Monday, September 22, 2008

Getting Smart on the Financial Crisis

Very few people understand the causes and implications of the economic events of the last few weeks, but many are starting to realize that we have just witnessed some hugely important and historic economic events.

As I mentioned in my last post, I'm still trying to get up to speed on all this and it's proving difficult even given my experience in business and economics.

I've found two articles so far that I'll pass on if you want to try to better understand the events you are witnessing. The second article is probably the better read, but I am mentioning it second because it is a few months old.

The first is by Robert Samuelson writing in The Washington Post. The article quickly becomes pretty dense - so you should read it at your own risk (I still find some aspects a bit confusing). You can find the whole article here, but I've tried to isolate the core of the article below. This section speaks to the causes of the crisis only. Other parts of the essay try to explain the government's actions over the last few days but in my opinion is not easily understandable without a bit of background in macroeconomics.

Every financial system depends on trust. People have to believe that the institutions they deal with will perform as expected. We are in a crisis because financial managers -- the people who run banks, investment banks, hedge funds -- have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is then everyone wants to sell and no one wants to buy. Paulson's plan aims to avoid that calamity.

As is well known, the crisis began with losses in the $1.3 trillion market for "subprime" mortgages, many of which were "securitized" -- bundled into bonds and sold to investors. With all U.S. stocks and bonds worth about $50 trillion in 2007, the losses should have been manageable. They weren't, because no one knew how large losses might become or which institutions held the suspect subprime securities. moreover, many financial institutions were thinly capitalized. They depended on borrowed funds; losses could wipe out their modest capital.

So the crisis spread because the initial losses were multiplied. AIG, the nation's largest insurer, is a case in point. Although most of its businesses -- insurance, aircraft leasing -- were profitable, it had written "credit default swaps" (CDS's) on some subprime mortgage securities. These contracts obligated AIG to cover other investors' losses. In the first half of 2008, AIG itself lost about $15 billion on its CDS contracts, and through the summer losses mounted, resulting in downgrades of the company's credit rating and a need to post more collateral. AIG didn't have the cash.

The second is a reference to a previous post I made some months back that links to an excellent tutorial on the mortgage crisis that seems to be at the root of this mess. It's a fantastic place to start (and even a little entertaining, believe it or not). The post is here.

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