I'm not sure how many people actually read my musings, but to those that may, I apologize for the delay as the past couple of weeks have been a bit turbulent for me personally. Let me put it succinctly -- this financial crisis hit closer to home than I would have liked; but then again what happens in life is not as important as how you deal with life.
OK, let's pick up where we left off, which is where I start to describe how this financial has become what it is today. I have written previously about the background and recent history of the banks, and basically it's all a big set up to comprehend how the whole thing went wrong.
I remember watching Loony Tunes cartoons as a kid. They'd have a staple gag where there's a whole stack of explosives (TNT was a favorite) at the end of a very long fuse. Someone lights the fuse, then after lingering for a while to build up the moment, you get a big Kaboom! In our situation, the tip of that long fuse was the housing market. And the stack of explosives were the derivatives and voodoo instruments that brought down the mighty banks on Wall Street. The aftermath of that explosion would be the the real economy and industries that rely on a properly functional financial system.
First, the fuse. There was a huge speculative bubble in the housing market that fed into the bad habits that created the set up situation. And as long as people were making money, everyone was happy to really just ignore a fundamental lesson in markets -- the price of anything is solely dictated by supply and demand. When prices go above what is the natural price set by this relationship, you have bargains or bubbles. In the housing market's case, it was a bubble and a huge one at that that everyone was happy to ignore. This bubble was created in large part because consumers were able to get access to debt at unprecedented levels.
This led to rise in prices that were not driven by supply and demand, but rather by easy access to debt -- a classic case for a bubble. Except in this case, there were way too many players and the big boys facilitated the bubble. And in any bubble, excess overflowed in all directions. Constructors built more houses, raw materials became more in demand, banks started to give out more and bigger loans, consumers started to take on bigger loans and basically living beyond their means, and finally Wall Street bit off more than it could chew in terms of turning these consumer mortgages into debt instruments.
This was not a sustainable situation, and eventually, people stopped buying new homes. They stopped "flipping" homes because suddenly, there were no more buyers and now those who thought they found an easy way to easy street was stuck with an asset that no one wants to buy. People stopped taking on new loans, but worse, people STOPPED PAYING their loans! I cannot emphasize this enough but people just lived beyond their means.
Let's follow the fuse along now as it lights up and burns closer and closer to the powder kegs. When you don't pay your mortgages, the bank forecloses on you and they now own the property. This means 2 things for the banks -- first is that your loan, which is an asset on their books, has been converted into something else, in this case a house. An asset replacing an asset if you will. Second and more importantly, this asset does not generate income for them. They either have to sell the house (perhaps via another mortgage) or rent it out to tenants. But wait, there's a really big problem. What if the house has gone down in value and the original loan was way bigger than what the house will be selling for right now? What if the bank loaned you 1 million dollars to buy that dream apartment facing the ocean, then when they take your house, it's only worth 700K? Not only are they not getting any income from the house, but they have to write down the value of the house on their books. This erodes income and eats into equity. I wrote earlier that equity was the basis that banks used to make loans. The smaller the equity, the less loans they can make. So losses like the worthless house make it invariably more difficult for banks to issue more loans.
And the whole thing blows up when all those toxic and voodoo instruments that Wall Street came up with suddenly paid nothing. Remember that the basic ingredients for these products were the mortgages of Mr. and Mrs. John Doe on main street and their inability to pay their mortgages means that these pseudo-bonds are also worth less, or just plain worthless.
And so the giants started to fall. They were holding so many of these arcane and complex instruments that relied on the ability of the bubble in housing to sustain itself. First came Bear Stearns, then Lehman Brothers. And in the finance world, everything is interconnected. It's one dynamite sitting on top of another. One explosion will trigger the rest. When Bear Stearns failed, it is because it could not meet its obligations anymore. They were probably expecting that they can either sell their voodoo instruments or at least collect some money from the mortgages that comprised them. But no, they didn't get what they expected, and now they could not repay their obligations to other banks. Other banks in turn, could not repay their obligations to other fellow banks. And we have a self-reinforcing mechanism that threatens to take down the entire system.
It got so bad that governments around the world had to use so much of taxpayer's money to rescue these banks.
And that's just one side of the crisis. I mentioned that losses eat away at equity and their ability to lend money. That means other businesses that relied on banks for financing just could not get any. The central banks have tried all the tricks up their sleeve -- cutting interest rates, opening the discount window to investment banks, and the bailout directly injecting equity into the banks balance sheets -- but banks still don't want to lend because of the amount of damage their balance sheet has taken.
