Step by Step: How the Financial System’s Coffin was Nailed!

In my conversations with people these days many quiz themselves on how a financial crisis of this dimension was conceived in the first place …. So here’s my attempt to piece the disaster together. I am not an economist by training, but will nonetheless try and build a layman’s model of what led to this doomsday!
. In my conversations with people these days many quiz themselves on how a financial crisis of this dimension was conceived in the first place …. So here’s my attempt to piece the disaster together. I am not an economist by training, but will nonetheless try and build a layman’s model of what led to this doomsday!

. Like any terminal illness, all this did not happen in a day, a week, month or even a year. Years of neglect, greed & improper governance were the root of the crisis. Lets take a peek…

. The financial world at the turn of the twenty first century created radically different trends with Asia generating massive surplus riding on the macroeconomic waves in China & India. The US on the other hand faced current account deficits despite being preceded by a Clinton era where the President actually turned around a deficit laden economy and balanced the budget before his term was over

. Despite the dodgy financial fundamentals in the US, the Bush government’s foreign policy was built around massive spending – a significant portion of which was linked to defense expenditure incurred in Afghanistan & Iraq

. Instead of Americans paying this bill, foreign borrowings (presumably the surplus from China) funded the spend while taxes were cut and interest rates were kept low at home– a surplus of cheap money was built for general consumption, falling into the hands of people, many of who did not know how to use it wisely!

. Stock, securities and real estate flourished and equity that was generated through asset appreciation related gains were reinvested in more of the same instruments and used for other forms of consumption, may of them needless (also called conspicuous consumption)

. The evolution of the ‘Free Market Economy’ in the US also radically changed innocuous financial instruments which I believe was built during the Clinton era to increase home ownership and labeled Collaterized Debt Obligations (CDO) into vicious financial tornadoes which coupled with sub prime mortgages extensive financial leverage practices and risk tolerance by established financial instruments broke the proverbial camel’s back in many places!!

. In parallel the excessive import related deficit of the current administration quickly eroded all the budget surplus benefits that the Clinton administration drove – the US dollar faced downward pressure and suddenly creditors both domestic and foreign had better options to route their funds

. Federal reserve had no choice whatsoever but to raise interest rates (despite a slowing economy) as the dollar fell and commodity prices rose driving an inflationary climate progressively

. As Interest rates rose, some of the sub prime mortgagees began to realize that the interest rate rise had suddenly turned their mortgage payments unaffordable. The snowball began small but grew rapidly and soon led to situations where lenders started revaluing the risk which in turn led to de-leveraging of assets!

. Large scale divesture of risky assets followed in increasingly illiquid markets while at the same time radical fall in asset valuations dramatically impacted balance sheets of very prominent establishments. The establishments had no choice but to raise capital till the money market ran dry as paranoia ran high amongst investors!!!

. Thus is the story so far as banks stop trusting each other and inter bank lending virtually stops – interest rate cuts do not help as the cash level in bank vaults continue to stay low (as the banks stop lending to each other) affecting both the individual and the corporation alike!

. The US administration has heeded the internal advisory and has stayed out of any direct involvement way too long – by the time Paulson, Bernanke and his cronies got involved it was too late! The bail-out plan that was prescribed by the Presidential decree was mired with conflicting opinions of why the common tax payer should bear the brunt of a trillion dollar rescue package needed to fix the greed and misdeeds of a section who have amassed massive wealth and are running scot free, still ‘very rich’!

. The financial community internally and externally lost all confidence – investment withdrawals and redemptions followed, causing the breakdown of financial systems worldwide and complete pandemonium!

. While the US government’s corrective policies have had scant impact with even the US arranged meeting of the G7 nations, the European Union’s follow up actions of injecting cash into their banking system and guaranteeing credit facilities have set the bank collaboration going freeing up the financial system and setting the world markets on an upswing!

. Still a long way to go before the tremors subside but any buck in the trend is welcome. Borrowing the lessons of greed (see my other Post), I hope the world will learn and end up being a better place going forward as we painfully navigate through the quagmire that is our own creation!