The United States has been one of the greatest super powers so far in the history of the world. Abundant natural resources, technological and industrial revolution, mighty military, strong infrastructure and research, excellent educational institutes etc have been forces in making it a super power. In recent years, US economy seems to be in trouble, riding from crisis to crisis.
US Economy is based on consumption and debt/borrowing and has become very unstable at the moment. The economy is post industrial i.e. service sector dominated. It has moved from the days of surpluses to huge deficits. USA is now the largest debtor country in the world. Outstanding public debt above $10 trillion and it needs the cash inflow of 2 billion dollars every day from the rest of the world.
So how does the world economy really work? USA is the world's biggest economy (30 per cent of global GDP) and the world’s biggest consumer. (E.g. Annual Consumption: USA -9.5 trillion dollars,China- 1 trillion, India – 600 billion) Countries like China and other Asian countries have a lot of workforce and relatively low domestic consumption. Hence these countries are mostly export driven – to produce more jobs and keep the unemployment low. This seems to be the fine picture, where is the problem? These countries through the exports are getting excess dollars and reinvesting in US treasuries (US government bonds). US deficit is increasing day by day. USA even needs to borrow the money from foreigners to run its government - other countries have to keep lending money to USA without ever demanding it back.
The personal savings rate in USA is negative. People in USA have been borrowing more than they need and spending more than they afford. Debt from the foreigners is not used for some constructive purposes but is mostly spent on foreign goods. They are purchasing some raw material and exporting the finished good back to foreign countries. I would like to quote Mark Faber here - he commented on the stimulus package -, ‘The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer/Software it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US.’ I think it is self explanatory. Another issue is the comparative advantage of Asian countries over USA with very low wages. (E.g. in China hourly wages are just $ 0.25 to 1 as opposed to $ 15 to $20 in USA)
It is not only the American people who have spent recklessly, but the government has played its part too. War on terror and world policing costs trillions of dollars every year to USA and it is not their own money - they paying for it via credit card. The biggest issue is entitlements. Through entitlements like social security, healthcare etc USA government has the obligations of around $60 trillion. To fulfill it they need to have around $10 trillion invested every year and the actual investment is nil. So how will the government finance this? – Printing more money – which will cause the dollar dilution and massive inflation.
USA dollar is becoming weaker against the other stable currencies like Euro. Other countries are slowly dumping dollars and moving to stable currencies like euro. OPEC, Russia, china are pushing to redenominated the global oil transactions in Euro. In 1944, dollar became world’s reserve currency. People had to use dollars for international transactions giving USA the tremendous financial power and leverage. Also oil can be bought from OPEC only if you have dollars. In November 2000, Iraq began selling its oil in Euros and its oil for food account at the UN was also in Euros. One can just imagine the threat it poses to US dollar. I don’t want to comment about the Weapons of mass destruction but the war on Iraq definitely removed above threat to USA and also sent the strong signals to other countries that were looking to re-denominate the oil transactions in other currencies. Iran has also proposed the Euro based oil trading system – Bush: "Iran is dangerous to USA". May be they are developing the nuclear bomb – I don’t know. Redenomination of oil in Euro is certainly profitable to middle-east countries as safeguard against falling dollar. If it happens, dollar could easily lose around 30-50% of its value.
United States has been facing other problems such as illegal immigrants. Piracy is also a big problem for US (they are definatley leaders in entertainment and research). Now they can’t handle natural disasters like Katarina too. Recent financial crisis has drawn the entire world into recession. Fed’s policies to keep interest rates too low and very loose credit standards have just help create the real estate bubble. Printing too much of money also ensures the high long term interest rates and high inflation. It could destroy its middle class. The government is encouraging people to spend more where one of the problems with USA is its excessive spending. Rich-poor gap in United States is very wide and it gap continues to grow - It could lead to civil war. Growing materialism is a big problem – it could well be one biggest reason behind weakening American economy.
US presidential candidates were also not too encouraging this time. Republican Ron Paul was the only one who was talking some sense and seemed to have clear and logical plans – should have been the president. Obama is still unsure what change is he going to bring about – talks a lot in the air. He is extremely good orator - that's it. If you listen to him, you will be very impressed but you can't even be sure about his single economic policy or plan.
