Financial Crisis - tip of the iceberg

These days, financial crisis seems to hog the media: governments pumping in more money into their economies, large corporations posting record losses, well known large companies filing for bankruptcies, people losing their job leading to homes being foreclosed, cars being repossessed etc.

You would think that we had seen the worse of it all in the financial crisis. How would you feel if I were to say that worse has yet to come? I do not have a crystal ball nor am I a psychic but I believe that the world has grown so tiny, thanks to globalization, that what we are seeing in the media today is just the tip of the iceberg.

The following is extracted from http://www.usatoday.com/news/nation/2008-10-16-crime-economy_N.htm :

The collapse of U.S. financial markets is forcing deep cuts in local police agencies and stoking fears among police chiefs that mass home foreclosures are bringing more crime to suburbs.

Problems created by the financial meltdown are starting to touch everything from police response times to unsolved crimes.

"As we see significant reductions, we'll be seeing increased response times, fewer cases solved and reduced services for victims of crime," says Prince William County, Va., Police Chief Charlie Deane. His $73 million budget could drop up to 30% next year because of declining property tax revenues.

Blocks of homes vacant from foreclosures are becoming magnets nationwide for gang members, drug users, prostitutes and thieves, who steal appliances and fixtures, Deane and other officers say.

At the same time, police agencies are dramatically reducing their forces as local governments struggle to allocate shrinking revenue from property and sales taxes to fund basic services.

This may very well be happening in other countries as well due to the ballooning credit crunch that many economies are now facing. A country’s economy is so heavily dependent on the well being of the financial sector; when this sector so much as sneezes (due to flu), the entire economy may suffer a seizure. The actual scenario now is the financial sector is crumbling, imagine what is happening to the economy.

When I was younger, I loved playing with dominoes. I would line them up in a long line and then I would push one tile down to see the domino effect. This is what happened in the financial crisis:

With good intentions (albeit against logic), USA Congress encourages lending to lower income people (which basically means high risk low returns instead of the conventional theory high risk high returns) resulting in the number of mortgages exposed to this group increase by a factor of 15 times (from a low of 2% high risk mortgages, it skyrocketed to 30%) (USA Congress being the 1st domino tile in a long line). Overzealous financial institutions (2nd, 3rd, 4th and more domino tiles) repackaged these high risk mortgages into low risk securities and sold them to investment banking firms (more and more domino tiles) who in turn sold them to individual and corporate investors worldwide (a whole lot more domino tiles). When the mortgages are defaulted, everyone gets burnt (and the domino tiles starts falling).

As a result, big corporations started posting record breaking massive losses, some even filed for bankruptcies, they had to reduce their costs thus they started retrenching. When people lose their jobs, that isn’t a nightmare; the nightmare begins when people find that they are no longer financially capable to continue to put food on the table or provide shelter for the family. That is when crime (blue and white collar) increases dramatically. This is just the tip of the iceberg; the domino tiles have yet to stop falling.

The corrective action for individuals is to appoint capable people to form a government and for the government to overhaul the entire financial system; never ever consider a high risk low return option.

The truth about financial crisis

Believe it or not, the global financial crisis spawned from good intentions that were poorly executed; the following is extracted from Wall Street Journal, who interviewed Stephen Schwarzman, the chairman of Blackstone Group
(http://blogs.wsj.com/deals/2008/09/24/wall-street-crisis-stephen-schwarzman-explains-it-all/?mod=sp_deals ):

It’s a perfect storm. It started with Congress encouraging lending to lower-income people. You went from subprime loans being 2% of total loans in 2002 to 30% of total loans in 2006. That kind of enormous increase swept into the net people who shouldn’t have been borrowing.

Those loans were packaged into CDOs rated AAA, which led the investment-banking firms [buying them] to do little to no due diligence, and the securities were distributed throughout the world, where they started defaulting.

When they started defaulting, out of bad luck or bad judgment, we implemented fair value accounting….You had wildly different marks for this kind of security, which led to massive write-offs by the commercial banking and investment-banking system.

In the face of those losses…you needed to raise new equity…which came from sovereign-wealth funds in part, which then caused political resistance to sovereign-wealth funds, who predictably have withdrawn from putting money into the system….It seemed pretty obvious that would happen. We now find ourselves with a liquidity crisis where fundamentally the cost of money for financial intermediaries [such as investment banks] is significantly in excess of their cost of lending it. So several institutions found themselves in a structurally impossible position. We had a series of bankruptcies, whether Bear Stearns or Lehman, or forced sales like Merrill. Goldman reverted to a banking charter for a lower cost of funds, which today is still not low enough for the business.

So that’s the story of how we got there.

In this high technology era, it makes one shudder now as to who we can trust these days; when financial institutions blindly follows orders by politicians (who may or may not have any knowledge of financial markets), it is high time for us to put in some check and balance. The question is not what or how – it is a question of when these check and balances are put into place to prevent such a major fiasco from happening – again.

The corrective action would be to ensure that we elect the right people to form the government.