Friday, October 10, 2008

Economic Crisis Explained

How Can A few bad mortgages in the suburbs of Florida lead to the Bankruptcy of a country like Iceland? What has caused the stock market to fall by 40% -the worst decline since the Great Depression? And why has the credit crunch pushed the global economy into recession?

The Subprime Mortgage Fiasco Explained

  • The Dot com bubble burst in 2001. Shares in internet companies collapsed and with events of 9/11, the US faced recession. The Federal Reserve responded by cutting interest rates to 1% - there lowest level for a long time.
  • Low Interest rates encouraged people to buy a house. As house prices began to rise, mortgage companies relaxed their lending criteria and tried to capitalise on the booming property market.
  • Mortgage companies actively sold mortgages to people with bad credit, low incomes - often first generation immigrants. This 'subprime market' expanded very quickly.
  • Mortgage salesmen were paid on commission. Therefore, they often hid the true cost of adjustable rate mortgages and did little to check whether the homeowners could actually afford repayments in the long term. Even the feeble lending checks were ignored
  • Many took out adjustable rate mortgages which were affordable for the first two years, but, then the interest rate increased making mortgage payments much more expensive.
  • In 2006, inflationary pressures in the US caused interest rates to rise to 4%. Normally 4% interest rates are not particularly high. But, because many had taken out large mortgage payments, this increase made the mortgage payments unaffordable.
  • Also many homeowners were not coming to the end of their 'introductory offers' and faced much higher interest rates. This led to an increase in mortgage defaults and companies lost money.
  • As mortgage defaults increased the boom in house prices came to an end and house prices started falling.
  • The falls in house prices were exacerbated by the boom in building of new homes which occurred right up until 2007. It meant that demand fell as supply was increasing causing prices to collapse, especially in suburban areas.
  • The Fall in house prices made the mortgage defaults more costly. If house prices are rising and someone defaults, the mortgage company can get most of the loan back by selling the house. But, now with falling house prices, they may end up with only a fraction of the house value.

The Role of Credit Default Swaps

You might imagine that this irresponsible lending by US mortgage companies would mean they would go out of business - end of story. However, the problem of the US mortgage defaults was spread across the financial system.
  • Mortgage companies in the US borrowed from other financial institutions to lend mortgages. They sold collateralised mortgage debt in the form of CDOs to other banks and financial institutions. This was a kind of insurance for the mortgage companies. It means that other banks shared the risk of these subprime mortgages.
  • Because these subprime mortgage debts were bought by 'responsible' banks like Morgan Stanley, Lehman Brothers e.t.c. risk agencies gave these highly dubious and risky debt bundles triple A safety ratings. Thus banks either ignored or were unaware of how risky their financial position was.
  • Therefore, when mortgage defaults in the US occured, many banks and financial institutions around the world had to write off bad assets. E.g. AIG had been insuring many of these mortgage debts so was faced with huge losses
  • The extent of this bad debt is estimated by the IMF to be close to £1.3trillion.

Freezing of Money Markets.

  • In addition to bad debts, the other problem was one of confidence. Because many banks had lost money and had a deterioration in their balance sheets. They couldn't afford to lend to other banks. This caused a shortage of liquidity in money markets.
  • Banks usually rely on lending to each other to conduct every day business. But, after the first wave of credit losses, banks could no longer raise sufficient finance.
  • For example, in the UK, the Northern Rock was particularly exposed to money markets. It had relied on borrowing money on the money markets to fund its daily business. In 2007, it simply couldn't raise enough money on the financial markets and eventually had to be nationalised by the UK government.
  • Because banks were short of liquidity, they have been selling assets such as their mortgage bundles. This caused further falls in asset prices, further liquidity shortages and further deterioration in bank balance sheets. (The Paulson plan is to try to reverse this cycle by the government buying these financial assets no one else wants to buy.)

The Vicious Cycle of the Financial Crisis

1. Share Prices

Because banks have lost money, people have been selling shares in banks. This fall in their share prices was speeded up by aggressive 'shorting' of banking stocks. The fall in share prices have compounded the problem of banks because
  1. investors / consumers lose confidence
  2. More difficult to raise finance on the stock market.
Part of the UK plan is to buy bank share capital to give greater confidence to the banks and enable them to raise sufficient finance.

2. Housing Markets

The shortage of finance means that banks have had to reduce lending, especially mortgages. The shortage of mortgages has caused further falls in house prices, especially in the UK. Falling house prices are magnifying the loss of banks as more default on their mortgage and loan payments.

3. Economy

Falling house prices, shortage of finance and collapsing confidence have caused the 'real economy' to decline. Investment and consumer spending has fallen therefore major economies face recession and rising unemployment. The rising unemployment increases the chance of more mortgage defaults and further bank losses.

Further Reading

16 comments:

Ernestrome said...

Why haven't you dealt you dealt with naked short selling and other financial fraud in your explanation?

Tejvan Pettinger said...

I mentioned short selling in passing with link to: http://www.economicshelp.org/2008/09/short-selling-explained.html

even though it is long explanation there are still over things to mention.

Karen said...

Great article!
Maybe I will link to this page.
Thanks for posting.

Anonymous said...

very good article to understand the basic behind ongoing crisis....

Anonymous said...

hey, great explanation for the uninitiated. Is there any estimate of the total losses to the world economy (stocks/ housing values/ jobs)

Tejvan Pettinger said...

It is hard to put a figure on it. Also the magnitude of the recession keeps changing. It now looks like we could have the first global recession since the war.

Truth said...

Lynn Tilton (CEO of Patriarch Partners) was on CNBC Squawk Box on Friday…relevant insights to this discussion…Fixing the Financial Crisis: The truth of the situation can be ignored no longer (http://www.cnbc.com/id/15840232?video=960926779.)



