Friday, October 10, 2008

Idiot's Guide to the Financial Crisis of 2008

Just when we thought that things couldn't get any worse, they did. For the past three weeks, the world financial markets have teetered on the brink of collapse. The really bad news? We're nowhere near any solid resolution, despite the efforts of central banks and state treasuries. We're all just at the beginning, and there are some very tough times ahead.

So what exactly happened, how did things get to this situation, and what lies ahead? I am not an economist but I have been trying to follow the events of recent weeks -- it holds all the morbid fascination of a train wreck. Ordinarily I would leave all the monetary dissection to the financial experts. However, since even the experts are at a loss, I take it as an open invitation for idiots to chime in.

There are many places where we could begin an analysis, but the crucial turning point of the crisis was the week of September 15 this year. Early that week, Lehman Brothers declared bankruptcy, Bank of America purchased Merrill Lynch, and the American Insurance Group sought a bailout from the Federal Reserve Bank.

To gain some perspective on the extent of these troubles, consider that in 2007, Lehman Brothers had total assets of $691-B, Merrill Lynch $1.02-T, and AIG $1.05-T. Consider that the Philippines' annual GDP is only about $120-B, less than a fifth of Lehman's assets.

Spectacular as these falls were, they were also the first dominos that sent many others tumbling, and not just in the United States. As of the second week of October, the financial firms in trouble included: Goldman Sachs, Morgan Stanley, Wachovia, Bradford & Bingley (UK), Grupo Santander (Spain), Fortis (Belgium), Dexia (Belgium), Hypo Real Estate (Germany), and Glitnir (Iceland). And not just firms, either: Iceland is on the verge of declaring bankruptcy.

The immediate cause of these woes is the flow of money; or more precisely, the money isn't flowing. Because of very high perceived risks (more on that in a while), the banks have stopped lending money to each other. Sure, the firms may hold all these high-valued assets but the problem is in converting it into operational cash. Ultimately, it was a problem of liquidity, i.e., having the money to meet its payment obligations.

Just why is liquidity so important? Imagine that, with the last P100 in your wallet, you're about to take a big lunch at your favorite carenderia. All of a sudden, a taxi with Bill Gates as passenger pulls over. Bill Gates has a problem: he forgot his wallet and doesn't have money to pay the cab. At that very moment, you're actually more liquid than the world's richest man.

If you forgo your meal and lend Bill Gates the P100, he promises to pay you P200 tomorrow. Do you lend him the money? Being Filipino and out of the goodness of your heart, you might. But by capitalist logic: it depends. Is the P100 enough to compensate for your hunger? Are you sure that Bill Gates will honor his promise? Your loaning Bill Gates the P100 -- a flow of money from you to him -- will depend on how confident you feel about repayment.

The government responses to the crisis have been aimed at restoring enough confidence for the money to start flowing again. The major actions include cash infusion via bailout (to be paid for by taxpayers later) as well as lowering key interest rates (thereby making it more attractive for banks to borrow money from their central banks.) However, the situation remains so volatile that it's hard to speak of any confidence at all. Will these actions work? No one knows for sure.

The consequences of the financial crisis are quite far-reaching. In the nature of a global enterprise, many banks and companies worldwide are also invested in the financial products of Lehman et al., firms which until recently were deemed solid and safe. Overnight, even small investors have found out that their holdings in some of these companies have suddenly become worthless.

All this uncertainty has also affected the stock market. At the end of the day, the stock market is a speculative tool and sometimes not very rational. In the midst of all this turmoil, the sharp decline in valuations also affects how listed companies fare, in how much money they're able to borrow (again, the liquidity problem) and how well their products and services will sell.

Don't think that just because we're out here in the Philippines, uninvolved in big-time financial instruments, that we're insulated from these events. We live within its shadow. So far, the local banks have not been very transparent about how much they're currently invested in the troubled companies. And if the American and European economies take a sharp downward turn, what will happen to the OFW and BPO dollars that we've come to rely so much on?