The world financial crisis,I just want to understand

Slimbo

Hi All,

I am looking to get a quick overview and explenation about the current financial issues affecting the globe.

Has the US sub-prime implsion really effected the entire world,or is it the money they have spent in Iraq.

Is it China that is having a big effect or is it the price of oil that knocks everything.

I know this is a broad question but I am just trying to understand it all a bit better.

Thank you very much for any replies.

daheff

I'll do my best to give a short answer on your question...below is a simplified answer...its not 100% accurate but will give you an idea of whats happening.

In fairness there is a lot happening at the moment in the world economy.

1 Sub prime crisis:
Some genius in the US had a great idea to give mortgages to sub-prime candidates (ie people with bad credit ratings-from no jobs, bad repayment histories etc). Then bundled a load of them together...got a credit rating and sold them off to investment banks. That was a couple of years ago when rates were low in the US. Rates rose and these people had problems paying back loans. In the last year when banks have started to write down the value of these loans on their books and because of this investors have sold off shares in these companies..hence share price drops.

Because of these problems banks are afraid to loan money to other banks. They dont know if they will get the money back....which means that banks cannot lend to people (your average punter /business) because they dont have money. When this happens people get nervous that they wont get their money back(deposits) from the bank...so they all go to get their money at the same time (called a run- happened to northern rock & bear sterns). When this happens sh* hits the fan & central banks are forced to step in maintain confidence in the market (Uk Treasury for Northern Rock & FED via large loan to JPMorgan)

The central banks have tried to stop this happening by loaning money to the banks directly (circa 500 BN$ so far injected this way)...and by cutting interest rates.

Because of the uncertainty of the banking sector (amongst other reasons) people are reducing their consumption - leading to a recession

2 Inflation

Higher prices mean less consumption.....for the past 5-10 years China & India have been using far more oil/steel than ever before. This has led to an increase in price of these commodities. OIL is currently around 110$. As recently as March 05 it was only 40$. Petrol (and diesel aviation fuel) come from oil. As petrol is used to transport most goods and has increased in price, so has the cost of most goods. Which has led to price inflation. OIl is also used to generate electricity...same problem...higher prices.

Another problem that is happening is that the US is giving a lot of subsidies to farmers to produce crops that can be used to produce ethanol (eg sugar)...which leads to less wheat/corn being grown...which leads to price inflation (if supply drops and the demand remains the same price increases)....which again is leading to inflation.

High prices reduces the amount that you can buy for a given level of income....which means reduced consumption.

If companies are selling less and their costs are rising some will go to the wall. Leading to unemployment....if you are unemployed you cant pay back your loans...bringing us back (indirectly to point 1)

So its a bit of a vicious circle. Central banks tend to try to break it by lowering interest rates (happening now in UK& US)and reducing amount of money supply (reverse is happening now!)

hope this helps your understanding.

Économiste Monétaire

Daheff's part on the sub-prime is slightly inaccurate so I'll try to clear that up and hopefully explain in a little more detail.

When the interest rates in the U.S. were low investment banks were able to borrow, and they do at what is called AAA rate, at quite low levels. Your traditional bank (like AIB) in the states didn't hold on to their customer's mortgages, they sold them on.

For example:
Investment bank A borrows 900 million and has to pay 54 million in interest while only putting up 100 million of their own money. They use that money to buy mortages from your traditional banks/mortgage lenders. The interest payments from those give 72 million.

72 - 54 = 18 million profit.

Thats a pretty crude example but you get the idea. Banks traditionally are risk adverse and so they are careful to whom they lend. Well the investment banks relied on the mortgage lender to scrutinise those who are credit worthy from those who aren't. But they no longer had the incentive to do that because they were selling the mortgages on to the investment banks. The banks didn't know whether the mortgages they were receiving were sub-prime or not. The mortgages were mixed together (think of it as a package with a bow).

