What a market meltdown. I know, some of you may have gathered much information from the Economist and other financial publications. If you are a financial person with strong know-how on the markets, then the essay that follows is not for you. If you are in debt of knowledge and information on the crisis, then herein lines a straightforward explanation.
With the current financial meltdown in the USA, Europe, and many other emerging economies, one may wonder how such disasters can strike when economists and other financial people are in charge. It seems that there are professionals who were sleeping on the job. If all the bridges in London come tumbling down we can easily say the same about engineers who did not do their jobs right. Unfortunately, finance is not a piece of rock or a piece of physical infrastructure; it is instead like a force of nature, normal when normal and catastrophic when disaster strikes. However, just like man-made carbon emissions are believed to cause radical climate changes, other man-made economic emissions also lead to economic catastrophes.
Seemingly, finance professionals forget that all systems are not deterministic. Furthermore, in a free-market economy, with lack of adequate controls, financial systems become so self-organizing that it adapts and reacts to stimuli with uncertain outcomes seemingly random and seemingly obvious. So why was the event (financial crisis) so obscure before it happened? Hindsight may seem like 20/20 when planners lay out plans and expect a certain beneficial outcome. When we look back at what we know, the past seems to point to an obvious direction. Estimating future events from prior actions is the bigger challenge. However, the media is full of entertainment how current events came about from past actions and what can be done to avoid this action in the future. But, when another catastrophic event happens in the future, again the gurus will look back and wonder what was not done to avoid the disaster. Studying what was not done become famous case-studies in MBA programs.
Central banks in the US and some parts of Europe reduced interest rates to such low levels that the demand for borrowing increased. In addition, at least in the USA, banks reduced the amount of down-payments on mortgage loans and loaned larger sums of money thereby increasing credit relative to incomes. The larger sums of borrowed money in people’s hands increased the demand for residential and commercial property. Increase in demand drives up prices and property prices likewise rose rapidly to unsustainable levels. In addition, people are allowed to borrow money on the value of existing homes adding further to the continuation of mortgage debt. The desire of the American dream to own a house also motivated borrowers to borrow more than they can afford. With housing prices raised rapidly the public borrowed more against unrealized gains and used that money to increase their consumption of other goods and services. So when housing prices rapidly dropped, there was also a big reduction in consumer confidence and a deep drop in the consumption of those other goods and services. Moreover, when mortgage loans exceeded property values and borrowers defaulted on loans and creditors refused to lend, credit markets collapsed. More usually, homeowners hold on to their houses when the values rise just like good investors buy and hold. However, when property values drop to the extent that mortgage values exceed property values, the property owners sell and realize the losses or go into foreclosure making losses for banks. In addition, banks had sold mortgages to other businesses that formed securities of these loans and used the “new money” to make further loans. The securitization of mortgages around the world created an entangled web of links that spread across the globe like a plague. Finance is no longer restricted to a country’s borders; it has become a globalized part of the world economy; when a butterfly flaps its wings in London the tree branches in New Delhi sway. So when one part of the world exceeds leverage limits it affects the whole world because they either invested in those overseas mortgaged-connected securities and/or followed the exemplary finance examples of the developed world.
Part of this financial crisis or a major part thereof is due to the fact that it is difficult to forecast financial success with certainty. The financial markets are fully of history about the rise and fall of the markets using indices such as the DOW or S&P 500 in the USA or the FTSE in the UK, DAX in Germany or the Hang Seng in Hong Kong. People who sell financial advice are quick to point out that the past is no guarantee of the future. However, at the same time, they use all historical data to form opinions of the future. They would tell you things like over the past so many years the market has increased on an average by such and such a percentage and that variations from the mean are by so many standard deviations. They would also tell you that the probability of a loss or gain at any one time can be within such and such a range. To make the sale of course, there is more happy talk about success than failure.
With the stock markets, of course, there is much history to talk about. But when it came to the mortgage crisis, there is not much history of failures to even think that the future can be grim. Everybody was confident in the resilience of property prices, which always go up. The same element of confidence existed with the stock markets in the 1990’s, where investors expected the stock market to rise in constant arithmetic progression and for the tech sector by geometric progression. The recent rises in the values of homes were extraordinary and borrowers and lenders made a critical forecasting error of its future rising. This belief spurred more mortgages because lenders assumed that borrowers could refinance when property prices go up. So when property prices dropped homeowners faced foreclosure. The meltdown of the housing industry (and consequently mortgage finance) impacted the stock markets like never before since subprime mortgages were packaged as securities and sold off to investors around the world.
If all the experts were not able to foresee the housing market collapse and consequently the stock market collapse, then the crisis was beyond anyone’s capability to judge. And if the experts were not capable to see these events far in advance, how could the borrowers or lenders know that disaster would unfold?
Perhaps, we have to go back to the normal distribution and the belief in the averages and deviations from the mean. Little attention is given to the deviations at the end of the tails of the distribution, which have very low probabilities of occurrence, but its severity can be harsh. With no previous history to back up good forecasts of housing slumps, this crisis was lurking in the tails of the normal distribution. As a matter of fact, no one knew it was even coming. Just 3-4 months before the crisis, US treasury officials confirmed that the fundamentals of the economy were sound. Just a few months later they learned that their predictions were totally off the bar. Other countries were quick to critic the US form of economic capitalism just like they were immune from the crisis. Within days the plague had also spread to other countries, their stock markets plummeted even more than that of the US.
I fervently think that the Internet is also responsible for the sudden mortgage and market crisis, not in an economic sense but in a practical sense. Think about it. The Internet has shortened the speed at which we communicate and transact business thereby reducing the time zone of business activity. Therefore, if it took one year a decade ago for a business cycle the Internet has perhaps reduced that business cycle to a few months or weeks making it more difficult for entrepreneurs and risk takers to make long-term forecasts. Even bad news also travels at the speed of light creating panic in the financial markets. A major recession has now spread across North America, Europe and the rest of the world precipitated by housing markets with a lack of confidence in doing business by credit. Credit markets are the life-line of industry and commerce. Without credit people cannot transact business in advance and own things in advance. Why should credit markets come to a standstill sounds mysterious to most?
A lack of trust, a lack of confidence in lending and borrowing has brought much of the credit markets to slow its operations. Basically, housing prices ballooned and that bubble has burst. Therefore, the rest of the economy should theoretically be sound. But if credit is not available then all sectors of the industry suffer. Infusing money into the banking system is not enough; government leaders must also infuse confidence to get the economy rolling again.
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