We're now at the third part of the scene, where we are feeling the effects of the crisis. Businesses like construction, shipping, and airlines who relied so much on credit lines to keep their operations humming suddenly found that they had no access to credit. Business slows down, earnings will have to be re-estimated downwards and stock prices take a tumble. Consumers and their retirement portfolios see so much red in their investments that they stop making purchases and don't spend as much. Businesses lay off people. It's a recession and we have one circumstance just exacerbating the entire situation and making things worse. Just as we had a self-sustaining and strengthening bubble one way, we have the same situation with a recession the other way.
In the meantime, everyone is getting hurt, confused and just angry at the entire situation. That's understandable but I hope that having a grasp of how this whole predicament came about gives you a better balance in terms of deciding how to deal with this, however it affects you. I'll try to write one last part on this crisis that will deals with how best to to cope with this crisis from a personal perspective, and where I'm putting my money right now in terms of investments.
Thursday, December 11, 2008
Sunday, November 9, 2008
The Financial Crisis 2008 -- Part Three
Who are the members of this shadow banking system and exactly where did this whole thing go wrong?
The members of this shadow banking system are mostly the investments banks, hedge funds, and other financial entities that did not fall into the traditional definition of a commercial bank. Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch are the 5 traditional investment banks in the US, and they were businesses outside of traditional regulation.
And where did this whole thing go wrong? Everywhere. This financial crisis was a societal failure. Everyone was at fault here from the common citizen to the CEO to the government at their highest levels. When I hear some pundits or analysts or talk show hosts say that the government or CEO's should be blamed, I find it really shallow. It's not that government regulatory bodies and big business were faultless, but they alone did not create the mess we find ourselves in. Everyone was at fault. The way society evolved made this an accident waiting to happen. It's like a village living at the foot of a volcano.
In my opinion, the best way to understand how this crisis evolved into something so damaging is to concentrate on the role of the traditional commercial banks. Let me be clear that I do not think they are the ones with the biggest share of the blame, but rather understanding it from their perspective is the easiest way to grasp the entire situation.
I explained in the previous part how traditional banks make money and how they are limited by regulations. But these commercial banks were able to make their way around the regulations by selling their loans to the shadow banking system! Therefore, these loans they passed on are now flying under the regulatory scope and the banks are then free to make new loans.
Let's give a hypothetical situation using real banks' names to make it explicit. Let's say the commercial bank is Wachovia. The investment bank is Lehman. And the customer is Mr. Roberts. Mr. Roberts goes to Wachovia to take out a mortgage loan to buy a home. Wachovia then gives Mr. Roberts 100,000 USD for the loan. And then, Wachovia sells this loan to Lehman Brothers. Lehman gives 100,000 USD to Wachovia. And all the interest and principal repayments that Mr. Roberts makes on the loan is passed onto Lehman. And presto, Wachovia has 100,000 USD back free to make more loans as if Mr. Roberts's loan never took place. Lehman is now the one holding all the risk of the mortgage but is also the one who is repaid from the loan.
Why would each party want to do this? For Wachovia, they just make the processing and administrative fees, without taking on the risk of the loan. So they make more money without going over their regulatory limits.
As for why Lehman would want to buy these small loans, it's a bit more complicated. There was this hot craze of in the financial world called financial engineering. Think of these new financial engineers as the witch doctors of finance. These small home mortgage loans from the public were the basic ingredients of the toxic alphabet soup they were concocting. They come with many names, CDOs, MBS, ABS, with SIVs buying them up. They 'bundled' these small loans and made them into large loans that they in turn sold as bonds to pension funds, endowments, hedge funds, etc. This toxic soup was a big hit and proved to be addictive to they buyers because they appeared to be safe. The ratings agencies (S&P, Moody's, Fitch) even rated these bonds as investment grade.
So now we had these voodoo instruments posing as bonds that purportedly offered higher payouts than your normal bonds. Everyone loved them, so the investment banks kept making more of them. And to make more of them, they demanded more of the small loans from the commercial banks as their ingredients. The small banks were more than happy to oblige. They encouraged Mr. Roberts to take on more loans. Since they were so free to make more loans because the investment banks were taking off their balance sheets for them, they tried to seduce Mr. Roberts with a lot of sweeteners to the loans like Adjustable Rates.
To make things worse, there was a speculative bubble forming in the housing market that artificially inflated prices of houses. This only made banks more eager to give out loans based on the rising values of the houses.
