Tuesday, October 14, 2008

The Financial Crash in Plain English

Credit crunch. Bear Stearns. Fannie and Freddie. Lehman Brothers. AIG. Following years of feverish expansion, the global financial system is having a fit.

Due to the low interest rates, banks were aggressively lending, especially for housing. Cheap funds fuelled big gains in house prices.Eventually, banks ran out of good customers to lend to, and started doling out money to people with poor credit records who had little hope of repaying their debts - no credit rating and no stable income. Bankers were lending because they thought the houses were very good collateral; in case of default, the price of houses were more than the mortgages.

Bank then rolled up these risky loans (‘subprime mortgages’) into mortgage-backed bonds (IOUs). They waved a magic wand and turned these bonds into highly rated securities. These were sold to other banks, insurers and pension funds around the world.

Unfortunately, inflation went up. By 2006, the Federal Reserve had to increase the rates. In June 2006, the cost of funds for prime rate was 8% (end 2002 was 4%).

This resulted in heavier mortgage payments for many house owners and they could not pay. Many had to forego their properties. The banks took over the houses and this created a slump in the market. As house prices started to fall, the value of bonds backed by subprime mortgages started to slide. The investors (banks, insurers and pension funds) stopped buying these papers causing the market for mortgage-backed securities to grind to a halt. This prevented selling banks from selling on loans, thus restricting their ability to continue lending. Thus, what could have been a local problem has escalated into a global drama. (Systemic risk)

As banks grew anxious about each other’s exposure to these toxic loans, they became increasingly wary of lending to each other. Thus, inter-bank lending (‘wholesale lending’) dried up in early August 2007. Within a month, this ‘credit crunch’ had claimed its first scalp in the UK – Northern Rock.

Although clever banks had sold on much of their subprime lending, many kept the supposedly choicest cuts for themselves. Then as house prices slid, the loans turned nasty and the US banks started to lose tens of billions of dollars.

In March, Bear Stearns, was rescued by JPMorgan Chase with government backing. The next bailout was on the two biggest players in the American mortgage market, Fannie Mae and Freddie Mac. A week later, Lehman Brothers, America’s fourth-largest investment bank, collapsed into bankruptcy. Next up was AIG, the world’s largest insurer, which received an $85-billion bailout in return for giving the US government an 80% stake in the firm. Meanwhile UK’s biggest mortgage lender, HBOS, is being taken over by rival Lloyds TSB. It not the end yet! More names will be inducted in the Hall of Shame.

The bad news is that very few people will be entirely immune from this financial meltdown. Thanks to these poisonous loans, banks worldwide have already lost over £250 billion. Even worse, this loss could double or quadruple before things improve. Hence, in order to rebuild their capital and profits, banks must increase lending costs.

Therefore, thanks to interest-rate hikes, borrowers are being hit hard. Nevertheless, as the economy slows down, rising bad debts will take their toll, forcing lenders into further rounds of rate rises.

Likewise, homeowners and property investors are suffering a double whammy, thanks to falling house prices, higher mortgage rates and a steep fall in the availability of home loans. In addition, stock-market investors around the world have suffered as economies begin to slow, company profits slip and share prices dive.

Rising inflation (higher prices) is undermining the value of the Ringgit in our pocket. Keen spenders will find retail therapy much less affordable, thanks to falling disposable incomes. Finally, falling company profits and the economic slowdown will lead to lower tax revenues. With public spending rising relentlessly, the government will have to milk taxpayers harder in order to avoid a huge budget blowout.


Ahmad Ikmal said...

Thanks bro for puting in it simple English. It is gonig to help many to understand what they watch and read about so much.

I would like to suggest yuo wrtie about the efffects to the Maalysian economy. Iceland is already seeking a USD5.4b loan from Russia. how is Malaysia gonig to handle this problem? Does it really affect us, maybe not directly but indirectly.

Read ther article you asked me to read. Made further comments on it.

Take care dude.

CheeWee said...

Glad that u enjoyed reading it. Thanks for the suggestion. Yeah, will do more homework b4 publishing a local context. Keep our debate alive, yeah.

Kayage said...

Chee Wee, I might be wrong here, but from what I read, the banks in US outsourced their loan sales. somewhat like the local banks here (in Malaysia) are doing with the sales of their credit cards. i.e Loan sales are sub to private companies and agencies. These bunch of people has only the interest of making sales. Thus, processing of loan against the land titles as collateral is not done throughly (semua tutup sebelah mata the open eye is staring at the comission they will be gaining from the loan sales!). The banks too failed in their part to perform random checks on the loan sales by these bunch of donkeys.

I notices that your article failed to address another guilty party (how can you let them slip, bro!!) - The Rating Agencies!! These buggers slept in their job as well. But then, it is a little hard to fault them when the people paying them to perform the rating ARE the owner of the papers themselves (in your article, the IOUs). Yes, who bites on the fingers that feed you, rite?

In AIG's case, it is mentioned in the article sent by Mr. Lim Hoe Yin.. (explaination was in detail). AIG almost collapsed coz they overly exposed themselves in sales of CDOs on these rotten papers. In short the buggers are bloody greedy (They failed to understand murphy's law - anything that can go wrong will go wrong! Which is what happened! though the % of it happening is so so small...). Well, they paid for their greediness... Rather the stockholders paid for the Management's greed (If I am not mistaken, one of our local paper showed that AIG CEO earns millions in pay!!! -gggrrrr...)

Finally, as for our currency weakening, you can see it is happening to a lot of countries in Asia. This is mainly coz them fund manages are taking home their $$$ to help out on their country's economy. Well, when people starts to sell out the coutries curency (in our case, RM), then the value of that country will drop. Simple economics. The good thing about Malaysia is we have had a number of foreign investors bailing out on us earlier already, thus, you can see that the sudden drain of foreign funds did not effect us as much as it had effected our neighboring countries!

Hope this compliments your article. Again, I have to stress, this comment is my 2 cents. I could possibly be wrong. (If I am, pls point it out, ok? We are, after all, learning along the way)

CheeWee said...

Thanks bro for yr inputs. It definitely complement the articles. As titled, I tried to make it as simple as ABC.. in fact, many many more issues that v could address in the crash! perhaps u could write something as a guest, on the domestic scene as u r qualified as a banker.. I can post it in my blog.

Kayage said...

lol!! thanx for the invitation, Chee Wee, but I doubt I dare write anything, what with the certain organization I am with, it is best I do not start indulging myself in article writing just yet.

I might accidentally post something that is not supposed to be posted and end up with OSA coming after me :P