As of now the long term picture for USA economy looks gloomy. We may well see another bubble or war to distract the people; but this can’t just go on. The depressed dollar may help US in reducing the trade deficit and promote the domestic production, but it will cause the high inflation and reduce the value of people’s wealth. USA needs to get back to stable, real production/manufacturing and job creating environment or some technological revolution – it is not impossible but the transition would involve a painful recession. ’Made in USA’ has to be rejuvenated – innovation is the need of the hour. It would be encouraging if the government invests the money in new science and technology programs and the invention of better/cleaner energy sources instead of propping up some of the failed and badly run firms.
-Finance freak
Friday, January 2, 2009
Thursday, January 1, 2009
USA's bailout plan
Year 2008 has been dreadful for US financial markets. It has further led to the credit crisis and liquidity freeze. It is also affecting the main street now making the availability of credit very difficult. US government has come up with the bailout plan (Paulson-Bernanke bailout plan) and it has been very controversial so far.
The plan is too buy so called ‘toxic waste’ (MBS, CDOs) from the troubled banks and infuse some liquidity in the system. Question arises – why bailout the Wall Street which was the one to cause the problem? After all what good does it produce for economy? Aren’t these just the giant speculative firms? The Wall Street does facilitate the easy and more credit flow in the system, provides the economy with hedging and risk sharing opportunities. But in recent years, Wall Street firms were not creating the value; they were speculating massively, leveraging up the system and creating the systematic risks.
The greatest negative impact of the financial crisis is the demolition of trust amongst the banks. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low interest short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Banks are very leery about lending to other banks. Another issue is the domino effect – failure of the one bank can cause many other banks to fail. Now the main street is also suffering. Most of the businesses rely on short term loans for running their daily operation and even the average people are finding it difficult access credit – economic growth has stunted i.e. the main street too is in danger. According to US government, the bailout is a safety net for the main street via rescuing the Wall Street. Also we are no way near bottom in terms of the number of bankruptcies; asset deflation is massive. The government also needs to make sure that they pay enough to the troubled firms to avoid the bankruptcies -The bailout needed is massive.
But this bailout is unjust to the tax payers and blessing to the people who made the bad decisions i.e. lenders and shareholders of the failing banks. These people received the rewards on their excessive risks in earlier years and when the real risks hit, it is borne by the average people. It creates so called ‘Moral Hazard’ problem i.e. people taking excessive risks are assured that the government will rescue them in troubled times and they will continue their risk taking behavior. And many of these people include the owners and top officials of these speculative firms. Wall Street executives paid themselves huge bonuses in 2008– totaled billions of dollars – this is immorality.
Also, it is fundamentally impossible to value assets (MBS and CDOs) with so much uncertainty; mostly government will end up overpaying. Government’s plan is to auction these assets, but most of the assets are worth nothing. If they were worth anything – why did not other people come up to buy these assets in first place? There are enough people and firms who are sitting on huge pile of cash.
Fed needs to distinguish between the companies which are solvent and companies which are only facing the liquidity crisis. There is no point in bailing out companies with bad management – it is putting tax payer’s money at a huge risk. E.g. bailing out someone like GM/Ford makes a very little sense, these have been very badly run companies, and they will continue producing big gas guzzlers. It is better to let such companies let go bankrupt – it also provides the opportunity for new entrepreneurs who may run such companies much more efficiently.
I heard this brilliant idea on ‘The real news’ by Doug Henwood - solution – why not bailout the main street directly? Why not let these speculative monsters fail? Many of these failed banks will come up in few years but with the cleaner balance sheet and much better risk profile. Why not create the government sponsored banking institutions who can lend money to general businesses? Government can make these banks public organization and distribute the shares amongst American citizens. Surely it won’t be easy to implement it, but it looks a much better plan. It may be a good plan, but considering its conflict of interest with Wall Street and Wall Street’s clout in Washington and FED, it may not fructify.
USA is world’s largest debtor nation; it even depends on the debt from foreigners to run its government.