This is the same woman who predicted the financial crisis on Bloomberg TV back in 2006 (http://www.blinkx.com/video/lynn-tilton-on-bloomberg/87JL8lMSQmrDI4ALaa5zdQ) so perhaps she’s worth listening to now.

She proposes direct lending to businesses through a new “Provisional Federal Bank (http://www.patriarchpartners.com/Lynn_Tilton_WashPost_NYT.pdf)”…Liquidity must be made available not solely to big banks where Treasury-injected capital has been amassed to fill the cavity left by gambling losses, but rather expressly to deserving American companies and their people who will reignite our sputtering economy. A provisional Federal Bank must be initiated to foster enterprise and to provide job opportunities for every American.”

Jon said...

You're not going back far enough with your history. Back in the 1970's, Congress started pressuring lenders to make home loans to less qualified buyers. This, in turn, caused lending institutions to lower their qualification standards again and again until just about anyone could get a loan, whether or not they could actually afford the house they were buying, a practice that continued until early 2007. These bad loans were tacitly underwritten by the US Government via Fannie May and Freddie Mac.

Tejvan Pettinger said...

Thanks Jon. Good point

Anonymous said...

The economy and econometrics are human made constructs, they merely only mimic us. If human nature and history teaches us anything, it teaches us that everything functions in a cycle-like fashion. The only unknown anomalous variables, is the timing of the chronological order of such a collapse. So from this premise, if economy is based on such cyclical patterns; it is not a question of if it is going to happen, it is a question of when is this going to happen! Trust me, it will happen!

I like using the parity or should I say similarity of comparing the cyclical nature of mass extinction rates throughout geological time, to that of economic cycles (i.e. deflation spirals) of recessions and depressions thoughout the history of monetary economy within societies. Ecology is economy, one can not exist without the other; they are so interconnected. They are all cyclical systems interconnected within paradoxical proportions. From a ecological perspective, we are currently in one of the worse recorded mass extinction rates, ofcourse the economy is going to eventually mimic other systemic cyclical patterns.

My point is that every known civilization has eventually come to a end (cyclical), and what is the very core functioning property of our current civilization, “our economy?”. Unfortunately our current economy takes unnatural precedence over everything else. Combine this with global warming, increasing populations, internalize conflicts (war), problems with logistics of goods (world hunger/poverty); collapse seems to be a strong plausible reality. The fact is, we live in a finite world, with finite resources, but yet our economy is based under the contingent of constant sustainable growth; which is not currently possible.

So I have agree we are in a economic crisis, and collapse does seem inevitable. Unfortunately, economic crises isn’t my biggest concern right now… However, some people argue that we as a civilization have reached a pinnacle moment in economic history. Just like when the barter and trade system evolved into a monetary/currency based system because the barter and trade system was not sustainable or collapsing at the time. If everything is cyclical as I claim, then from an optimistic perspective, we are currently experiencing the collapse of our current system, and it will naturally evolve into a more robust and sustainable system, maybe even one based on no currency.. Who knows, what the future holds is all I am saying. I currently do not have much faith in the current economy, and I imagine many others do not have faith either.

vicnic said...

It is all very well to make up lame excuses and pontificate ad infinitum on the current global mess.

As long as banks have licence to create money based on promises to repay or debt, as per the current monetary system, the world will continue to suffer the consequences of their greed and complete lack of compassion for society as a whole.

It is indeed a sad day when the pursuit of profit is more important than societal stabilty.

Finally, one wonders at the reaction of people on the street when modern banking is explained to them in language they really understand.

Anonymous said...

wow....great article.now i understand the crisis much better.but does this crisis affect developing countries?

Anonymous said...

All legal money is created by three entities: the U.S. government that only mint coins amounting to $36.4 billion, or just 0.07% of the $50 trillion plus money supply; the Federal Reserve that issues paper currency amounting to $998 billion, or about 2% of the money supply, and paying the U.S. printing office to print the currency; and commercial banks that Issues checkbook money in the amount of about $48 trillion, or 98% of the money supply.

The money created by the Federal Reserve and commercial banks is created as debt that is extended into the economy as loans that must be repaid with interest. Since these institutions create only the principal of the debt, not the interest, collectively fulfilling the loan obligations is impossible. If the total principal is repaid there is no money left to pay interest; if interest is paid from the money supply, there is insufficient money to repay the principal. In either case meeting, the terms of all the contracts are impossible.

When it is expressed as a mathematical inequality, the difficulty is evident: the sum of all principals cannot equal the sum of all principals plus the sum of all interest payments. (P does not equal p + i)

In order to give the banking system the appearance of solvency, stability and increase profits, banks must continually increase the number of new, larger loans, using the newly created money to service old loans. This pattern is the easily recognized signature of a common pyramid or Ponzi scheme. Drawing its value from existing currency, the new currency dilutes or devalues the old currency. The reduction in the currency’s buying power is euphemistically termed inflation. The current crisis is a sure sign that the scheme has reached it mathematical limits requiring greater interest payments than the system can supply: the house of cards is collapsing.

Jonny said...

Yes these are few examples of the great disaster for economic crisis

Real Estate Omaha said...

Recent economic events have brought gold to new heights stirring constantly. As traders commodity many follow and participate trends, some of these increases self-fulfilling prophecies.

Anonymous said...

Tejvan, thanks for your explanation, it was good. In my experience teaching this crisis, people with little background in econ have trouble wrapping their minds around one simple thing: that debt, like anything else, can be bought and sold. If you don't understand this concept, you won't understand how the situation multiplied. If you do understand this concept, its actually very easy to understand. I like to explain it this way. Thanks!