Banks now don't know whether what they bought were sub-prime so they are making large provisions for defaults on those mortgages. When the prices of houses fall then the collateral the banks were using didn't match up to the loans. You can see what that means and it isn't good.

You can say part of the problem is lack of information. Banks don't know who has sub-prime loans and who doesn't and so they are being conservative with inter-bank lending.

When the FED started putting up interest rates people started defaulting on loans and the chain reaction began. Oh and there wasn't a run as such on Bear Stearns as it doesn't opperate like a highstreet bank. Banks just refused to lend to it rather than your regular Joe queuing outside to get his money like what happened to N. Rock.

nesf

UCD_Econ wrote: »

The mortgages were mixed together (think of it as a package with a bow).

It was more than mortgages mixed together wasn't it?

OP: The key issue was the misjudgement (intentional or not) of risk. If you package together 5 products which have different level of risk and yield (think of interest payments on a loan) and you're clever about it you can make something very risky which pays out a lot look a lot more "safe" by packaging it with other safer options. If you have perfect information and can calculate risks very accurately, this works fine but since you don't essentially what the actual risk of the package is can be very different to the calculated risk. Basically there's a constant struggle between balancing risk and return. Investors are always hungry for a better return without taking loads of risk (or risk-adjusted return in the jargon) and essentially there was an incentive for very clever people to figure out really esoteric ways of combining assets that maximised return and minimised risk according to some particular risk measure. The problem is when this risk measure is missing some vital component or underestimating a substantial risk, then the quoted value suddenly becomes almost useless (especially if you can't figure out which "packages" it effects and which it doesn't which is part of the problem).

I'm oversimplifying here obviously, but in short, people got a bit too clever and the incentive structure meant people at many levels had no reason not to go along with the flow even if they knew it was just a really delicate house of cards. Now there's been an unforeseen blip (ie the sub prime crisis) that wasn't included in many models because simply banks had no real idea just how exposed they were to it (or at least if they did, they weren't telling people about it).

UCD_Econ wrote: »

Oh and there wasn't a run as such on Bear Stearns as it doesn't opperate like a highstreet bank. Banks just refused to lend to it rather than your regular Joe queuing outside to get his money like what happened to N. Rock.

Exactly.

silverharp

the china effect here is that china was bidding up the price of US gov. bonds and as all other debt securities are priced off these the risk premiums diminished. basically china has been vendor financing the US, and the housing bubble in the US was one of the effects. the US is now in a credit contraction which will not turn around until asset prices are marketed to market, in the past if bubbles corrected , they always overshoot to the downside, so expect more pain in the US, house prices may fall another 20%.
i would expect the dollar to rally soon which should cap commodity prices for now.

daheff

UCD_Econ wrote: »

Oh and there wasn't a run as such on Bear Stearns as it doesn't opperate like a highstreet bank. Banks just refused to lend to it rather than your regular Joe queuing outside to get his money like what happened to N. Rock.

Yes Bear Sterns are not a highstreet bank...but they had a run on them because people/investors were trying to get their money out of accounts/investment funds that they had with them.

Because of the rumors that were going around that Bear Sterns were in financial trouble people lost faith and were afraid they wouldnt get their money back. Other banks saw this and refused to lend to them because they couldnt see how the loans would be repaid. FED couldnt let them go to the wall because they were/are counterparties to a large amount of derivatives in the market.

nesf

daheff wrote: »

Yes Bear Sterns are not a highstreet bank...but they had a run on them because people/investors were trying to get their money out of accounts/investment funds that they had with them.

Because of the rumors that were going around that Bear Sterns were in financial trouble people lost faith and were afraid they wouldnt get their money back. Other banks saw this and refused to lend to them because they couldnt see how the loans would be repaid. FED couldnt let them go to the wall because they were/are counterparties to a large amount of derivatives in the market.

A bank run generally denotes a commercial bank being flooded by depositors screaming for their money back from any usage I've seen in both academic and non-academic stuff.

