Sunday, September 28, 2008

Trying to Understand the Global Financial Crisis

On Friday, as I watched various news networks follow the fate of the $700 billion bailout plan, I heard several Congressmen and reporters opine that "The average American will probably never fully understand the danger that the American economy is in." That was like a waving red flag for me. In physics, there are variations on a quote that goes something like this, "If you can't explain something to your grandmother, then you don't really understand it." I've seen this quote ascribed to both Ernest Rutherford and Albert Einstein. Richard Feynman's version supposedly goes like this, "If you can't explain something to a first-year physics student, you don't really understand it." As a physics teacher, I am forced to admit that I don't fully understand a concept if I can't explain it clearly and succinctly.
When Congressmen and reporters tell me that I cannot understand the situation and yet do not attempt to explain it, that tells me that they probably do not understand it. The President in press conferences and the current candidates during the debates did nothing to explain causes of the situation either. I have spent a few hours this morning trying to understand the basics of the current crisis. Personal finance blogs and the links they contain have been the resources I used. I still don't have a clear picture of the situation, but I have learned a few things--I think. If I am drawing incorrect conclusions, please let me know. I really would like to learn.
  • There is no such thing as a completely "free" market. Initiators of the system have an inherent advantage over others, therefore regulation is necessary for to help establish a fair playing field.
  • This crisis did not develop overnight; it has been building for the past three decades (at least). The Federal Reserve and the Treasury Secretarys during the past five administrations should have had a clue that the bubble could not go on forever, and that the correction would be severe.
  • Lobbying by the banking and investment sectors have had too much influence on the lack of regulation.
  • Congress has not kept pace with the changes in the stock market. They don't understand it either (and they should!)
  • The increases in the stock market over the past 30 years do not reflect increases in real, physical value. The increases reflect investing in and insuring debt--not real goods.
  • Speculation, junk bonds, hedge funds, credit default swaps (CDS), and deriviatives are all things that I do not completely understand, but have to do with the current crisis. I really don't understand why these practices were accepted and encouraged by financial companies. I think that people made a lot of money without adding any real value to anything.

The sources I used were:

Lynne at Being Frugal has a great round up of links concerning the financial crisis. This is were I started.

From there, I went to three financial blogs that have been around for a while and whose authors:

The American 419 Scam at Cash Money Life
What Caused the Financial Crisis of 2008? at Moolanomy
The $700B Bailout Bill at Blueprint for Financial Prosperity (This has been updated--3 times so far)

On Cash, Money Life, there is a link to the Treasury Department Fact Sheet on the bailout. It sounds like socialization of the stock market. Strange from Republicans. I think old strategies ("free markets") won't work for international stock markets.

On Moolanomy, there is a link to a funny article, Me too, Secretary Paulson! at Wise Bread. A link in the comments led to the most informative article by Henry Liu, Too Big to Fail Versus Moral Crisis. There is too much information here to take in all at once, but overall there is a historical framework that was instructive for me.

Is anyone else struggling to understand the economic crisis? Maybe we can help each other.


Patrick said...

I think you have a fairly good understanding of what is going on, and I think this quote says a lot:

"I think that people made a lot of money without adding any real value to anything."

This is very true. Much of our economy is built upon people making money without creating anything - simply shuffling paper and creating "wealth."

The bulk of the problems were created by greed and a lack of oversight on just about every level.

More regulations are needed in the financial industry, though I couldn't tell you exactly what they are, as I'm not an expert. I can only opine that allowing people to declare their income when applying for a mortgage, not verifying their income, then giving them a loan for more than the value of the appraised house is not in the list of best practices and is borderline fraudulent. But it is easy to do when you can then bundle that mortgage in a lot of others and sell it to a clearing house.

This will be an interesting turn in our economy and the is no easy fix to the problems we are seeing.

RTC said...

Thanks, Patrick, for your article on the economic bailout. It was very helpful to me in trying to get the big picture. I agree that these are interesting times with no easy fix.

Anonymous said...


This is my understanding of "the crisis".

The Jargon Version

Some banks are going under, because they have too much bad debt.

The bad debt was created, because banks were granting high-risk loans, primarily on property, on the false belief that the property prices will keep growing at record rates.

The Non-Jargon Version

Joe at ABC bank gets commission for every loan he grants. Joe wants to earn A LOT of commission.

So Joe gets careless. He starts granting loans to people who don't have jobs (let's call them hillbillies), and are likely to miss loan payments. But Joe doesn't care - he gets commission for those loans!

Surprise surprise, the hillbillies then do start missing loan payments. The bank then does the logical thing - it repossesses their properties!

However, so many hillbillies are missing loan payments that MANY properties are being repossessed.

The bank then tries to sell these properties, e.g. on auctions, but because there are sooooooo many repossessed properties for sale, all the properties around them start loosing value. Remember, when supply exceeds demand, the prices go down.

Now, the banks have a problem. The properties are selling for so little, that the money recovered from the repossessed properties aren't enough to cover the loans that were granted on those properties.

The difference is a straight loss for the bank - bad debts. Too many bad debts, too many losses, the bank simply can't survive.

Down goes Merrel Lynch. Another one bites the dust!

What to make of it all

I'm sitting in South Africa, so I have very little exposure (only about 20% of my investments are internationally invested).

However, I don't think this is the end of the world. There have been many "crisis's" before.

You don't have to stress too much. You especially don't have to stress if you don't own property, and don't have many investments.

My take on it is - 10 years from now we're all going to look back and think to ourselves... crisis? Whatever. It was a little uncomfortable and scary. But the world carried on.

Why on Earth did everybody make such a big fuss about it?

But that's just me. :)

natedavidscott said...

you make a very good point with your quote!

Anonymous said...

Great post! Here's my take, very simple:

People spent (buying: second homes, houses, electronics, SUV's, clothing, vacations, furniture) what they didn't have!!!

Jolie said...

Thanks for writing this. I have been trying to follow the financial crisis for homeowners and lending agencies in the US. It's structured differently up here in Canada, but I can sure see people in the same kinds of troubles. It is just as 'notes from frugal trenches' said...people are spending WAY more money than they have and are only hit with a level of financial awareness when it is too late, or almost too late.