The Financial Crisis in 4 Easy Steps

(A précis for friends and family)

How did it all get so ugly? It can be broken down into 4 stages:

1. A bubble in property values burst initiating a market contraction. This is history repeating itself for the umpteenth time. No revelation here.

2. New financial instruments exacerbated the problem. Credit derivatives meant that many financial institutions were exposed to risks they didn’t fully understand (namely the dodgy lending practices of the firms originating the mortgages). Many counted on the strong ratings provided by the rating agencies* who likewise didn’t understand the risks. The ensuing downgrades caused huge write-downs and credit losses.

3. Over-levered financial institutions became insolvent leading to a banking crisis. Many investments banks and hedge funds were so highly leveraged that the reduction in asset values had a severe impact on their balance sheets and they became insolvent. When Lehmans was allowed to fail, confidence in the banking system evaporated. This led to a breakdown in the interbank market: banks wouldn’t lend to each other so central banks had to provide massive amounts of liquidity. Likewise governments had to come in with bailout plans to recapitalise the banks.

4. The massive stock market melt down which followed is largely driven by hedge funds who are liquidating their funds as investors withdraw their monies. These funds were big buyers when markets ran up, and many are now closing shop. Saying that, they are not the only ones who played this game and now almost everyone who borrowed against share collateral is in trouble.

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In many ways, this was a Ponzi scheme that finally collapsed when everyone realized it was built on fictitious value. The difference between this bust and others is that the run up was unusually long and massive, partly because of a prolonged period of cheap money (low interest rates). Deregulation of the home mortgage sector as well as weak leverage limits for investments banks added to the hot air in the system.

The sad part is that we are barely into this. The economic impact is only just starting to feed through. Bank have almost completely stopped lending money to corporations which means that investment is dead and in turn economic growth.

 
Worth noting:

After the 1929 crash, the Dow tracked down for 3 years finally ending its drop in 1932 at 90% below peak. It wasn’t until 1954, 25 years later, that the Dow returned to pre-crash levels.

How bad is this crash? Check out this Graph

MY OWN TAKE – WE WILL NEVER LEARN BECAUSE IT IS HUMAN NATURE

The side story is, of course, how bank execs continue to pay themselves massive salaries despite their complete failure at risk management. I feel it’s worth noting that their greed is not the only greed that fuelled this crisis, just the most egregious example of it.

The fact is that personal profiteering was evident throughout the chain:

• the poor guy who just wanted to jump onto the housing boom and his less innocent cousin who lied on the mortgage forms
• the mortgage broker who signed people up for mortgages they couldn’t afford
• the regional banks who bought and sold on those mortgages without raising a red flag
• the rating agencies who didn’t do a proper due diligence and were paid to provide an “independent risk assessment” *
• the investment banks who lobbied to leverage up their firms to ridiculous levels
• the same guys who continue to pay themselves in the tens of millions after the house of cards collapsed

 
The truth is that everyone was getting high and while we hear the occasional story of some guy warning it would all end badly, most of these buzz kills were ignored, marginalized or fired. Bottom line is that the people making money have more power than the guys tasked with putting on the breaks (auditors, risk officers, regulators).

… the Federal Reserve Board and the economics profession as a whole functions more like a fraternity than a real forum for debate and truth seeking. Those whose views are taken seriously mimic the views of those with status and power within the profession, they do not think independently. – Source

It’s an imbalance which will always manifest itself and which no amount of “learning from history” will ever cure. These status differences – and resulting bullying – are part of our DNA. It’s not just human nature. It’s simian… mammalian. It will always be. (Ironically, traders call profit alpha and are thus engaged in “seeking alpha”).

* The rating agencies haven’t really come under public scrutiny yet but they will eventually have their day. I expect that they may eventually go the way of Andersen Accounting after Enron. At the very least, their role in the crisis should be the subject of congressional hearings.