Slimbo

Thankyou all so much, that has certainly gone some way to understanding my question.

So we are effectively looking at a really tight year ahead and the knock on willeffect us here in Ireland until the US clears the backlog of debt, and gets basically on top of things again.

All the while China/Indian will keep forging ahead with their respective countries economic success.

Does the emerging markets of Russia and South america play any partin the future economic struggles we find ourselves in?

Thanks again:)

nesf

Slimbo wrote: »

So we are effectively looking at a really tight year ahead and the knock on willeffect us here in Ireland until the US clears the backlog of debt, and gets basically on top of things again.

There is some speculation over how long the recession in the US will last. I think this article from the Economist is available to the public: http://www.economist.com/opinion/displaystory.cfm?story_id=11016333

Edit: It's worth bearing in mind that the Economist is pro-free trade etc. It's not that they are wrong in their analysis but with any economic or political argument you need to put it in context of who is saying it. A laissez-faire disciple would say they don't go far enough with their talk of liberalising trade, a left wing disciple would criticise them for going too far etc. Personally I like their analysis but I wouldn't ever consider it to be more than educated musings and so on.

silverharp

ignore what central bankers say. Watch short term interest rates, if they are falling, the recession/contraction is on, when short term interest rates start to rise then the contraction is over. The Fed and other central banks effectively follow the short end of the curve, it's that simple.

Économiste Monétaire

Yes Bear Sterns are not a highstreet bank...but they had a run on them because people/investors were trying to get their money out of accounts/investment funds that they had with them.

Because of the rumors that were going around that Bear Sterns were in financial trouble people lost faith and were afraid they wouldnt get their money back. Other banks saw this and refused to lend to them because they couldnt see how the loans would be repaid. FED couldnt let them go to the wall because they were/are counterparties to a large amount of derivatives in the market.

A bank run never happened on Bear Sterns. Some investors are suing Bear Sterns for the collapse of two of its hedge funds, but no one flooded the bank asking for their money back. Other banks simply refused to lend to it after its credit rating was reduced.

So we are effectively looking at a really tight year ahead and the knock on willeffect us here in Ireland until the US clears the backlog of debt, and gets basically on top of things again.

All the while China/Indian will keep forging ahead with their respective countries economic success.

Ireland’s growth rates are exceeding the EU average; Eurostat gave projections for 3.6%. People get used to 6-8 % growth but that simply isn’t sustainable. The figures for unemployment for ‘07 are 4.5% which is again below the EU average and a large part of that is frictional unemployment. You will never get 0% unemployment. On the whole I’d say we’re doing ok, not great but not bad either.

China has a big problem with inflation. I believe the prophetic view of China is overvalued. Their growth rates are simply not sustainable as the surplus of labour will eventually run dry and they have in recent years gone from a net exporter of energy to a net importer. The one child policy will have obvious consequences for pensions and labour supply.

daheff

this is a good article on what happened at Bear

http://online.wsj.com/article/SB120569598608739825.html


main issues are:

Bear Stearns's fortunes started to take a dramatic turn for the worse on Thursday as its trading partners started making margin calls

By Friday evening, the walls were closing in around Bear. Banks and other counterparties were refusing to do any business with it at all. They stopped taking collateral on short-term lines of credit, even those backed by the highest-quality mortgage bonds backed by Fannie Mae and Freddie Mac. Prime-brokerage clients were also fleeing. So much was moving out of Bear accounts, that a final accounting was still going on through the weekend.

escobar

The U.S. sub prime has hit banks very hard. Namely credit Suisse Northern rock RBOS.
On another thread I saw that the Bank of England has just given out 50 billion after another 15 billion and I know has had to bail out Northern Rock. RBOS has just written down 5 billion and issued 15 billion in shares devaluing their company. They seem to be the worst affected country by the American Sub prime crises.
Credit Suisse has written down losses on more than one occasion. At least 50 billion. I don't think the government has had to step in though. Not completelt au fait on the affect on european banks which will obviously have an affect on the economies wonder if anyone else could shed some light on it.

