Home > Market Commentary > Causes and Consequences of the Financial Crisis

Causes and Consequences of the Financial Crisis

Posted by Rob Weigand. (These are some of the most frequently-asked questions I hear in the various speaking engagements and media interviews I’ve participated in over the past several months.)

How did we get into this mess?

The recent mess is due to a “perfect storm” of factors interacting with and accelerating one another. For example, the Greenspan Fed’s policies of fast money supply growth and low interest rates allowed for increases in leverage (debt financing) by banks, brokerages, investment banks and households during the early years of the 21st century. This high leverage fueled a “global asset bubble” in virtually all investable asset classes — US and global stocks, real estate, commodities, etc. Regulatory standards were also lax: the Fed, the SEC, the Treasury Department and Congress rationalized these rising valuations as evidence of the health of the global economy, and relaxed the financial regulatory structure, which paved the way for creation of the toxic financial instruments that have brought bank lending and other forms of financing to a halt around the world.

Why did big banks stop lending?

When banks create new credit by extending a loan, it lowers the reserves they are required to hold on their balance sheets. Normally banks can replenish these reserves by borrowing from other banks that have a surplus of reserves. Banks are not extending as much new credit now because most banks are hoarding their surpluses of reserves rather than lending them out to other banks. Until banks have confidence that they will not need these reserves to stave off liquidity crises (caused by panicky investors withdrawing their deposits), credit creation will not return to normal levels, and economic growth will be suppressed.

What will happen to Fannie Mae and Freddie Mac?

That’s tough to predict, because it depends on the outcome of political and regulatory processes. My best guess is that Fannie Mae and Freddie Mac will re-emerge as more closely-regulated entities. They will use lower leverage and be more restricted in the types of mortgages they can buy. These higher standards will ripple through the mortgage system and have the effect of tightening mortgage lending terms. You can think of this as “the return of the down payment” — one of the most troubling aspects of our current economy is the percentage of homeowners with negative net equity in their homes. Declines in housing prices are bad enough, as this triggers a negative wealth effect worldwide. But it’s another matter entirely when homeowners have negative equity in their homes, as this works in conjunction with restrictive credit markets to bring real estate transactions to a screeching halt.

Congress approved a $700 million bailout. Will taxpayers get their money back? Was the bailout needed?

No taxpayer should doubt that the government’s emergency intervention in credit markets was desperately necessary. This underscores the severity of the problem currently facing credit markets — the effect of the bailout on the deficit and the question of moral hazard (bailing out risk-takers only encourages them to repeat their behaviors) are secondary compared with the dire need to jump-start the credit creation process.

Regarding taxpayers getting their money back . . . they will probably get some of it back, but my guess is it will be less than 25 cents on the dollar.

What is a credit default swap? Is it legal? Is there likely to be re-regulation of these types of securities?

A credit default swap is a type of financial insurance on either a bond default or the bankruptcy of a company. Just like auto or life insurance, if a severe event occurs, the insured are mostly covered — in theory. Credit default swaps are legal, which underscores how loose financial regulations had become. The problem is, unlike auto or life insurance, the creators of credit default swaps were allowed to hold little or no reserves in case the entitites they insured filed claims. But the mainstream insurance industry is regulated, of course — these insurers are required to hold reserves in the event of claims. There will almost certainly be tighter regulations on credit-default insurance in the future.

The stock market declined in September and October. What should investors do?

(Before making any changes to their portfolios, all investors should seek professional advice from a certified financial planner.) Investors’ personal course of action after a large market decline depends on their age and how soon they might need to convert their investments to cash. Younger investors (under 40) should move more heavily into stocks now — stocks haven’t been this cheap relative to fundamentals since the early 1990s. Investors are being paid to take risk again, which is good news for long-term buy-and-hold types. Older investors face a tougher decision. Moving too much portfolio wealth into cash at a market bottom exposes retirees to the risk that they will miss out on future equity returns they need to repair and extend the value of their portfolios. But, as the recent bear market has reminded us, just taking more risk is not a guarantee of higher returns. After a bear market/credit crisis/recession like the one we’re in, the economic and financial market recovery could be far off in the future (just look at Japan since the early 1990s). My advice to investors would be to have a financial planner assess their individual needs and create a strategy based on their personal circumstances.

What is the silver lining in this economic fallout? Opportunities?

The silver linings are mainly Pyrrhic victories. The relative valuations of stocks, real estate, and other investable assets will be more in line with fundamentals going forward (another way of saying that their risk premia will be positive and appropriately large) — at least for a while. Starting from a low level of interest rates increases the odds that future stock returns will be lower than long-term average historical returns for an appreciable period, however. Although the equity premium (stocks minus bonds spread) is normal, in the early 1980s that spread suggested 16% returns on stocks and 10% returns on bonds. Today we’re looking at returns more in line with 9% returns on stocks and 3% returns on bonds. Moreover, US households will almost certainly be forced to gradually de-leverage their balance sheets, exposing themselves to less financial risk, which will dampen consumer spending for a considerable period, as consumer spending has been propped up by greater borrowing since the 1980s. The best opportunities exist for investors with a lot of cash and a long time horizon — I would recommend these people increase their exposure to US and global equities.

Do you expect deflation?

I do not expect a Japan-style deflation, at least in the short run. As a matter of fact, I’m more concerned with the opposite — a slow-growth stagflation scenario like the 1970s. Real wages have gone nowhere in the US in 30 years. With the election of a Democratic president and Congress, the middle class is going to expect improvement in wages and their standard of living. Unfortunately, wage increases are often inflationary. In the longer run, however, if the economy remains stagnant, a deflationary spiral cannot be ruled out as a possibility. That’s why it’s so important to repair the function of credit markets and begin paving the way for the next economic expansion, which will hopefully begin sometime during the second half of 2009.

What impact will the new president have on the economy?

I think the new president’s impact on the economy should be judged in the long term. In the short term, given that President-Elect Obama has inherited enormous budget and trade deficits, the worst financial crisis since the Depression, two wars, insolvency of the social security and medicare systems and rising household insolvency, I believe that the first several years of his term will be characterized by financial and economic malaise. Moreover, if his administration does the right thing, it may make things worse before they can get better (tightening the federal budget in an attempt to stabilize the federal budget deficit). If we ever want to see the US restored to economic and financial preeminence in the world, however, we need national leadership that’s capable of making tough choices on behalf of the US right now.

How does the average American get ahead financially during these times?

It may not be possible for many families with credit card debt, negative home equity, and uncertain employment prospects to get ahead in the near term. Americans can sow the seeds of prosperity by reducing debt, increasing their saving rates, and taking more appropriate risks with the equity and real estate portions of their personal wealth than has been the case in recent years.

You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand or email him at profweigand@yahoo.com.

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