To bring it home, Mr. Roberts, so seduced by the attractive rates and 'easy terms' of the loans the banks were offering, takes on bigger loans to buy a bigger and better house. The bank assures him that as long as the house price keeps going up, then he can "refinance" his loan based on the house's appreciating value.
And there you have it, the elements and set up for a disaster. First, we have ordinary people and households, so seduced by the banks that they start living beyond their means on CREDIT. Whatever happened to savings and the value of keeping something away for a rainy day? According to CNN, the average American household has about $9,200 in debt and according to MSNBC, 43% of Americans spend more than what they earn.
Second, you have the commercial banks being able to pass their loans and risks to the shadow banking system, making them free to make more loans and just making money from the administration of these loans. They don't bear the risk of the loans on their balance sheets so they have an incentive to just keep on pushing people to make loans.
Third, you have the investment banks with their witch doctors buying these small loans from the commercial banks, bundling them together and magically coming up with investment-grade bonds. Even the ratings companies were in on it and rated these bonds highly.
All the while, government willfully turned a blind eye because lobbyists wined and dined officials to turn the other way because anyway, everyone was making money.
Then, it all went wrong... (to be continued...
The members of this shadow banking system are mostly the investments banks, hedge funds, and other financial entities that did not fall into the traditional definition of a commercial bank. Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch are the 5 traditional investment banks in the US, and they were businesses outside of traditional regulation.
And where did this whole thing go wrong? Everywhere. This financial crisis was a societal failure. Everyone was at fault here from the common citizen to the CEO to the government at their highest levels. When I hear some pundits or analysts or talk show hosts say that the government or CEO's should be blamed, I find it really shallow. It's not that government regulatory bodies and big business were faultless, but they alone did not create the mess we find ourselves in. Everyone was at fault. The way society evolved made this an accident waiting to happen. It's like a village living at the foot of a volcano.
In my opinion, the best way to understand how this crisis evolved into something so damaging is to concentrate on the role of the traditional commercial banks. Let me be clear that I do not think they are the ones with the biggest share of the blame, but rather understanding it from their perspective is the easiest way to grasp the entire situation.
I explained in the previous part how traditional banks make money and how they are limited by regulations. But these commercial banks were able to make their way around the regulations by selling their loans to the shadow banking system! Therefore, these loans they passed on are now flying under the regulatory scope and the banks are then free to make new loans.
Let's give a hypothetical situation using real banks' names to make it explicit. Let's say the commercial bank is Wachovia. The investment bank is Lehman. And the customer is Mr. Roberts. Mr. Roberts goes to Wachovia to take out a mortgage loan to buy a home. Wachovia then gives Mr. Roberts 100,000 USD for the loan. And then, Wachovia sells this loan to Lehman Brothers. Lehman gives 100,000 USD to Wachovia. And all the interest and principal repayments that Mr. Roberts makes on the loan is passed onto Lehman. And presto, Wachovia has 100,000 USD back free to make more loans as if Mr. Roberts's loan never took place. Lehman is now the one holding all the risk of the mortgage but is also the one who is repaid from the loan.
Why would each party want to do this? For Wachovia, they just make the processing and administrative fees, without taking on the risk of the loan. So they make more money without going over their regulatory limits.
As for why Lehman would want to buy these small loans, it's a bit more complicated. There was this hot craze of in the financial world called financial engineering. Think of these new financial engineers as the witch doctors of finance. These small home mortgage loans from the public were the basic ingredients of the toxic alphabet soup they were concocting. They come with many names, CDOs, MBS, ABS, with SIVs buying them up. They 'bundled' these small loans and made them into large loans that they in turn sold as bonds to pension funds, endowments, hedge funds, etc. This toxic soup was a big hit and proved to be addictive to they buyers because they appeared to be safe. The ratings agencies (S&P, Moody's, Fitch) even rated these bonds as investment grade.
So now we had these voodoo instruments posing as bonds that purportedly offered higher payouts than your normal bonds. Everyone loved them, so the investment banks kept making more of them. And to make more of them, they demanded more of the small loans from the commercial banks as their ingredients. The small banks were more than happy to oblige. They encouraged Mr. Roberts to take on more loans. Since they were so free to make more loans because the investment banks were taking off their balance sheets for them, they tried to seduce Mr. Roberts with a lot of sweeteners to the loans like Adjustable Rates.
To make things worse, there was a speculative bubble forming in the housing market that artificially inflated prices of houses. This only made banks more eager to give out loans based on the rising values of the houses.