silverharp

escobar wrote: »

The U.S. sub prime has hit banks very hard. Namely credit Suisse Northern rock RBOS.
On another thread I saw that the Bank of England has just given out 50 billion after another 15 billion and I know has had to bail out Northern Rock. RBOS has just written down 5 billion and issued 15 billion in shares devaluing their company. They seem to be the worst affected country by the American Sub prime crises.
Credit Suisse has written down losses on more than one occasion. At least 50 billion. I don't think the government has had to step in though. Not completelt au fait on the affect on european banks which will obviously have an affect on the economies wonder if anyone else could shed some light on it.

it's not over yet, as house prices continue to decrease, all this crappy paper looses value as well. The next shoe to drop will be credit card debt in the US which has been securitised also. so expect more write offs in the months ahead

is_that_so

Thought this might be a useful update here. Maybe someone has some thoughts or comments on it. My own feeling is that things seem to be straightening themselves out very very slowly but that maybe the worst of it is over. As a result of the whole debacle what will be the long-term effect on financial institutions' attitudes?

Fed, ECB see financial tensions easing
Tuesday, 13 May 2008 15:19

Federal Reserve chairman Ben Bernanke said today that financial markets are still 'far from normal' but have improved as a result of the extraordinary measures taken by the Fed and other central banks.

His remarks came as the European Central Bank also said it saw signs of an easing of tensions on euro zone money markets.

'To date, our liquidity measures appear to have contributed to some improvement in financing markets,' Bernanke told a conference of finance officials in Georgia.
Advertisement

'These are welcome signs, of course, but at this stage conditions in financial markets are still far from normal,' he added. Bernanke made no comments on monetary policy or the economic outlook in his remarks.

The Fed chairman said the US and other central banks have been taking exceptional measures to keep credit flowing since a crunch that began last year and prompted a drying up of the important system of interbank lending, amid fears of heavy losses on US real estate.

Liquidity is better in several markets, Bernanke said, but 'ultimately, market participants themselves must address the fundamental sources of financial strains - through de-leveraging, raising new capital, and improving risk management.'

Meanwhile, the ECB reported a fall in interest rates on its weekly refinancing operation, under which it lends cash to banks, suggesting an easing of tensions on euro zone money markets.

According to the ECB, the weighted average interest rate on accepted bids fell to 4.26% from 4.29% last week.

Commercial banks have become wary of lending to each other since the US market for high-risk, or sub-prime, mortgages collapsed in August. As a result, central banks in Europe and the US have sought to ensure money markets are well supplied with cash so commercial banks can continue lending to consumers and businesses.

Story from RTÉ Business:
http://www.rte.ie/business/2008/0513/fed.html

nesf

is_that_so wrote: »

As a result of the whole debacle what will be the long-term effect on financial institutions' attitudes?

Interesting article here from the FT: http://www.ft.com/cms/s/0/2790929e-203b-11dd-80b4-000077b07658.html

Dimitri

Just a thought on the china issue that i think is often overlooked. I believe they will hit the wall sooner then many think, they have the one child per family policy with very few exceptions (certain families i.e farmers can have keep going till they produce a son, but these families are generally so impoverished a girl is often killed at birth sadly).
This policy means that China has a massive rapidly ageing population, this means that the will have a lot fewer people earning than people who require financial support. India on the other hand have a very young population which on average are far better educated than their chineese counterparts.

nesf

Dimitri wrote: »

Just a thought on the china issue that i think is often overlooked. I believe they will hit the wall sooner then many think, they have the one child per family policy with very few exceptions (certain families i.e farmers can have keep going till they produce a son, but these families are generally so impoverished a girl is often killed at birth sadly).

