Fernando MonteiroDo You Understand the Current Financial Crisis?
September 29th 2008 14:32
Are you au par with the financial crises affecting the world now? This article is written as events unfold in the international arena. When did it all started? That was around mid-July 2007. What happen then was that, due to the finance industry realising that most of their institutions would have to write-off large amounts of money related to the sub-prime mortgage crisis, they also became unwilling to lend any money to other financial institutions therefore effectively clogging the financial system.
In practical terms, we moved from a time of easy and cheap credit, which was the delight of high debt laden companies, to one of no-credit or at least expensive credit. One characteristic of the current credit situation is the large spreads in fixed interest assets, that is, that the difference between interest charged and interest paid is much larger than usual reflecting the current difficult conditions.
One question that imposes itself here is: what exactly is the sub-prime mortgage debacle? The explanation of that will lead us to find out what institutions such as Fannie Mae and Freddie Mac do. Basically, during the last housing boom in the US many loans for home purchase were made to people who couldn’t really pay them. They end up defaulting their repayments and this event sent ripples through the finance industry.
Front-line banks, that is, banks that lend directly to the mortgage borrower, sell their loans to institutions such as Fannie Mae and Freddie Mac, which are intermediaries in the financial system. These then bundle the mortgage loans, discount them and on-sell them to other financial institutions such as investment and retail banks, insurance companies and municipalities and other state and private organisations. The motto was that this was bricks and mortar money and so totally safe. But obviously it was a castle of cards that crumbled by itself. All of these organisations haven now been through the process of writing-off such amounts taking large losses in the process.
What happens as I write is that US Secretary of State Henry Paulson is trying to get one bill passed in the Congress to allow the injection of US$700 Billion into the financial system with a view to obviate the unthinkable – a total collapse of the banking system.
The plan works by the government buying CDOs, which are just the bundled mortgages I mentioned above, that are not in demand and do not have a market price, and by doing that injecting liquidity into the financial system and re-starting the lending activity again. The Republican party members came up with the idea of offering insurance instead of buying CDOs, and the Democratic party members indicated they would like to see in place a commission to oversee the application of the bill and its performance with powers to query the President on its application.
What is the worse to be expected? The financial industry worldwide is like the circulatory system in the human body. If it stops lending money for multiple economic activities what could happen? I think the comparison with the Great Depression 1928-32 is allusive. Commerce and industry would not find credit for their operations, economic activity would decrease abruptly, the housing and stock market could collapse, who knows what else. Notice that the crisis is spreading to other countries with the Belgium government providing AU$20 Billion to Fortis bank to improve its liquidity.
There is some wisdom to be applied here, and is not new: banks are prepared to demand independence and self-regulation when times are good, but do not hesitate in asking for quick government money to bail them out when it’s convenient for them.
There is in this whole story a special spot for Australia: its banks are liquid and lending to the market and didn’t have many write-downs relative to the sub-prime mortgage debacle. The central bank has been effective in keeping the financial system liquid. The interest rate as set by the Reserve Bank is 7 per cent; our currency is around 81 cents to the US Dollar and 52 cents to the Euro with room to appreciate, so come and deposit with us, we’re guaranteed.
In practical terms, we moved from a time of easy and cheap credit, which was the delight of high debt laden companies, to one of no-credit or at least expensive credit. One characteristic of the current credit situation is the large spreads in fixed interest assets, that is, that the difference between interest charged and interest paid is much larger than usual reflecting the current difficult conditions.
One question that imposes itself here is: what exactly is the sub-prime mortgage debacle? The explanation of that will lead us to find out what institutions such as Fannie Mae and Freddie Mac do. Basically, during the last housing boom in the US many loans for home purchase were made to people who couldn’t really pay them. They end up defaulting their repayments and this event sent ripples through the finance industry.
Front-line banks, that is, banks that lend directly to the mortgage borrower, sell their loans to institutions such as Fannie Mae and Freddie Mac, which are intermediaries in the financial system. These then bundle the mortgage loans, discount them and on-sell them to other financial institutions such as investment and retail banks, insurance companies and municipalities and other state and private organisations. The motto was that this was bricks and mortar money and so totally safe. But obviously it was a castle of cards that crumbled by itself. All of these organisations haven now been through the process of writing-off such amounts taking large losses in the process.
What happens as I write is that US Secretary of State Henry Paulson is trying to get one bill passed in the Congress to allow the injection of US$700 Billion into the financial system with a view to obviate the unthinkable – a total collapse of the banking system.
The plan works by the government buying CDOs, which are just the bundled mortgages I mentioned above, that are not in demand and do not have a market price, and by doing that injecting liquidity into the financial system and re-starting the lending activity again. The Republican party members came up with the idea of offering insurance instead of buying CDOs, and the Democratic party members indicated they would like to see in place a commission to oversee the application of the bill and its performance with powers to query the President on its application.
What is the worse to be expected? The financial industry worldwide is like the circulatory system in the human body. If it stops lending money for multiple economic activities what could happen? I think the comparison with the Great Depression 1928-32 is allusive. Commerce and industry would not find credit for their operations, economic activity would decrease abruptly, the housing and stock market could collapse, who knows what else. Notice that the crisis is spreading to other countries with the Belgium government providing AU$20 Billion to Fortis bank to improve its liquidity.
There is some wisdom to be applied here, and is not new: banks are prepared to demand independence and self-regulation when times are good, but do not hesitate in asking for quick government money to bail them out when it’s convenient for them.
There is in this whole story a special spot for Australia: its banks are liquid and lending to the market and didn’t have many write-downs relative to the sub-prime mortgage debacle. The central bank has been effective in keeping the financial system liquid. The interest rate as set by the Reserve Bank is 7 per cent; our currency is around 81 cents to the US Dollar and 52 cents to the Euro with room to appreciate, so come and deposit with us, we’re guaranteed.
| 85 |
| Vote |
subscribe to this blog
Comment by TimmyH
Tech News
Can you HACK it?
Genyration
Comment by unlock iphone 3g