To bring it home, Mr. Roberts, so seduced by the attractive rates and 'easy terms' of the loans the banks were offering, takes on bigger loans to buy a bigger and better house. The bank assures him that as long as the house price keeps going up, then he can "refinance" his loan based on the house's appreciating value.
And there you have it, the elements and set up for a disaster. First, we have ordinary people and households, so seduced by the banks that they start living beyond their means on CREDIT. Whatever happened to savings and the value of keeping something away for a rainy day? According to CNN, the average American household has about $9,200 in debt and according to MSNBC, 43% of Americans spend more than what they earn.
Second, you have the commercial banks being able to pass their loans and risks to the shadow banking system, making them free to make more loans and just making money from the administration of these loans. They don't bear the risk of the loans on their balance sheets so they have an incentive to just keep on pushing people to make loans.
Third, you have the investment banks with their witch doctors buying these small loans from the commercial banks, bundling them together and magically coming up with investment-grade bonds. Even the ratings companies were in on it and rated these bonds highly.
All the while, government willfully turned a blind eye because lobbyists wined and dined officials to turn the other way because anyway, everyone was making money.
Then, it all went wrong... (to be continued...
Wednesday, November 5, 2008
Why Obama's Victory Moved Me
Obama's victory in the USA truly moved me. It stirred deep passions in my heart and renewed my belief in America that this was a place of ideals. I celebrate and bask in his victory, and hope sincerely that he can succeed as the president.
First, I'm fully aware that there's a sense of misplacement when an election that I cannot be part of moves me like this. So I'll start with explaining where this comes from.
America, for me, has always been a special place. When I was a child, some of my most beloved relatives moved to the US to start their lives anew. They didn't have much, but what did was have a desire to begin a new chapter in their lives or enjoy a healthier retirement. As a child, this has a profound impact on you because it gives you the notion that this was a place where dreams can be pursued and where hope is worked to fruition.
Then there's the fact that I was born and raised in the Philippines, a place where the American ideals and everything American is lionized and given a premium. The Philippines is unique in America's place because this is a country that Americans ruled and occupied, not as aggressors, but as saviors (particularly after WWII). Now Philippine-American history is quite complicated and was even mired in a war early on, but what is unmistakable is that the Americans were responsible for establishing and founding the very basis of our modern society. Our political, judicial, educational, legal and military systems are all based on the American model. Even our social norms and to some extent, our tastes are heavily influenced by America. There's a long and deep-seated cultural slant in the Filipino's identity towards America. And the causes and implications of that is a whole other story. But let it suffice as a background of why American affairs matters so much to our country.
I grew up watching Sesame Street, reading Dr. Seuss and basically being disproportionately exposed to all things American, compared to other foreign influences. I still remember my first trip to the USA as a child, and how magical it all seemed to me. It was a place of ideals, of aspirations of the best we can bring out of humanity.
9/11 changed the world, and the whole world cried with Americans on that tragic day. But what it also ushered in was a kind of America that I have not seen before. An arrogant, imperialistic America that viewed others as either being "with us or against us." George W. Bush appealed to the worst in Americans and they voted him in for 4 more years. With that narrow 'mandate', he continued to alienate allies, ignore science, compromise human rights, and now has made a complete fiasco of the financial system. The idea that America was a place that can bring out the best in people was violated fundamentally.
But deep inside, I and many others I suspect, still wanted the America we idealize. The America that truly embodied the dream, that one can work his or her way to success with equal opportunities.
That's why Barack Obama's victory today is more than just an observation of history. It renews America's promise in my eyes and reminds of what I find so ideal about that place. It gives me hope that the US can find its bearings and once again take leadership and act as a beacon on the things all of humanity holds dear. I look forward to an America that understands its power and influence does not spring from the barrel of a gun or the volume of her bellicosity, but rather in the brightness of her ideals and conviction in principles of equality, freedom and opportunity.
I wish the new president success and have high hopes for his tenure. I congratulate him, and most of all America, for once again, finding the best in yourselves.
First, I'm fully aware that there's a sense of misplacement when an election that I cannot be part of moves me like this. So I'll start with explaining where this comes from.
America, for me, has always been a special place. When I was a child, some of my most beloved relatives moved to the US to start their lives anew. They didn't have much, but what did was have a desire to begin a new chapter in their lives or enjoy a healthier retirement. As a child, this has a profound impact on you because it gives you the notion that this was a place where dreams can be pursued and where hope is worked to fruition.
