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?

6 comments:

  1. "just because we just because"

    Nice analogy about liquidity but you haven't really touched on why Lehman Brothers declared bankruptcy. I've read a bit but haven't really been able to write down in words how the subprime mortgage crisis connects to the shortselling of stocks which also leads to the Lehman Brothers bankruptcy.

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  2. Hi, Mike: thanks for catching the typo.

    Lehman had trouble even since last year, again, relating back to the mortgage crisis. On the runup to September 15, Lehman's price was spiraling down. Lehman had to file for bankruptcy because they couldn't find any buyers.

    Will attempt to cover the mortgage crisis in the next post.

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  3. Hi Doms,

    The warning signs started Mid Oct last year. Bear Sterns, Lehman, and others had lots of Mortgage Backed Securities, and other derivatives based on credit.
    An example of MBS would be you buying a house and getting a mortage. The bank that loaned you your mortgage doesn't just put your mortgage in a vault or something. It does something interesting. It "groups" your mortgage with other people's and SELLS this to investors AROUND THE WORLD as safe INVESTMENT vehicles. Safe as long as people kept paying their mortgage. BUT, alas, in the high point of the US Housing market the mortage originators didn't even bother to check the income of people buying the houses. You can buy a house at ZERO downpayment and live in it too. Around 2005, the US Fed started raising interest rates. When interest rates goes up, the variable mortgage rates goes up too. Many ppl, who in the first place really cannot afford to pay for the house were not able to meet payments at all. They started DEFAULTING. As the number of defaults grew, so did the bank's woes. Until you have what happened this year. TADAh... =)

    note: By the way, even in the Phils. "unpaid" credit can be "sold" to other institutions.
    If you have not paid your credit card and somebody calls you offering a sweet deal of low monthly payments -- the caller is usually another finance institution buying your credit. Of course you pay them small amounts but the total interest on payments is big. That is their pay-off, but of course they are taking a huge risk too.

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  4. Thanks for the summary, Anonymous.

    I was thinking of a simpler analogy to derivatives. What comes to mind is the "side bet" or "insurance" as in Blackjack.

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  5. Very well said. Now, I have a better insight. :)

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  6. I found these two radio show episodes gave a clear explanation (though they take about 2 hours to listen to):

    http://www.thislife.org/Radio_Episode.aspx?episode=355

    http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365

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