China is a decade or more off having a greying population (I don't have the time to actually check the stats but iirc most of the analysis hasn't been warning of an impending decline in available labour there a la what Europe is going through for the most part at the moment). They will see a decline in labour growth as a result of the one child policy but that will just reduce growth rather than ending it and it can take a long time for these kinds of changes to filter through into the economy especially when better heath care and services is lengthening the average worklife of people. All across mainland Asia demographic shifts due to improving health levels, life expectancy etc have been fuelling growth. China hasn't peaked yet in this regard I think, versus say Korea that pretty much has.

The present financial crisis will be over long before this happens in China to be honest about it.

Dimitri

Dimitri wrote: »

Just a thought on the china issue that i think is often overlooked. I believe they will hit the wall sooner then many think, they have the one child per family policy with very few exceptions (certain families i.e farmers can have keep going till they produce a son, but these families are generally so impoverished a girl is often killed at birth sadly).

While this is the case, they do have 1/6 of the worlds population, the majority of which are existing on a subsistence level and not acually manufactuting goods

This policy means that China has a massive rapidly ageing population,

Eh, surely we all age at the same rate??

this means that the will have a lot fewer people earning than people who require financial support.

You are assuming that the Chinese have a social security / social infrastructure system in place.

India on the other hand have a very young population which on average are far better educated than their chineese counterparts.

And also ballooning costs

nesf

Deleted User wrote: »

While this is the case, they do have 1/6 of the worlds population, the majority of which are existing on a subsistence level and not acually manufactuting goods

I think it was Paul Krugman who summed it up as (and I'm paraphrasing) "Yeah, China will hit the wall at some point and start getting diminishing returns on labour accumulation. On the other hand, they do have a billion people to use in that accumulation first and they started from a pretty low base."

Dimitri

I agree they haven't peaked yet but i do believe if either is ever to become an established economic superpower than it'll be India not China. I just feel with the 1 chid policy and the high proportion of males is a major disadvantge and a point that doesn't get mentioned enough in the papers.

Dimitri

Dimitri wrote: »

I agree they haven't peaked yet but i do believe if either is ever to become an established economic superpower than it'll be India not China. I just feel with the 1 chid policy and the high proportion of males is a major disadvantge and a point that doesn't get mentioned enough in the papers.

Correct me if I am wrong here but is not China an economic superpower already? And is India not too far behind? This seems a little like calling a race with the horses 5 yards from the line....

nesf

Dimitri wrote: »

I agree they haven't peaked yet but i do believe if either is ever to become an established economic superpower than it'll be India not China. I just feel with the 1 chid policy and the high proportion of males is a major disadvantge and a point that doesn't get mentioned enough in the papers.

Yeah but China's GDP per capita at the moment is not even $3,000 yet. The US's for reference is over $40,000. Even if China managed to get to half the level of efficiency of the US per head it'd have multiplied it's gross GDP level by around seven times. The point about China and India is that they don't even need to mobilise capital or labour that well to have truly intimidating GDP levels and have very large shares of the global economy in GDP terms.


The big question about China and India is whether rising living standards will be compatible with their present Government/Caste arrangements respectively. Will the Chinese still be happy to live under a "dictatorship" when stellar growth rates are a thing of the past? Will they hit the same wall the USSR did? Can such a large and geographically diverse country stay united? Etc.

Économiste Monétaire

the high proportion of males is a major disadvantge and a point that doesn't get mentioned enough in the papers.

The current projections for China's population distribution in 2010 are as follows:



Overall the one child policy is having an effect but distribution of sex cohorts isn't extremely distorted (I.E: ratios of something like 3:1).

Edit: I thought I'd throw in the forcast for 2050 too

nesf

The contrast with India is fairly drastic though:



Edit: Bah, you had to add 2050 didn't you...

Économiste Monétaire

Yeah, the explosion in population in India is astonishing. It's also a country more religiously and culturally diverse than China so it will be a challenge to keep the country together. In fact there was even a terrorist bombing today

http://news.bbc.co.uk/2/hi/south_asia/7398989.stm

nesf

UCD_Econ wrote: »

Yeah, the explosion in population in India is astonishing. It's also a country more religiously and culturally diverse than China so it will be a challenge to keep the country together.