Then there's the fact that I was born and raised in the Philippines, a place where the American ideals and everything American is lionized and given a premium. The Philippines is unique in America's place because this is a country that Americans ruled and occupied, not as aggressors, but as saviors (particularly after WWII). Now Philippine-American history is quite complicated and was even mired in a war early on, but what is unmistakable is that the Americans were responsible for establishing and founding the very basis of our modern society. Our political, judicial, educational, legal and military systems are all based on the American model. Even our social norms and to some extent, our tastes are heavily influenced by America. There's a long and deep-seated cultural slant in the Filipino's identity towards America. And the causes and implications of that is a whole other story. But let it suffice as a background of why American affairs matters so much to our country.
I grew up watching Sesame Street, reading Dr. Seuss and basically being disproportionately exposed to all things American, compared to other foreign influences. I still remember my first trip to the USA as a child, and how magical it all seemed to me. It was a place of ideals, of aspirations of the best we can bring out of humanity.
9/11 changed the world, and the whole world cried with Americans on that tragic day. But what it also ushered in was a kind of America that I have not seen before. An arrogant, imperialistic America that viewed others as either being "with us or against us." George W. Bush appealed to the worst in Americans and they voted him in for 4 more years. With that narrow 'mandate', he continued to alienate allies, ignore science, compromise human rights, and now has made a complete fiasco of the financial system. The idea that America was a place that can bring out the best in people was violated fundamentally.
But deep inside, I and many others I suspect, still wanted the America we idealize. The America that truly embodied the dream, that one can work his or her way to success with equal opportunities.
That's why Barack Obama's victory today is more than just an observation of history. It renews America's promise in my eyes and reminds of what I find so ideal about that place. It gives me hope that the US can find its bearings and once again take leadership and act as a beacon on the things all of humanity holds dear. I look forward to an America that understands its power and influence does not spring from the barrel of a gun or the volume of her bellicosity, but rather in the brightness of her ideals and conviction in principles of equality, freedom and opportunity.
I wish the new president success and have high hopes for his tenure. I congratulate him, and most of all America, for once again, finding the best in yourselves.
Thursday, October 23, 2008
The Financial Crisis 2008 -- Part Two
What I'll attempt to do now is to illustrate how the banking system works, how they make money and where the public comes in. This is the key to understanding how the system was abused and why all investors were hurt by what transpired. Worse, this crisis has spread to non-finance industries and has made a real impact on people and their lives.
Banks are very unique animals in the business world. Their simplest functions are to collect deposits from those who have spare cash, and make loans to those who need cash. These 2 things are their basic roles in life. Taking in deposits is pretty simple and is the side of the bank that most of us are familiar with. It simply is the bank being a place where you can deposit your money in exchange for certain things -- safety, a certain interest rate, convenience (ATMs, checkbooks, other banking services).
The key to this crisis is the other function of banks -- lending.
Lending money has risks attached to it. And banks are their to spread the risk, and minimize its impact for individuals.
Think about it this way -- Suppose someone knocks on your door and asks for a loan to start a business, say a restaurant. He shows you his business plans, his marketing strategy, his floor layouts, menus, etc... If you give him the loan, then you are taking on the risk that his business might fail and you don't get your money back. So to compensate you for that risk, he gives you an interest on your loan. The riskier a proposal is, the higher the interest you must demand. But if he does fail, you lose all your money that you loaned to him. Not good.
However, if he goes to a bank, then that risk is spread across all its depositors. No one single depositor faces the sole risk of this one business failing, therefore there is greater safety for everyone involved. Of course the banks still have to do their due diligence and assess what loan applications are worth taking on. After all, it's the depositors' money that they're lending out at the end of the day!
But banks cannot just make loans indiscriminately. They are restricted and limited in the amount of loans they can make. How much loans can banks make? It's set by the central banks as a percentage of their deposits and capital. So a small bank with let's say 10 million in deposits cannot make loans going to the billions because one single failure will completely destroy the bank. We in the finance world have many terms for this -- leveraging, gearing, borrowing. It's all the same. It means using a small capital base to make larger investments.
That's why the conventional banking industry is so heavily regulated. They are a crucial cog in our modern economy and yet they are also very fragile. That's why central banks regulate them and tell them how much loans they can give out. In return, some of the deposits are insured (PDIC in the Philippines, FDIC in the USA).
This is the way the conventional banking system is supposed to work. We depositors have a place that gives us safety and convenience for our money. And people and businesses who need credit and need a loan have a place to go to that will not put any single person at great risk.