From where does the money come for the bailout? – It’s by printing more and more money. Which is again a sure fire way to cause more inflation, higher interest rates and the weakening of dollar in the long run.
Bailout is certainly the step in right direction, but the plan itself is quite flawed. Also the whole implementation of the plan itself is quite cumbersome. And this is just the solution to the short term liquidity issue; there are many more issues to be sorted out with the weakening American economy.
- Finance freak
The plan is too buy so called ‘toxic waste’ (MBS, CDOs) from the troubled banks and infuse some liquidity in the system. Question arises – why bailout the Wall Street which was the one to cause the problem? After all what good does it produce for economy? Aren’t these just the giant speculative firms? The Wall Street does facilitate the easy and more credit flow in the system, provides the economy with hedging and risk sharing opportunities. But in recent years, Wall Street firms were not creating the value; they were speculating massively, leveraging up the system and creating the systematic risks.
The greatest negative impact of the financial crisis is the demolition of trust amongst the banks. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low interest short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Banks are very leery about lending to other banks. Another issue is the domino effect – failure of the one bank can cause many other banks to fail. Now the main street is also suffering. Most of the businesses rely on short term loans for running their daily operation and even the average people are finding it difficult access credit – economic growth has stunted i.e. the main street too is in danger. According to US government, the bailout is a safety net for the main street via rescuing the Wall Street. Also we are no way near bottom in terms of the number of bankruptcies; asset deflation is massive. The government also needs to make sure that they pay enough to the troubled firms to avoid the bankruptcies -The bailout needed is massive.
But this bailout is unjust to the tax payers and blessing to the people who made the bad decisions i.e. lenders and shareholders of the failing banks. These people received the rewards on their excessive risks in earlier years and when the real risks hit, it is borne by the average people. It creates so called ‘Moral Hazard’ problem i.e. people taking excessive risks are assured that the government will rescue them in troubled times and they will continue their risk taking behavior. And many of these people include the owners and top officials of these speculative firms. Wall Street executives paid themselves huge bonuses in 2008– totaled billions of dollars – this is immorality.
Also, it is fundamentally impossible to value assets (MBS and CDOs) with so much uncertainty; mostly government will end up overpaying. Government’s plan is to auction these assets, but most of the assets are worth nothing. If they were worth anything – why did not other people come up to buy these assets in first place? There are enough people and firms who are sitting on huge pile of cash.
Fed needs to distinguish between the companies which are solvent and companies which are only facing the liquidity crisis. There is no point in bailing out companies with bad management – it is putting tax payer’s money at a huge risk. E.g. bailing out someone like GM/Ford makes a very little sense, these have been very badly run companies, and they will continue producing big gas guzzlers. It is better to let such companies let go bankrupt – it also provides the opportunity for new entrepreneurs who may run such companies much more efficiently.
I heard this brilliant idea on ‘The real news’ by Doug Henwood - solution – why not bailout the main street directly? Why not let these speculative monsters fail? Many of these failed banks will come up in few years but with the cleaner balance sheet and much better risk profile. Why not create the government sponsored banking institutions who can lend money to general businesses? Government can make these banks public organization and distribute the shares amongst American citizens. Surely it won’t be easy to implement it, but it looks a much better plan. It may be a good plan, but considering its conflict of interest with Wall Street and Wall Street’s clout in Washington and FED, it may not fructify.
USA is world’s largest debtor nation; it even depends on the debt from foreigners to run its government.
From where does the money come for the bailout? – It’s by printing more and more money. Which is again a sure fire way to cause more inflation, higher interest rates and the weakening of dollar in the long run.
Bailout is certainly the step in right direction, but the plan itself is quite flawed. Also the whole implementation of the plan itself is quite cumbersome. And this is just the solution to the short term liquidity issue; there are many more issues to be sorted out with the weakening American economy.
- Finance freak
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
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
USA financial crisis
Year 2008 has been dramatic for United States and the whole world. To summarize everything - Real estate crash, financial sector turmoil, credit crisis, liquidity crisis, a wave of bankruptcies and worldwide economic slowdown!!! The subprime crisis was just a trigger to a much bigger and pervasive crisis. It is not a mere downturn, but the problem has deep roots.
