Financial Crisis: Is it Troubled times ahead?

In the past one year, we have seen a number of myths being ground to dust, some of them being:

a)     In a Capitalist country, the Government will not come to bail out companies;

(US, UK, Germany and many other countries all representing capitalism have pumped in money to help bail out companies)

b)    Brilliant and Intelligent people who constitute the Wall Street don’t make mistakes;

(The Wall Street has one of the highest concentration of top class graduates from the likes of Harvard, Stanford, Wharton, IIM’s etc and none of them could catch the problem when it started)

c)     American companies like Lehman brothers, Bears & Stern, Citibank, Merrill Lynch, AIG are too large to get into trouble;

(The Who’s Who of US Financial District has fallen into bad times. As of Aug 08, 17 banks in US has gone under and 117 banks are under watch)

d)    World economy is so much decoupled that problems in one country/region do not affect the others;

(US crisis has hit UK, Germany, and other bourses across the world and a major fear exists that if not supported by Central banks, the whole world could see a recession. The Yo-Yo in Oil price reflects the market sentiments)

e)     Audit controls and rules have been tightened after Enron fiasco;

(Lehman brothers reported profit till last quarter and the next quarter they went belly up- Where did the Mark to Market rule go?)

f)      We continue to learn from past mistakes.

(Earlier crisis like the Long Term Capital Management, Savings & Loan crisis, Russian financial crisis, the Internet bubble have not had any impact on our understanding)

But what has caused all of these myths to be broken and that too so fast. It is the ongoing financial crisis that has caught on and is spreading like AIDS (All Investments in Derivative Securities).

While hundreds of theories and books will soon come out analyzing the reasons for this financial earthquake, this article tries to give a basic understanding of what is happening.

The Origin:   

The current financial turmoil is rooted to the Sub Prime crisis. During boom years, mortgage brokers enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without proper

credit checks. Banks and financial institutions then repackaged these mortgage debts with other high-risk debts and sold those to world-wide investors creating financial instruments called CDOs (collateralized debt obligations). Banks and Financial institutions felt safe as the property prices were going north and thus considered their investment safe.

The Crisis:

The mortgage loan to these customers were so packaged that initially it looked attractive as they had to pay a small amount every month, but then, within the fine prints of the contracts, the payments started becoming larger. Since a majority of the mortgages were sold to customers with poor credit, some of them began to default. Since this was a non-recourse mortgage, the only option with the lender was to foreclose the property upon continued defaults and thus banks and financial institutions money was soon blocked in properties. As more foreclosure started happening, and the banks and financial institutions were trying to get rid of the foreclosed properties, the property prices also started crashing in a domino effect, thus creating a huge liquidity crisis in the financial system.

The Impact:

It soon became serious in June of 2007 when two Bear Stearns hedge funds collapsed. Other institutions like Lehman brothers, Merill Lynch, AIG also started coming out with their exposures and it thus snowballed into a major crisis.

The preliminary symptoms of the problem was felt a couple of years back when the defaults started to occur.  But Federal Reserve Bank and European Central Bank dumped $100-billion in liquidity into the system that calmed the market down for a short period. However the sub prime crisis creation continued to grow as long as the housing market continued to escalate in prices and interest rates were falling or didn’t go up much.

The first impact of a major crisis brewing was felt when Bear Stearns collapsed and the full impact was hammered home when Lehman brothers, quickly followed by Merrill Lynch, AIG, Freddie Mac and Fannie Mae started showing signs of collapse.

Resolving the Crisis – Is it enough?:

As one after another major institutions reported problems, the Federal Reserve of US had to step in and announced on September 8 a take-over of Fannie Mae and Freddie Mac. Lehman’s stock plunged as the markets wondered whether the move to save those mortgage giants made it less likely that Lehman might be bailed out.

Treasury Secretary Henry M. Paulson Jr. and Federal Reserve officials encouraged other financial institutions to buy Lehman, and take over of Merill Lynch

The Bush government then proposed a bailout package of a huge 700 Billion Dollars to get out of this crisis. After great difficulty, the $700 Billion bail out package was passed by the House of Representatives after initially failing to pass it.

The central banks all across the world have also got together to inject more cash into the financial system, as the banking trust among various lenders and customers have evaporated causing a liquidity crisis.

But is this a solution and an end to the crisis? Many believe that this is primarily a Band-Aid solution and there are still huge numbers of banks that are under trouble and the crisis may spread across regions. Some predict recession hitting the world, while many believe that the various governments will step in to prevent it happening. Majority though believe that there will definitely be a slow down in the economic activities through out the world.

Lessons Learnt

AIG Investment banking is an intrinsically cyclical business, but Wall Street’s greedy-and-aggressive top management forgot about that as they chased profits and bonuses during a stretch in which money was always easy to obtain.

AIG shouldn’t have had problems as it’s primarily an insurance company. However, when you look at AIG’s balance sheet, it has also made a specialty of speculative trading in derivatives. That was an attractive business for many years but like other businesses has recently run into trouble, it also followed suit.

Shortly after Lehman Brothers filed for bankruptcy, Merrill Lynch complained of suffering from a similar disease, and before the effects could become devastating, it cut a deal with the Bank of America for $50b, far below its value.

The above examples show that unrestrained greed was the prime factor in bringing down historic institutions. Two appropriate words of wisdom from two different type of person aptly sum up the crisis.

Lyndon H. LaRouche, Jr. is an American political activist and a maverick has this to say:

When people forecast, they forecast what they wish, not what could be. That's the problem. Also, the typical American today is very small-minded. He thinks only of what he can experience in the next immediate future. He thinks about being rich. He doesn't think about his grandchildren or the world he is creating after him. We used to think two or three generations ahead. We don't do that anymore. So they don't think about building the future. So therefore they're waving what they want to forecast, they're like gamblers. They want to forecast victory at the gambling tables. That's their mentality.

Corporate business is a gambling table. It is not an enterprise anymore. In the old days, somebody would have a business. Their purpose was to be successful at that business and to have the business survive for the coming generations. But with the corporation, you have people who invest in a stock for one or two days. There is no real long-term commitment to doing something. There is a short-term commitment to becoming rich, but not a short-term commitment to building the future. They're always looking for a short-term get-rich, they're always looking for ME, not for what they do for the country. Therefore, forecasting is based on these kinds of ideas. But the world doesn't work that way.

Mahatma Gandhi, the pioneer in non-violence movement rightly said, that there is enough in this world for everyone’s Need, but not for everyone’s Greed.

Maybe it is time we thought about it.