However, fairly recently, there was the rise of the so-called shadow banking system. This is a term used by this year's Nobel-prize winner of economics, Paul Krugman. He writes excellent articles on the New York Times so read it if you have time.
Anyway, this shadow banking system arose because banks started to get greedy. They realized that there was money to be made if only central banks would not regulate them so heavily. So this gave rise to the other banking system that was not bound by regulations and restrictions the same way that regular banks are.
Regular banks and the shadow banks found a mutually beneficial arrangement that lead to everyone making more money. And it worked magnificently -- for a while. To give a complete picture, it was because there was a legitimate financial and business need for the banking system to evolve. But regulations were too slow to adapt to them so this separate shadow system arose unencumbered because they did not fit the traditional definition of what banks were.
Part three will deal with how this entire system failed, how it was abused and how it has led to where we are -- government bailouts, plunging stock markets, and a real recession where new jobs are harder to come by, loans are harder to get, and everyone's investment portfolio is bloodier than the Carrie's ending.
Banks are very unique animals in the business world. Their simplest functions are to collect deposits from those who have spare cash, and make loans to those who need cash. These 2 things are their basic roles in life. Taking in deposits is pretty simple and is the side of the bank that most of us are familiar with. It simply is the bank being a place where you can deposit your money in exchange for certain things -- safety, a certain interest rate, convenience (ATMs, checkbooks, other banking services).
The key to this crisis is the other function of banks -- lending.
Lending money has risks attached to it. And banks are their to spread the risk, and minimize its impact for individuals.
Think about it this way -- Suppose someone knocks on your door and asks for a loan to start a business, say a restaurant. He shows you his business plans, his marketing strategy, his floor layouts, menus, etc... If you give him the loan, then you are taking on the risk that his business might fail and you don't get your money back. So to compensate you for that risk, he gives you an interest on your loan. The riskier a proposal is, the higher the interest you must demand. But if he does fail, you lose all your money that you loaned to him. Not good.
However, if he goes to a bank, then that risk is spread across all its depositors. No one single depositor faces the sole risk of this one business failing, therefore there is greater safety for everyone involved. Of course the banks still have to do their due diligence and assess what loan applications are worth taking on. After all, it's the depositors' money that they're lending out at the end of the day!
But banks cannot just make loans indiscriminately. They are restricted and limited in the amount of loans they can make. How much loans can banks make? It's set by the central banks as a percentage of their deposits and capital. So a small bank with let's say 10 million in deposits cannot make loans going to the billions because one single failure will completely destroy the bank. We in the finance world have many terms for this -- leveraging, gearing, borrowing. It's all the same. It means using a small capital base to make larger investments.
That's why the conventional banking industry is so heavily regulated. They are a crucial cog in our modern economy and yet they are also very fragile. That's why central banks regulate them and tell them how much loans they can give out. In return, some of the deposits are insured (PDIC in the Philippines, FDIC in the USA).
This is the way the conventional banking system is supposed to work. We depositors have a place that gives us safety and convenience for our money. And people and businesses who need credit and need a loan have a place to go to that will not put any single person at great risk.
However, fairly recently, there was the rise of the so-called shadow banking system. This is a term used by this year's Nobel-prize winner of economics, Paul Krugman. He writes excellent articles on the New York Times so read it if you have time.
Anyway, this shadow banking system arose because banks started to get greedy. They realized that there was money to be made if only central banks would not regulate them so heavily. So this gave rise to the other banking system that was not bound by regulations and restrictions the same way that regular banks are.
Regular banks and the shadow banks found a mutually beneficial arrangement that lead to everyone making more money. And it worked magnificently -- for a while. To give a complete picture, it was because there was a legitimate financial and business need for the banking system to evolve. But regulations were too slow to adapt to them so this separate shadow system arose unencumbered because they did not fit the traditional definition of what banks were.
Part three will deal with how this entire system failed, how it was abused and how it has led to where we are -- government bailouts, plunging stock markets, and a real recession where new jobs are harder to come by, loans are harder to get, and everyone's investment portfolio is bloodier than the Carrie's ending.
Wednesday, October 22, 2008
The Financial Crisis 2008 -- Part One
We are living in a truly historic period in financial history. I have been in the industry for just a little over two years, so I don't make this judgment from my own observations. Rather, this was what I gathered from my seniors, my more experienced colleagues, my university professors and lecturers and reading up on history. People who have been in this industry for decades have all said the same thing -- they have never seen anything like this before. Not the Asian financial crisis, not the Russian default, 9/11 or the tech bubble affected the markets in the same way that this crisis has. I work in wealth management, and it gives me a great view of how events unfold everyday in this crisis.
