Financial crisis - what went wrong?

This may be debatable but the seeds of the crisis seem to be sown back in 70’s, when US went off the gold standards and opted for fiat currency which is not backed up by anything. It definitely gave the Fed (USA central bank) freedom to print the unlimited money or as they say create the money in the air.

Liquidity infusion in the market through printing money stimulates the economy in the short run. It also discourages people from hoarding cash and promotes investing. But it has disastrous long term consequences. It devalues the currency – if government prints X dollars, it as good as taking out X dollars from the people’s bank account – it is hidden inflationary tax. It is destruction of the real money that the people hold.

Printing too much money is a sure fire way to create the hyper inflation. It already caused so much trouble in 1970s (interest rates had to be raised as high as 20% to curb inflation). Another grave mistake that Fed did is to keep interest rates too low for too long. They did not let the recession take it normal path after dot com bubble burst. It would have been much less severe than today’s crisis. United States is just riding from crisis to crisis due to too low interest rates and printing too much money. After dot com bubble fed created the real estate bubble; but this can’t go on.

Fed is doing the same thing again – print too much money – keep interest rates low – it is high probability that we will see high inflation, high interest rates and much weaker dollar in the New Year. (Do they really want weak dollar ?? I don't know)

By keeping interest rates too low for too long Fed injected too much leverage in the system. It led to very loose credit standards, increase in leverage, increase in risk appetite, increase in asset prices and oversupply. Recession is just the market correction mechanism; bigger the bubble, severe will be the recession.

Greed, arrogance and dishonesty of the Wall Street played a major role in financial crisis. The combination of high leverage and liquidity risk is a super precarious combination. Wall Street firms created the mortgage backed securities (MBS) so called the ‘Toxic waste’. Not only did they sell this gold plated crap all around the world but also had a large exposure to it themselves. Moreover to increase their profit, they opted for extremely high leverage of the order of 1:30 –i.e. the debt is around 30 times the equity. E.g. A bank with just 1 millions of equity would acquire 30 millions of debt and would invest in very risky securities. And the risk is not limited to banks themselves but its creditors, counterparties etc. But the fall of the big bank can create the domino effect and bring the whole system down. Even the government sponsored enterprises like Freddie Mae and Fannie Mac were leveraged more than this, right under the eye of the government and SEC. Why did the regulatory bodies ignore the great systematic risks that these Wall Street giants pose? Credit rating agencies like Moody‘s and Fitch are also equally to blame for clearly understating the risks of MBS. No investor would have thought that the AAA rated security would turn out to be junk rated.

Even when the Wall Street was losing lots of money, Wall Street executives paid themselves huge bonuses – totaled billions of dollars in 2008. These bonuses are based on short-term profits and encourage the traders to take excessive risks – i.e. to act like gamblers. The worst thing is – huge chunk of bailout money was used by banks to pay down bonuses to its executives. You may wonder - whose interest is FED protecting here? Many people accuse FED being the cartel with representatives from major banks of America.

Why this crisis has affected the whole world? Most of the countries have heavily invested in USA. Not only did they make losses in their investments, but their exports also took deep hit with demand from world’s largest consumer plummeting. So, what we are seeing right now is the US led global recession.

- Finance freak