Home .Finance Financial Crisis -- how did we get in this mess?
Financial Crisis -- how did we get in this mess?
Saturday, 29 November 2008 09:12

Globalization has lifted so many people out of poverty, and raised prosperity the world over.  But highly globalized financial markets have brought the world economy to its knees.  How did this happen?  How did we get into this mess?  This simple answer is that there was a boom in bad lending and borrowing that led to a mountain of "toxic debts", debts that will not be repaid.

Where did all this money come from?  Easy money flooded into the US from countries with big external surpluses like China and oil producers.  Also, the US central bank, the Federal Reserve ran an easy money policy. So, as Dire Straits used to sing, "Money for Nothing", as interest rates were low, and loans readily available for everyone.

Where did the money go to?  This easy money led to a massive credit expansion, especially for mortgages which ended up in a housing price bubble.  Lenders increased lending to "sub-prime" customers (those without a good credit history), often without regard for the risks involved.  Everyone imagined that housing prices would keep going up and up and up, as the market herd all charged in the one direction.  When bankers bonuses are tied to short-term business results, they are also tempted (or even pushed by the bosses) to take on excessive risks. And it has now come to light that many aspects of banks' internal risk management systems were far too loose, often guided by complex computer risk models that few people understood, thereby letting all this to get out of control.

Some consumers were encouraged by loan sharks to tell a few white lies on their loan applications.  Other poor consumers were almost tricked into borrowing by fancy and sometimes incomprehensible deals that had upfront teasers like initial low interest rates, but meant that these poor borrowers were living beyond their means.  And organisations like Fannie Mae and Freddie Mac were pushed by government into lending to sub-prime borrowers to improve house ownership for low-income citizens. 

Regulatory and prudential oversight of financial institutions has also been too lax -- especially in the US where there are great disparities and fragmentation such oversight systems, and also between the different authorities responsible for such regulation and supervision.  And what's more, some of the most speculative elements of financial markets, like investment banks and hedge funds, are even outside regulatorý nets.  This lending boom was of course based on the orthodox banking model of using short term finance to finance long-term consumer loans -- if short term finance ever dries up (such as through debt defaults), the system falls apart -- all the moreso when financial institutions are not fully transparent. 

Financial innovation had clearly run ahead of regulation. It added to these problems as mortgages (many low quality) were bundled up ("securitisation") into new, opaque financial products and sold on secondary mortage markets.  This ultimately meant that the bankers who had made the risky loans were no longer responsible for these risks.  And the complexity of the new financial products was such that their buyers often did not know what they were buying -- a bit silly!  And last of all, the credit ratings agencies, who are there to blow the whistle in these situations, did not do their job!  The ratings agencies even helped design these complex financial products in a way that ensured high ratings (AAA). 

As we all know, what goes up, must come down.  And so, not surprisingly this whole pack of cards started crumbling as US housing prices started declining in 2005 -- and as prices kept falling, more and more debts became toxic, undermining the viability of the financial institutions carrying these toxcic debts.  Financial turmoil started in mid 2007, and turned into a full-fledged crisis in September 2008.   

And what is at its root a US financial crisis, became a global financial crisis.  Some of the good money which became bad money came from Asia and the oil-producers (China was a big investor in Fannie Mae and Freddie Mac).  Most of the US financial institutions carrying these toxic debts are global operations, so their activities are affected worldwide.  And a number of non-US financial institutions had also bought up secondary mortage products full of toxic debt.

So what is the mess?  As housing prices tumbled, borrowers began defaulting on their loans.  As banks were in a mess, inter-bank transactions froze, and market trust evaporated.  Stock markets also crashed wiping out much wealth.  Governments have responded quickly injecting money into the financial system to restore normal market conditions, and also by bailing out some but not all financial institutions (AIG, but not Lehman Bros).  But, the balance sheets of many banks remain weakened.   

The economy is now sinking.  Some economies are already in recession.  Many workers are losing their jobs after losing their houses. And fragile developing countries are being hit through weakened export markets.  In short, we have gone from financial to economic to social to development crisis.

Governments have launched a fiscal spending spree to reboot the economy.  Ultimately it should take effect.  But as economies start to take off, governments will have to cut back on spending, because most countries cannot afford the spending spree. 

The main thing will be redesigning the prudential and supervisory governance of our financial systems so that this never happens again.  This is easier said than done.  Financial products have now become so complex that it is far from easy to design the right governance.  And then comes the most difficult task of all -- implementing the prudential and supervisory governance.  Who would want such a job today!

A good reference is:

"The Origins of the Financial Crisis" by Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson.  Initiative on Business and Public Policy at Brookings --  www.brookings.edu  


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