One day, I know that I will look back at this and remark what a truly extraordinary time that we went through.
So this journal is an attempt to keep my thoughts for posterity, so I can look back at these events not with any bias or tilt, as we often do when looking back at the past. I invite you to share your thoughts with me if you read this. My objective is to provide some clarity to my thoughts and feelings as this phenomenon unfolds. And I hope that this helps anyone who reads this blog understand better the situation we're in.
Let me start with a little background of how we got here and set up the conditions that created this mess we find ourselves in. The modern world of commerce and finance run on a very important resource -- credit. Credit is an intangible, it is not a physical thing. But it has value. Credit, in its purest form, is simply the ability of someone to pay back money. Credit is the lifeblood of modern business for a variety of reasons. One is that it's an important source of capital. When one wants to set up a business, or an existing business wants to expand, they can take on credit to get necessary capital. Second is that it allows businesses to conduct their operations more freely without having to constantly worry about cash. For example, a real estate developer hires a construction company to erect buildings. But since the building won't generate cash revenues until it is finished and operational, then there's a mismatch of cash flow. How will the construction company pay for the materials? Pay its workers in the meantime? The answer is credit. For airlines, car manufacturers, telecom services, credit is what makes these big corporations function effectively. The same is true for almost all businesses. Think of any business and they all use credit in one form of another.
Private individuals also use credit. Credit cards, mortgages, car loans, student loans are all examples of this. It allows you to buy or pay for things based on your ability to pay for it in the future.
So who provides credit? Who makes the widespread and universal use of credit possible? It's the banking system. These institutions are supposed to keep the credit facilities open so that the economy and businesses can function as efficiently and effectively as possible.
For the commercial banks' part, it's fairly straightforward. They take in deposits from people and institutions that don't need the cash right away. They pool them and give out loans to other people who need them. They're like real estate agents where they try to match the needs of one side to another. They take in deposits and give depositors an interest, say 3% per annum. They lend to businesses at 6% per annum. And they make the 3% difference. They fondly called it the 3-3-3 principle. Give at 3, make 3 difference, and hit the golf courses by 3. Simple, supposedly. What interest rates do they set for deposits and loans? Well, this is where central banks come in.
The Central Banks of the world (this is the Federal Reserve in the USA, the Bangko Sentral in the Philippines and the MAS in Singapore for example) are the regulators of their country's financial systems.
The primary jobs of the central banks is to regulate money. In general, the easier it is to get a loan, the more money there is in the economy and vice versa. The central banks primarily regulate money through the use of interest rates. The lower the interest rate, the easier it is to get loans. So in effect, if the central banks want to encourage more lending and borrowing, they lower interest rates. If they want to discourage, they raise rates. What are the driving factors for their decisions? It's a two-fold job. The first is to control inflation, the second is to help the economy. If the economy needs a kick-start, the central banks tend to lower interest rates and encourage businesses and people to borrow. That way, more businesses are encouraged to start up or expand, and more consumtion from individuals is coaxed as well. This is called an easing or a loosening of monetary policy.
The reverse is true for inflation. If they need to combat inflation, they raise interest rates. It is called a tightening of monetary policies. Some of us may not realize it but inflation used to be a big bane of economies. In Germany, Argentina, and now Zimbabwe, hyperinflation killed the economy and was the source of instability for the countries. Imagine where the money you hold in your wallet and banks was decreasing in value right before your eyes! What you could buy in the morning, you could not anymore in the afternoon. Store merchants would display their price in markers because they need to keep changing the price within a day! Thankfully the fight against this kind of insidious inflation has been won (with a few exceptions like Zimbabwe today). But it is the central banks who are responsible for making sure that this kind of disaster does not occur.
So that's the background. We live in a world where banks are there to lend to businesses and people and that has generally contributed to our economic progress in modern times. Central banks set an interest rate that balances economic growth and the fight against inflation. And the commercial banks are there to make it all work based on the benchmark rate set by the central banks.
That's it for part one. Just a primer, a background into modern business and finance. Part two will be how the entire system works and how different players interact with one another. I'll try to give real world examples and anecdotes to drive home certain points.
And part three is how the system broke down, how it was abused by some players and how utterly misguided some participants were that created this whole mess. What I hope to do is at least provide some basic understanding of why this all happened and hope it helps you make better investment decisions. Because whether you like it or not, whether you understand it or not, this crisis is already affecting us all.
