How did exotic investment products such as derivatives lead to the crash? What other investment products contributed to this crash and what are they?
1. This topic is very important during this recession time, because if we can determine what part derivatives and other exotic investments had on the economy, we can understand as an economy how to combat the current crisis, and as individuals where to put, or not put, our money. Mortgage derivatives are fairly new investment tools and have not been studied sufficiently to understand them and their effects in their entirety, but from what we’ve seen and the information received during this crisis, we can better understand their possible effects and what part they should play in the future of the economy.
As noted above, since derivatives and other such exotic investments are relatively new to the market, there is not a lot of well-established knowledge of their role in the financial crisis. Nonetheless, I will discuss here some of the prevailing ideas concerning them that have been given by top officials, as well as academics who have recently focused their research on this topic.
2. First of all, it is agreed upon by most that the exotic investments did contribute to the crisis, so that will not be disputed here. The main role that academics and officials say that exotic investments played in the crisis is that they added risk where people expected little. Derivatives are supposed to pool the risk of mortgage default by getting a bunch of mortgages together and selling parts of the whole pool, instead of individual mortgages. This seems like a reasonable thing to do, except at the same time government was encouraging (through little regulation and providing excess credit) companies to give mortgages to people who normally wouldn’t qualify. While the market was doing well, these subprime mortgages were great investments, especially for banks who didn’t have to bear the risk of the mortgage because they could just sell it off to government sponsored Fanny May and Freddy Mac, or to other large mortgage dealers. The market grew even more due to increased investment coming in from abroad, which caused treasury bills rates to go down, causing investors to look elsewhere for good returns; the derivatives market and other such investments seemed good, low risk options. But these mortgages were pooled in complex ways that were little understood, even by those who created them. Since so many people had access to mortgage loans, the housing market boomed. But, when the market booms artificially because of government intervention, then a bust is sure to come, as it did. When housing prices finally stopped rising due to oversupply, then default on homes increased because people owed more on the house then it was then worth. Banks began to lose a lot of money because of these bad mortgages, and credit began to tighten. Then some large banks such as Bear Sterns and others began to go under, or come close to it. This made lenders even less willing to make loans, causing a credit freeze, which even worsened the situation. Stocks dropped along with consumer confidence, leading to decreased spending, and a large contraction in employment and financial growth. The Federal Reserve, the Treasury, Congress and other institutions have been very proactive in trying to free up credit flows by buying off bad assets and shoveling huge “bailout” investments into banks to keep them from going under. No one knows really when this will all end, or what the consequence of the actions taken will be.
So, in concluding this summary of some of the causes of the crisis, we see that exotic investments and derivatives did play a part in the financial crisis, but it was not the only party to play a major role. Simple living beyond their means of the people in general caused the bulk of the problem. Credit in general was too relied upon, and so when it froze up, everything went sour. The housing bubble, which includes the mortgage derivatives, was perhaps the straw that broke the camel’s back, but was something that had been building up for some time before 2007.
3. Information on this topic is nearly always biased in some way. Everyone’s reputation or name is on the line, so the conclusions made will be biased in their favor whether the information come from government, commercial, or academic sources. Though this be the case, I feel that academic sources will be the most reliable for information concerning the causes and effects of crisis so far. For some interesting academic looks at the crisis, I recommend reading H. Thompson’s article titled “The Political Origins Of The Financial Crisis: The Domestic And International Politics Of Fannie Mae And Freddie Mac,” or John B. Taylor’s article, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” both of which are very informative. For a good news-version, basic overview of the credit crisis, I recommend reading this article on NYTimes.com: http://topics.nytimes.com/topics/reference/timestopics/subjects/c/credit_crisis/
How much can the federal government borrow? Could our government go bankrupt? Could it become financially irrelevant?
My topic is extremely relevant to these uncertain times we are facing economically. A discussion of this topic is essential for this recession time because in this very delicate situation, any small decision the government makes will have a great impact on the economy. It is important that we first understand the reasons why we have got to this point so that we can then define the necessary steps the government should take to rebuild America and avoid any dangerous decision. I am going to talk about whether or not the federal government should borrow money and if they could go bankrupt.
Ron Paul, a former presidential candidate, said that the federal government cannot borrow, spend, or print its way out of the current financial crisis, as it is trying to do, and that similar actions by the government in the 1930s only prolonged the Great Depression. By using a past experience and pattern to defend his argument, Ron’s point of view makes perfect sense, since the strategy of borrowing money did not work in the last recession. Ron also said the only solution is to allow the market to clean out the bad investments and lower taxes and regulations to allow individuals and businesses to invest, thrive and create real jobs.