How it all started? Asset prices in US were massively overpriced thanks to mainly irresponsible and illogical Government and FED (USA central bank) policies and reckless Wall Street. Extremely loose credit standards led to people borrowing money to buy houses which they could not afford- be it a pizza delivery boy or someone working at McDonalds. These subprime borrowers (borrower who have a credit score below a particular level – high credit risk) were able to pay low initial mortgage payments. (For first 1 or 2 years they had to pay only interest component and interest rates were very low). They were hoping to make some money with rising home prices.
Wall Street securitized all these mortgages and repackaged it as Mortgage backed securities (MBS) and CDOs. MBS are securities whose cash flows are backed by the principal and interest payments of a set or a pool of mortgage loans. In CDOS, these pools are divided into different levels or tranches ((by issuers); the top level represents the higher credit rating, pays lower coupon and are less risky, whereas the lowest level has the low credit rating, pays high coupon but enclose more risk. Most of these securities are highly illiquid and should have been given very low credit rating, but were given AAA rating by credit agencies. These mortgages were insured by the companies like AIG. Wall Street giants used their reputation to sell this gold plated crap worldwide; they also had considerable exposure to MBS themselves. Most of the banks engaged in arbitrage where they would obtain funding on short term loans with low interest rates and invested in MBS (which yield high interest rate but are fundamentally risky); these banks were significantly over leveraged.
Adjustable-rate mortgages began climbing in mid-2007; most of the subprime borrowers found it difficult to pay mortgage payments after reset period (Where payment also includes Principal component). Homeowners began to default on their mortgages. House prices were also on decline from 2005. In many cases the value of the homes fell below mortgage; here creditors are at big risk as the homeowner can just walk away. MBS turned out to be toxic waste; everyone now wanted to avoid it but there is no market for it. Subprime crisis further led to credit crisis. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Their arbitrage using MBS started falling apart and they stared incurring huge losses in subprime. In June 2007, 2 Bear Stearns managed hedge funds declared huge losses in subprime. Real blow hit USA in 2008, with Bear Stearns going under in March, then followed Fannie Mae and Freddie Mac in summer and Lehman, AIG in September; Morgan Stanley, Citi also took huge blows and now we have auto giants like GM, Ford in immense troubles. After financial sector meltdown, Stock markets took real hit with more and more companies declaring depressed or negative earnings. It has now hit the main street with the wave of bankruptcies and the surge in inflation. There are deep economic consequences too - People with negative home equity cannot take out money to start new businesses or send their kids to college etc.
US led financial Tsunami soon hit the world. USA is the world's biggest economy (30 per cent of global GDP) and now world's biggest debtor country. Its economy is based on consumption and borrowing with negative saving rate. Most of the countries have heavily invested in USA. To add to their woes, their exports took deep blow with demand from world’s largest consumer plummeting.
In nutshell, outrageous monetary policies and easy credit standards led to credit expansion, increase in leverage, increase in risk appetite, increase in asset prices and oversupply. Now as the bubble is deflating, we are seeing the opposite - credit contraction, tightening lending standards, deleveraging, risk appetite goes down, asset prices go down, and markets go down, decrease in supply through bankruptcies.
What to expect now? The recession may last for one more year if the situation is handled properly, can last for even 10 years if it is messed around. House prices fall will continue for some time. We are no way near bottom in terms of bankruptcies. There will be more unemployment. Asset deflation will be massive – bailouts needed are massive. Low interest rates and excessive money printing will start showing its evil side and there could well be hyper inflation after democrats take over. Dollar may collapse. The list of troubles is just too big.
What needs to be done? Need to get supplies down through bankruptcies. We need to create belief, trust and conservative loan. It’s not bad thing if prices of home fell, we can have more credit checks. Also as more defaults occur, the face value of the debt decreases - there is growth again. As there are more bankruptcies there are great entrepreneurial opportunities. The time is also apt to revamp the regulatory architecture.
There has been too much of wealth destruction. The golden question - Where has the major portion of the money gone? I bet - it’s the pockets of big Wall Street executives!
