The Financial Crisis -- Part Four

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.