The current financial crisis has basically been caused by the credit market freezing up, which means that we cannot borrow anymore. Primarily because the people and businesses that normally loan money have lost confidence that those that borrow will actually pay it back. With so much of our consumption being permitted only by borrowing, a lack of credit basically translates into an economic catastrophe.
In a situation like that, it is less likely to say that the government borrowing and spending more money is going to fix the problem. Even if it lowers the unemployment rate from 6.5% down to full employment, that will not necessarily do any good if all the employed people are hoarding their money.
What is happening today is not because the government has not spent enough money. It is because we (as individuals and as the government) have all been spending too much borrowed money. We have been living on borrowed time, so to speak, and the time has come to adopt a more conservative and frugal lifestyle, one that is more similar to that of our grandparents who lived in (and learned from) the Great Depression
The economy will eventually recover. It always does. But, given the cause of the current crisis, I do not think any recovery will be because the government decides to borrow and spend a few hundred billion--or even a few trillion dollars--on roads and bridges. The recovery will come, with or without government spending, as the economic correction takes its course, consumers adapt to the lifestyles they can afford, and we slowly pay off the debts that we generated in our excessive borrowing.
New Hampshire Republican Gregg said of the Obama’s administration’s recently released budget blueprint. “There’s no other way around it. If we maintain the proposals that are in this budget over the ten-year period that this budget covers, this country will go bankrupt. People will not buy our debt, our dollar will become devalued. It is a very severe situation.” Borrowing money cause also leads us to bankruptcy.
Borrowing money now will just avoid the symptoms of this current issue, it will make it seem that all is getting better for a short period of time. However, this action will not combat the real cause of the crisis. And borrowing money itself is not a principle that we should base our economy on.
If you would like to look for additional, legitimate, objective information and recommendations on your topic, you can go to http://www.cnsnews.com/public/Content/Article.aspx?rsrcid=44566.
What do the words recession, depression, correction and financial armadeddon really mean?
Knowing what the words recession, depression, correction, and financial Armageddon actually mean is crucial today. The reason for this is obvious—we are in fact in a recession. Knowing what that is and also what it isn’t will greatly assist the laymen in his financial decision making process. By understanding exactly what the situation is we find ourselves in, we can then understand what it is we need to do to survive, and indeed thrive, in these conditions.
The NBER (National Bureau of Economic Research) defines a recession as: “a significant decline in economic activity lasting more than a few months.” Other economists define a recession or economic contraction as a decrease in gross domestic product for at least two quarters. The GDP is the value of all the goods and services produced by people and institutions operating in a country. Surprisingly, mild recessions are common, and come as a natural result of the economic cycle. Decreased corporate profits, investments, and employment rates are typical of a period of economic contraction. Recession comes as a result of the economy attempting to self correct. There is an organization called the Federal Reserve, and it is their responsibility to maintain the balance between money supply, interest rates, and inflation. Inflation is the rice of prices in goods and services over a period of time, and when there is inflation people tend to cut back on spending. When people spend less and save more, businesses tend to cut costs, which leads to a decline in the GDP. Unemployment rises as workers are laid off in an attempt to save money, which leads to less consumer spending. Add to this an ability to get large amounts of loan money due to lax loan practices and we find ourselves in unsustainable economic circumstances—a recession. The economy will then self correct as it cycles between prosperity and recession, and these painful transitions are called economic corrections. There is in fact one benefit of a recession, and that is that it cures inflation.
An economic depression is not so easily defined. Until the severe economic downturn in the 1930’s all recessions were called depressions. But following the Great Depression, in order to distinguish between this economic- downturn and the other more mild declines, the term recession was employed. A depression is simply a recession that lasts longer and has a larger decline than milder and shorter recessions. A good rule for defining depression is any economic downturn where the GDP declines by more than ten percent. An important thing to note is that the economy is not a single entity, and it does not have a mind of its own. It is simply the result of millions of people’s choices. Economic prosperity or depression is determined by people guessing what other people will do. In times of prosperity people have a positive outlook on the future. They feel secure in their jobs and are comfortable spending money. When they spend more money, demand increases, and so companies increase supply. This increases jobs, and leads to higher wages, which in turn leads to higher spending. People see the growth of companies and invest shares in companies in the stock markets, and so market prices are driven up. On the other hand, when the future looks bleak people are hesitant to spend money. Demand drops and with decreased demand comes increased unemployment. People lose their jobs and are again less likely to spend their money, driving the economy down even further. Companies make less profits, and people are less likely to invest. These factors lead to economic decline, and because it’s the result of so many individuals choices the government, or any other single entity, cannot control or correct it. Only the consumer can. The term economic correction explains this cycle between growth and recession.