Yeah it's going to get messy as living standards rise and the lower classes don't have to spend all their time living "hand to mouth" and annoying concepts like equality start raising their ugly head. Ditto for China though to be fair.

Économiste Monétaire

Yeah, 300 million Chinese are classified as being in poverty last time I checked so its definitely a challenge for the governments of both countries. I was just trying to show Dimitri that the difference in male to female ratio isn't as bad as some people say.

nesf

UCD_Econ wrote: »

I was just trying to show Dimitri that the difference in male to female ratio isn't as bad as some people say.

Yup, I appreciated that, I just find the disparate demographics of the two rising giants very interesting. In so many ways they are so alike but at fundamental levels they are two very different entities.

Économiste Monétaire

Yep, both are having a tough time with inflation at the moment. There was an article about 4 weeks ago (I think) in the economist about the new head of the indian central bank and rampant inflation. Both seem to be following the same lines of increasing the reserve deposit ratio for banks. India's is only something like 6.5-7% whereas China's is at 13.5% last time I checked.

Tough times ahead in all areas I suppose

Dimitri

Overall the one child policy is having an effect but distribution of sex cohorts isn't extremely distorted (I.E: ratios of something like 3:1).

I was under the illusion it was far greater than this but in saying that i hadn't seen any figures to support that opinion. I'm gratly interested in how the future growth of both countries will be affected by their respective political regimes. Is there anything worth reading on the this that goes a bit deeper into it? It won't get read now with exams but hopefully come the summer i'll have a bit of time!

Will they hit the same wall the USSR did?

In what way? To be fair both china and India aren't suddenly opening up after decades in darkness, they seem to have enjoyed a slightly more gradual opening of markets.

nesf

Dimitri wrote: »

In what way?

There's a point where building new factories or mobilising the workforce doesn't produce very good returns. When you hit this wall, and it very much is a wall, things slow down and this can be a fundamental shift in an economy and a very hard test for any country economically, socially and culturally. When times are good it's easy to hold a disparate and tense nation together, when things are bad, it ain't so easy etc.

Économiste Monétaire

Dimitri wrote: »

I was under the illusion it was far greater than this but in saying that i hadn't seen any figures to support that opinion.

I'd hazard a guess in saying that a lot of people would be fooled by media coverage of families killing female children in favour of males. It's usually best to find some figures and make up your own view from them.

Dimitri wrote:

I'm gratly interested in how the future growth of both countries will be affected by their respective political regimes. Is there anything worth reading on the this that goes a bit deeper into it?

Well book wise I'd say there are a certainly a few dealing with China and its economic rise. "The Chinese Economy: Transitions and Growth" by Barry Naughton (MIT press) gives a solid historic chartering of economic progress from 1949 onwards (and before 1949).

Areas like Market transition, Patterns of growth and development, Chinese Rural and Urban Economies, China and integration into the 'World Economy', the financial system and the author's view of China's future. Thats just one book but I'm sure there are some other great ones on the subject.

I don't know enough about China's political system to advise on a book for that. Naughton's book deals with the 5 year plans which are trademarks of Soviet Leninist/Marxism regimes but nothing too deep into the political structure of China. You might want to take a look at the politics forum for that.

My knowledge of India is limited but I'm sure you would find books on the subject in Hodges Figgis.

Time Magazine

Dimitri wrote: »

I'm gratly interested in how the future growth of both countries will be affected by their respective political regimes. Is there anything worth reading on the this that goes a bit deeper into it?

UCD_Econ wrote: »

I don't know enough about China's political system to advise on a book for that.

China's history and politics is far more interesting to me than India's. To that end I recommend Will Hutton's The Writing on the Wall. It's a feckin' steal at $6 from Amazon.

Haven't read about India's transition prospects in any depth.