- Finance freak
How it all started? Asset prices in US were massively overpriced thanks to mainly irresponsible and illogical Government and FED (USA central bank) policies and reckless Wall Street. Extremely loose credit standards led to people borrowing money to buy houses which they could not afford- be it a pizza delivery boy or someone working at McDonalds. These subprime borrowers (borrower who have a credit score below a particular level – high credit risk) were able to pay low initial mortgage payments. (For first 1 or 2 years they had to pay only interest component and interest rates were very low). They were hoping to make some money with rising home prices.
Wall Street securitized all these mortgages and repackaged it as Mortgage backed securities (MBS) and CDOs. MBS are securities whose cash flows are backed by the principal and interest payments of a set or a pool of mortgage loans. In CDOS, these pools are divided into different levels or tranches ((by issuers); the top level represents the higher credit rating, pays lower coupon and are less risky, whereas the lowest level has the low credit rating, pays high coupon but enclose more risk. Most of these securities are highly illiquid and should have been given very low credit rating, but were given AAA rating by credit agencies. These mortgages were insured by the companies like AIG. Wall Street giants used their reputation to sell this gold plated crap worldwide; they also had considerable exposure to MBS themselves. Most of the banks engaged in arbitrage where they would obtain funding on short term loans with low interest rates and invested in MBS (which yield high interest rate but are fundamentally risky); these banks were significantly over leveraged.
Adjustable-rate mortgages began climbing in mid-2007; most of the subprime borrowers found it difficult to pay mortgage payments after reset period (Where payment also includes Principal component). Homeowners began to default on their mortgages. House prices were also on decline from 2005. In many cases the value of the homes fell below mortgage; here creditors are at big risk as the homeowner can just walk away. MBS turned out to be toxic waste; everyone now wanted to avoid it but there is no market for it. Subprime crisis further led to credit crisis. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Their arbitrage using MBS started falling apart and they stared incurring huge losses in subprime. In June 2007, 2 Bear Stearns managed hedge funds declared huge losses in subprime. Real blow hit USA in 2008, with Bear Stearns going under in March, then followed Fannie Mae and Freddie Mac in summer and Lehman, AIG in September; Morgan Stanley, Citi also took huge blows and now we have auto giants like GM, Ford in immense troubles. After financial sector meltdown, Stock markets took real hit with more and more companies declaring depressed or negative earnings. It has now hit the main street with the wave of bankruptcies and the surge in inflation. There are deep economic consequences too - People with negative home equity cannot take out money to start new businesses or send their kids to college etc.
US led financial Tsunami soon hit the world. USA is the world's biggest economy (30 per cent of global GDP) and now world's biggest debtor country. Its economy is based on consumption and borrowing with negative saving rate. Most of the countries have heavily invested in USA. To add to their woes, their exports took deep blow with demand from world’s largest consumer plummeting.
In nutshell, outrageous monetary policies and easy credit standards led to credit expansion, increase in leverage, increase in risk appetite, increase in asset prices and oversupply. Now as the bubble is deflating, we are seeing the opposite - credit contraction, tightening lending standards, deleveraging, risk appetite goes down, asset prices go down, and markets go down, decrease in supply through bankruptcies.
What to expect now? The recession may last for one more year if the situation is handled properly, can last for even 10 years if it is messed around. House prices fall will continue for some time. We are no way near bottom in terms of bankruptcies. There will be more unemployment. Asset deflation will be massive – bailouts needed are massive. Low interest rates and excessive money printing will start showing its evil side and there could well be hyper inflation after democrats take over. Dollar may collapse. The list of troubles is just too big.
What needs to be done? Need to get supplies down through bankruptcies. We need to create belief, trust and conservative loan. It’s not bad thing if prices of home fell, we can have more credit checks. Also as more defaults occur, the face value of the debt decreases - there is growth again. As there are more bankruptcies there are great entrepreneurial opportunities. The time is also apt to revamp the regulatory architecture.
There has been too much of wealth destruction. The golden question - Where has the major portion of the money gone? I bet - it’s the pockets of big Wall Street executives!
- Finance freak
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