In the meantime, I hope things get better and I wish your finances are safe and protected.
One day, I know that I will look back at this and remark what a truly extraordinary time that we went through.
So this journal is an attempt to keep my thoughts for posterity, so I can look back at these events not with any bias or tilt, as we often do when looking back at the past. I invite you to share your thoughts with me if you read this. My objective is to provide some clarity to my thoughts and feelings as this phenomenon unfolds. And I hope that this helps anyone who reads this blog understand better the situation we're in.
Let me start with a little background of how we got here and set up the conditions that created this mess we find ourselves in. The modern world of commerce and finance run on a very important resource -- credit. Credit is an intangible, it is not a physical thing. But it has value. Credit, in its purest form, is simply the ability of someone to pay back money. Credit is the lifeblood of modern business for a variety of reasons. One is that it's an important source of capital. When one wants to set up a business, or an existing business wants to expand, they can take on credit to get necessary capital. Second is that it allows businesses to conduct their operations more freely without having to constantly worry about cash. For example, a real estate developer hires a construction company to erect buildings. But since the building won't generate cash revenues until it is finished and operational, then there's a mismatch of cash flow. How will the construction company pay for the materials? Pay its workers in the meantime? The answer is credit. For airlines, car manufacturers, telecom services, credit is what makes these big corporations function effectively. The same is true for almost all businesses. Think of any business and they all use credit in one form of another.
Private individuals also use credit. Credit cards, mortgages, car loans, student loans are all examples of this. It allows you to buy or pay for things based on your ability to pay for it in the future.
So who provides credit? Who makes the widespread and universal use of credit possible? It's the banking system. These institutions are supposed to keep the credit facilities open so that the economy and businesses can function as efficiently and effectively as possible.
For the commercial banks' part, it's fairly straightforward. They take in deposits from people and institutions that don't need the cash right away. They pool them and give out loans to other people who need them. They're like real estate agents where they try to match the needs of one side to another. They take in deposits and give depositors an interest, say 3% per annum. They lend to businesses at 6% per annum. And they make the 3% difference. They fondly called it the 3-3-3 principle. Give at 3, make 3 difference, and hit the golf courses by 3. Simple, supposedly. What interest rates do they set for deposits and loans? Well, this is where central banks come in.
The Central Banks of the world (this is the Federal Reserve in the USA, the Bangko Sentral in the Philippines and the MAS in Singapore for example) are the regulators of their country's financial systems.
The primary jobs of the central banks is to regulate money. In general, the easier it is to get a loan, the more money there is in the economy and vice versa. The central banks primarily regulate money through the use of interest rates. The lower the interest rate, the easier it is to get loans. So in effect, if the central banks want to encourage more lending and borrowing, they lower interest rates. If they want to discourage, they raise rates. What are the driving factors for their decisions? It's a two-fold job. The first is to control inflation, the second is to help the economy. If the economy needs a kick-start, the central banks tend to lower interest rates and encourage businesses and people to borrow. That way, more businesses are encouraged to start up or expand, and more consumtion from individuals is coaxed as well. This is called an easing or a loosening of monetary policy.
The reverse is true for inflation. If they need to combat inflation, they raise interest rates. It is called a tightening of monetary policies. Some of us may not realize it but inflation used to be a big bane of economies. In Germany, Argentina, and now Zimbabwe, hyperinflation killed the economy and was the source of instability for the countries. Imagine where the money you hold in your wallet and banks was decreasing in value right before your eyes! What you could buy in the morning, you could not anymore in the afternoon. Store merchants would display their price in markers because they need to keep changing the price within a day! Thankfully the fight against this kind of insidious inflation has been won (with a few exceptions like Zimbabwe today). But it is the central banks who are responsible for making sure that this kind of disaster does not occur.
So that's the background. We live in a world where banks are there to lend to businesses and people and that has generally contributed to our economic progress in modern times. Central banks set an interest rate that balances economic growth and the fight against inflation. And the commercial banks are there to make it all work based on the benchmark rate set by the central banks.
That's it for part one. Just a primer, a background into modern business and finance. Part two will be how the entire system works and how different players interact with one another. I'll try to give real world examples and anecdotes to drive home certain points.
And part three is how the system broke down, how it was abused by some players and how utterly misguided some participants were that created this whole mess. What I hope to do is at least provide some basic understanding of why this all happened and hope it helps you make better investment decisions. Because whether you like it or not, whether you understand it or not, this crisis is already affecting us all.
In the meantime, I hope things get better and I wish your finances are safe and protected.
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