What is Going On? An Explanation for the Non-Financial Person
I’ve seen plenty of questions floating around on Yahoo! Answers and elsewhere from average investors or other individuals asking for clarification of why the recent meltdown is occurring. Questions range from: “Why are the world markets going down?” to “Why is this happening?” I’ll do my best to provide a relatively non-technical/financial explanation of what’s going on, both domestically in the US and abroad to bring individuals up to speed.
Basically, banks became greedy a few years ago and started selling blocks of mortgages together as assets which others could invest in. (So if you owned a mortgage, it might be sold as an investment to a number of different people/institutions). The problem was twofold in this regard. First, these packages that were being sold were extremely complex so most people buying them couldn’t see what they actually were. A single mortgage could be sliced into many different portions, repackaged, and then have that package sold again and repackaged, etc. The common analogy is that the “bad debt” was like rotten meat thrown into a grinder, so that the banks only knew if they had it after they were already sick.
Secondly, the banks were greedy in that they were giving out mortgages to people who shouldn’t have normally been able to afford them. So, the “sub-prime” was basically giving away teaser rates to individuals who wouldn’t be able to afford the “normal” mortgage payments. For instance, if an individual had $2,000 they could allocate to their mortgage, a bank would issue a mortgage to them at a teaser $1,800 payment, knowing that the real payment would be around $2,500 after a few months. So in essence, the banks knew that the individual would not be able to afford it, but they would get a few months worth of payments, then reposes the house, and sell it again to make a profit. That practice was supported because all the housing prices were so high (so the banks never really lost money).
However, when the housing prices fell, all of a sudden the banks couldn’t resell the houses for what they paid for. There was literally trillions of dollars of “bad debt” in these packages - holdings which were worth nothing that the banks had to write off. Because the packages were so complex though, it was hard to tell which banks were holding which bad assets (think of a horrific game of bank Russian roulette – no pun intended with the status of the Russian markets). So, as they discover them, and have to write off hundreds of millions (or billions) at a time, the banks are being forced to go out of business – hence all the collapses recently. This creates an environment where no one trusts each other. The banks typically loan a significant amount of money to each other in their normal day to day operations, but now that they feel each other might go out of business overnight (which is very possible), they aren’t loaning anymore out of fear, which locks the credit lines up. That in turn makes it harder for average individuals to get loans for mortgages, cars, etc. Of course, this creates a panic and the rapid swings/sell off which we have been seeing in the last 7 days.
As for a macro-world view. Not only was the “bad debt” packaged and sold here in the US, much of it was sold abroad. So, you might have Taiwanese, German, or Brazilian banks/companies which are having the same problems. This, plus a generic fear of the markets, and the fact that many markets are pegged fairly largely to the US economy, has created the global financial meltdown we have seen. The entire country of Iceland has had to shut down their banking system and suspend trading on their stock exchange. The Russian stock market lost 19% of its value two days ago, most major markets are having extremely severe declines as well. One great place to see how the world economies are doing is a startup called Emerginvest. It has intuitive heat-maps of the world so even if you’re not familiar with markets, you can see how specific regions, sectors, or the world as a whole is responding.
Many people have been questing whether or not the US was to blame for the current economic meltdown. One opinion is: absolutely not. The subprime practice became a world-wide trend with many banks selling mortgage securities to one another for profit. The other is: yes is definitely is – The US started the practice and sold the vast majority of securities to foreign investors.
That being said, I personally think the US is to blame on account that it was the US who first started the practice because of the extremely high domestic housing prices which supported it. I recognize that the trend caught on, but the US did initiate it. I certainly feel that many international individuals will see the US as having caused the crisis, and especially as the US sold the bad debt abroad. Is the US entirely to blame? Absolutely not. Do I personally feel like the US was much more largely responsible than any other party? Yes.
I hope this goes a long way to clearing up any gaps of understanding
Best,
Jonathan
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Filed under: Discussion, Jonathan (Marketing), World Analysis
Nice simple explanation… Good job… However, I’m on the ‘Sorry, it isn’t the USA’s fault’ side of the fence.
I grew up overseas and have a basic understanding of various European cultures. Through reading, I also feel I have a basic understanding of parts of Asia and Russia. All of these countries would like to have what they ‘think’ we have. They tend to change their thinking to a degree if they move here and recognize that the image of the US is different from the reality. This is akin to an American moving overseas.
As a result, they (the populace, businesses and the governments) mimic our taste in music, movies, clothing, business and government practices. In essence, along with IPods, rap music and Levis, they have adopted those practices that they feel will provide the same ‘apparent’ results as we ’seem’ to have.
