Wednesday, September 3, 2008

Why There's A Financial Crisis

Here's a good place to start. First, begin with, as Bernanke says, a global savings glut. Where's all of this money coming from? Middle Eastern and Russian investors sitting on appreciating energy reserves. Asian countries with large and positive trade balances against the U.S. Consumers and businesses in Asia and Europe that save a lot.

Why such high savings? Consumers in Japan and Europe are facing a poor economic outlook and clamp down on spending (Americans will feel this way soon enough). Consumers in Asia are increasingly losing old safety nets (many children), while not gaining modern-day safety nets (pensions); so they save a lot. High-risk countries in Africa and Eastern Europe see large flows of money outside to "safe" environments. Companies in Asia--State Owned Enterprises in China, private firms in India--invest overseas because, frankly, they don't see high returns at home. Despite (or because of) high growth, these countries have not spent political capital on next generation reforms, so domestic investment is dicey. All this money sloshes over to the US, looking for safety.

Here, this money intersects with other bad trends. Consumers increasingly rely on houses as savings, over a stagnant stock market (aided by tax breaks). The Fed is keeping rates low, because hey, growth is anemic and inflation is low as well. Mortage originators have no problem finding investors, and steadily lower lending criteria. Investment Banks don't bear responsibility (in large part) for bad loans, which they package and dispense of as soon as possible. The whole system is propped up by low interest rates and rising house prices, and rationalized by models predicting low delinquency/foreclosure rates.

When housing prices fall, people find themselves in homes worth less than their loan, so they walk out. Low "Teaser" rates reset to higher current rates, and people walk out. Delinquencies and foreclosures spiral, make entire asset classes worthless, and destroy financial sector trust.

This is not exclusively a "subprime" problem. Prime borrowing showed many of the same problems, and "Option ARMs" are going to be a giant issue in the coming years.

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