumers are overloaded with debts. The jobs losses over the past few years and the recent loss of wealth due to the stock market crash is going to increase the influx of Seniors in the job pool, as they decide to delay retirement or get back to part time work. This is going to place pressure on wages.
Listed below is the link to a presentation made by an Indian Economist in February 2008. Listen to his insight and straight forward talk.
http://video.google.com/videoplay?docid=4343898391323537541
October 12th, 2008 02:13
interest only mortgages uk…
Well spoken. I have to research more on this as it is really vital info….
October 17th, 2008 10:53
Dearest RupeshKumar: Prannamm Namaskaraam:
Truly since 1960’s this propaganda has become a manifestation of political economy rather than pure financial economics. Fundamental issue facing our world is “ACCUTE SCARCITY” of oil, gold reserves, and grains. Now, if your economist in India suggests that India will not be subject of Globalisation and that it is a term associated purely with the AMERICANISM, then strictly speaking you and your economist professor in India perhaps must contemplate upon removing the “STOCK-MARKET” world wide. When you do so, you remove the term “global-political-economy”. Until then, whatsoever transpires in the USA will have great repurcussions and effects and consequences in the west U.K., EUROPE and its ripples spread across the globe without the shadow of a doubt. Just remember this much: THE GIMMICK OF articificially saving the banking system in itself affects not only the American tax payers but the investors and business enterprises world wide. Why? It is because we see today stock market share prices with artificially false shareholder value. Therefore “VALUE” is the cause of all doom and gloom.
Many potential trans-national and multi-national corporations have already entered into massive “mergers and acquisitions” program and “joint ventures” program to survive in the next ten years. This entails in the main transporting the port of manufacturing to low-cost labour and establishing lower-cost materials, lower-cost distribution costs [by putting up assembly plants in the country of exports]. So effectively “TOYOTA” ; “HONDA”; and others are made in Japan but assembled in respective territories for distribution to be minimal. For example: We have huge shift in production plants moving to ‘Wales’ in the U.K., and so forth.
The future world will NO LONGER be a dominance of USA and EUROPE but a shift in ownership and control of multinational and transnational corporations as more and more rich companies in India, China, Russia and Africa awake and buy out the American and European companies at large. It is only a matter of time, I humbly re-iterate, that AFRICA and INDIA once third world countries will be feeding GREAT USA AND EUROPE.
Already India is the fastest growing and the most booming economy in the world and this in itself will attract back those very Indians who fled India to got to the USA in search of more money and better lifestyle.
Lifestyle?
One only need ponder upon the lifestyle of the American Hindus. Most of my family and friends spend nearly 60 hours working and 30 hours in travelling to and from work places. Thats nearly half the time gone. Average per day of 11 hours is therefore spent say like this: 6 hours in sleep, 3 hours in domestic chores, and probably 2 hours in personal time [less than 5%].
Compared to UK: Where the time spent in personal development is between 20% and 30% of the total time.
To much apathy and compassion, we have to reserve our better judgement for the worst times ahead and sincerely hope and pray that THE GREAT AMERICA shall be LED by a reliable president, an honest humankind.
“VALUE” is what needs restoring.
October 27th, 2008 23:29
Sir, I have heard conservatives put blame on the Community Reinvestment Act of 1977 for this crisis. They argue that this compelled banks to give loans to low income people with shaky credit and backed up the shaky loans with federal vehicles (Freddie Mae and Fannie Mac).
Can you qualify or refute this statement? It would be much appreciated.
April 2nd, 2009 19:56
to briefly answer Pratik-ji, Community reinvesment act alone can’t be blamed for the crisis. The existence of a secondary mortgage market because of Fannie/Freddie, repeal of the Glass Steagall Act, allowing investment banks to lever up 30:1, no regulation of CDS (where one would not only buy/sell insurance to hedge but also to make speculative bets), Alan Greenspan lowering interest rates so low so as to induce a housing bubble after the tech bubble, all these are factors. Rating agencies were asleep at the wheels also. So it was a combination of many factors. Only blaming Community Reinvestment is rather short-sighted.