Thursday, October 20, 2011

Understanding Financial Crisis

Readers Question. I have recently been trying to better understand the financial crisis and it has been very useful, however I am curious to your own opinions, as the articles are very neutral.

Where possible, I try to avoid preconceived ideology / expectations. Of course like everyone I have my preferences and prejudices. Not everyone would think my articles neutral.

Bankers can make millions from a recession, and as people suffer in Greece for example, they continue to do so, making profit from the taxpayer´s bailouts as austerity measures leave thousands homeless and without work. I for one am mad as hell and I want to clarify that I have my facts straight.s

Some bankers can make millions from a recession and financial crisis, though some have also lost their jobs. Many had their job saved through government intervention (which wouldn't have occurred in other industries) Even the Bank of England have issued a blunt warning about unjustified bank bonuses [BBC]

Subprime mortgages and CDOs and derivatives were made legal under Greenspan, right?

Alan Greenspan was chairman of the Federal Reserve (1987-2006). He primarily was responsible for setting interest rates, though the Federal Reserve do have a role in overseeing aspects of the financial system. (see: mistakes of Alan Greenspan)

During the 1980s and 1990s there was a general move to deregulate the financial sector in both UK and US. This was partly due to legislation by governments; sometimes it was the Federal Reserve, e.g. adopting different interpretations more favourable to banks (e.g. in 1996, Fed reinterpreted Glass-Steagall act - banks could now devote up to 25% of business to investment banking.)
Also, there is an element that financial institutions were creative in selling and expanding new financial instruments that didn't fall under any regulation. One problem is that it wasn't always clear who was responsible for financial regulation (e.g. Central Bank or government). The outcome of this financial deregulation was:
  1. Easier to lend subprime mortgages (less checks on people's incomes - especially in US)
  2. Easier to buy and sell complex financial derivatives.
  3. Banks able to take on more risky (and profitable) lending practises.
  4. Greater competition between banks in attracting custom.
  5. In the UK many (non-profit) building societies became public companies listed on the stock market. This changed their business model. They were more likely to lend money with smaller reserve ratios, e.g. Northern Rock were borrowing money to lend for profitable loans. - This led to liquidity shortage at start of credit crunch.
People were falsely sold mortgages by banks who then bet against the said mortgage, so as people were evicted, bankers got fatter.

Yes, mortgages were miss sold. Mainly this problem was confined to the US. (problems US housing market) But, banks didn't benefit when people started to default. In fact banks lost a significant amount of money because people defaulted and house prices started to fall; therefore banks could only recover a fraction of initial loan. Many mortgage companies went bankrupt.
Also, as a result of US mortgage defaults, many banks (e.g. European banks) who had bought these CDO's and sub-prime mortgage derivatives lost money too. It was because these mortgage bundles were sold on, that problems in US subprime market became widespread leading to global credit crunch. See: Credit Crunch Explained

The first UK bailout, as you say in one blog, was to revive the banks so they would begin lending again. That didn´t happen.
  • True, lending remained very low. However, the main focus of the UK bank bailout was to prevent banks going bust, which would have caused a catastrophic decline in confidence and possible 'runs on the bank' (UK Bank bailout)
  • Quantitative easing was a different program involving creating money and buying bonds from commercial banks. Banks only increased lending in a limited way in response to this quantitative easing. But, QE is not a 'bailout'
  • In one sense lending didn't pick up, but the bank bailout did prevent a collapse in the financial system (bank failures were one of main reasons for the depth of the Great Depression in 1930s).
The Eurozone bailouts are now paying disappointed investors, through public money, rather than going to the people, who are without blame. This is lunacy, and yet nobody seems to be screaming it from the rooftops. Why??

The Eurozone bailouts are different. Here we are bailing out government debt, and each case is a little different.

Greece had a fundamental deficit before the crisis and has mismanaged its finances very badly.
Ireland had very low government borrowing until 2007. But then the Irish banks lost a fortune. The Irish government had to bail out the Irish banks (arguably, they shouldn't have given so much public money, e.g. Bank shareholders should have accepted much greater losses). But, after bailing out the Irish banks, Irish government debt rose rapidly and the Irish government needed its own bailout. So in Ireland's case it is definitely a case of taxpayers 'paying' for the mistakes of their big banks.

It seems the only people writing about this obscenity without censorship are the protestors of the 15-M movement in Spain and the Occupy movement which, quite rightly, has support globally.

No, there are economists who have criticised many responses to the current crisis. e.g. Nobel economist Joseph Stiglitz suggested 'let the banks fail'

My personal belief is that governments are slaves to the financial industry and big multinationals as much as the rest of us; if not they couldn´t possibly vote yes to these bailouts while (in Greece´s case) demanding that the people pay for banker´s greed and corrupt practices through austerity measures which seem designed to kill society.

I generally disagree with Europe's insistence on so much spending cuts and austerity. In the case of Greece, Spain and Portugal and UK, they are proving counter-productive pushing the economy back into recession.

To be honest, membership of the Euro has made it much more difficult to deal with this crisis because countries have much less flexibility (e.g. can't devalue, can't pursue independent monetary policy, face great pressure to cut costs) It was hoped the Euro would give many economic benefits, but it hasn't.

Since the credit crunch exploded in 2007/08 - there have been no really easy answers.

Initially I thought governments generally did the right thing:
  1. Prevented banking collapse (even if bankers didn't deserve to be bailed out, it was still in interest of society to prevent banking collapse)
  2. Tried to get out of recession - expansionary fiscal and monetary policy.
More recently I have been disappointed in the response of governments.
  1. Banks haven't been effectively regulated to prevent future crisis (though there is time)
  2. Governments have made a mistake in rushing to austerity before strong economic recovery. This has risked a double dip recession.
  3. In US particular, there is a reluctance to contemplate taxes on the rich and wealthy. There is great political pressure to keep taxes low on the rich. Also there has been an attempt to ignore the fact it was the free market, the financial sector which failed spectacularly.

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