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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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This entry was posted on Wednesday, October 1st, 2008 at 7:08 am and is filed under Current Events. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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