We are a very young and naive Nation. Dubya is just an expression of our juvenile attitude. Brash, ego-centric and foolhardy. In fact, his handling of the war, Katrina and now our financial problems reminds me of my kid’s lack of interest in completing his homework.
Europe and Asia have very well established and older societies. Their view of the world tends to be an eye to the future, but a firm remembrance of their long pasts. In fact, Europe still remembers 2 World Wars and several depressions.
If you wish to blame the US for this financial mess, then are you also going to blame the US for the near failure of LLoyds of London a few years back? How about blaming the US for the collapse of real estate in Spain, or more recently in China? No! The old conservative cultures of Europe and Asia have failed to watch over their own interests. We are not other countries watchdogs.
Whenever I wanted to do something stupid, my Mom would say “Just because I jump over a cliff, does that mean you have to do so?”… Each country is responsible for its own actions.
jegan
John,
First off, thanks for the very nice remarks about the article. I thought it was time to catch some people up on it who might not have been following it as closely as most of our normal readers.
As for your thoughts on the “blame” argument - I can completely respect and support that. I still stand by my statement that the US is “more to blame” than anyone else, but I can respect the opposing side that says “just because the US started the trend, doesn’t mean that they are to blame because others decided to follow.” I guess my reaction was more to point out that the US did 1) start the trend and 2) created a larger portion of the bad debt than other countries.
Like you said, perhaps that’s perhaps because of our “brash” cultural ideals (something I personally 100% agree with, although I typically don’t like to get into on posts).
Well, in any case, thank you very much for taking the time to write such a thoughtful post and I’d love it if you’d continue to - we’ve had limited conversation on the blog and I’d be more than happy to debate/discuss more events in the future.
Thanks and will talk to you soon.
Best,
Jonathan
I was living in England about 35 years ago when they had a similar overheated real-estate boom as we have experienced in the last few years. At the time, the British called it ‘gazumping’, which referred to the amazing increases in property values when a home hit the market. It would be listed one day and then a feeding frenzy would overcome the sale. People wold be clamoring to buy the home and eventually the price would bump up 20% sometimes within a week.
I can’t remember the numbers (well, it was the 70’s..) but I remember vaguely that home values were jumping about 30% a year.
Oddly enough, my then girlfriend and now ex-wife’s parents were able to refi their cottage time and again, while unemployed, just on the basis of the increased home values! I was amazed that banks would lend to them!
We didn’t invent unrealistic home valuations, nor did we invent irrational lending practices….. We do have a larger population, and our country does have (well, maybe not this week) greater wealth and banks in other countries may have been seduced into buying worthless paper…
By the way, love your heat-map!
jegan
Very informative read
A well elaborated clear cut message for all.
Amit,
Thanks for the compliment! I hope you keep reading and let me know what you think (for good or bad).
John,
That’s incredible. I can’t imagine being able to claim one’s home appreciation as justification for a loan! Its a bit before my time but I’ll be sure to read up on it. What’s going on now is certainly like nothing I’ve ever seen before (although I’m sure thats true for most economists).
Thanks again for the comments and I look forward to discussing further pieces with you!
(And thanks for the compliment on the heat map - we’re quite proud of it)
Best,
Jonathan
This from SeekingAlpha -Apparently China’s banks have been busy writing bad loans on their real estate as well, which correlates to the drop in home sales in China over the last several months. I think you might find the same in Spain (Banco de Santander) as their housing market has plunged in the last year as well.
http://seekingalpha.com/article/99507-can-china-weather-a-downturn?source=feed
——————————— excerpt —————————-
Here’s what’s going on with China: After decades of double-digit growth… an incredible stock market boom…. and an even bigger real estate and building boom… the big four, government-run banks are now sitting on record non-performing loans (NPLs).
That’s banker’s talk for “bad loans”. Not debt. Not deficits. But loans that will never, ever be repaid.
The Chinese NPL market is one of the largest in the world… The last more or less reliable data about the total of outstanding balances dates from 2007. Back then, it was over a trillion dollars. That’s about 40% of China’s gross domestic product! Almost half of what the entire Chinese economy — one billion hard-working people! — produce in a year. In the past, Beijing has spent the equivalent of 25%-30% of GDP in bank bailouts.
Accounting firm Ernst & Young calls the main reason for why these bad loans were generated in the first place “political”. Remember, China is a corrupt one-party state. And that one party is still Mao’s old Communist Party.
——————————————————————————–
Anyway… Enough on this.. Look forward to your next article…
Thx jegan
Hvor er i fra, det er meget fornuftigt det i skriver, men det fremgår ret tydeligt at i ikke er danskere:)