Financial Armageddon is a phrase coined by Michael Panzer. It is a prediction of complete and entire economic collapse. Recession will lead to a depression, and send stock prices plummeting. Bonds will default, and real estate prices will drop. Banks and insurance companies will fail and government promises will amount to nothing. Unemployment will skyrocket, and then we will see a huge increase in crime and gang activity. The government will try to print more money too quickly which will lead to hyperinflation with the cost of goods and services doubling every few months. A pretty bleak picture indeed, but one that more and more Americans are beginning to believe. The idea of total financial Armageddon is not accepted entirely by many economists, but in today’s recession we are seeing some of these predictions come to pass.
Today there are countless books and magazines available providing information and advice on the current economic situation. A search on amazon.com revealed over 77, 000 results for books dealing with recessions. Sorting through valid advice and doomsday prophecies can be a chore, but any reputable financial magazine or newsletter seems to contain a lot of practical information. There are also many websites dedicated solely to the recession, and abundant information can be found on non-profit websites such as recession.org. As a result of my research I came to find that in times of recession saving money is important, getting out of debt is a must, and also contributing to the economy in a positive way by actually spending money is also important.
What is in a insurance company guarantee? What is in an investment guarantee? How did these contribute to the current financial crisis?
Insurance is well defined by wickipedia.org as a guaranteed small loss incurred to prevent a larger one. In essence one insures an asset such that if something should happen to it which decreases its value, the loss incurred by the asset’s owner is made minimal. Insurance companies stand to make very large profits by pooling the risk of all their insured clients. In the event of a disaster that affects the majority, or even just a large number of the insurance company’s clients, the insurance company may well find its self unable to pay all of its obligations. Such is the case with AIG, which insured investments in company bonds. When a very large number of companies quickly became unable to pay their bondholders, AIG found its self swamped with claims, which rendered the massive company insolvent, or unable to pay its short term obligations. As a result, the government has seen fit to invest heavily in the economic bailouts which are so prevalent on the news these days.
Investment guarantees could be seen as a form of insurance for those who are investing, typically in other, often developing, countries. These guarantees seek to encourage investors to put money into seemingly less stable countries by essentially insuring them against a myriad of problems that these countries can face such as war, civil disturbance, breach of contract and other common business killing problems other countries face. These guarantees can also be purchased for domestic investments. Essentially, the insurance company calculates the expected performance of the company and a well trained actuary calculates the risk associated with an investment in that company. Premiums are paid, and if the investment does not come to fruition as per the terms of the contract, than a benefit is paid.
As with any insurance, this is a dandy system as long as investment markets are healthy and growing. In the event of a large scale recession, such as that begun around the world in the third quarter of 2008, the companies issuing these policies find themselves insolvent, as with AIG. Because of the profit that guaranteeing corporations make during periods of economic expansion these companies tend to become quite large, as seen in AIG’s $1.1 trillion in assets. When these giants start to struggle they have a direct affect on the economy as a whole and their struggle contributes to the already struggling markets which made life hard in the first place.
Specific consumer related information on guarantees can be hard to find, and when found is often rather difficult to grasp, as per www.stats.uwaterloo.ca/Faculty/erratum.pdf a small sample of which reads:
I believe that this equation has something to do with calculating market volatility, but cannot be entirely sure given the complex language of the document. Until insurance companies start anticipating the possibility of future economic catastrophes (which will never happen), or at least adjust their premiums to make marginal room for major recessions there is no way to safely invest in companies that make guarantees on investments. Investing involves risk, and selling that risk to another entity in the end only results in greater costs thanks to risk come to fruition, because now not only are the losses in the markets still being incurred, but a middle man is being paid to help you incur them.
The safest time to invest could be argued to be shortly after a major economic recession because in all likelihood the markets which were undervalued will increase to more realistic values. The real trick is just knowing when to invest- and that’s always been the case.
Where did all the money go that was flowing through our financial system just over a year ago? How has the banking crisis contributed to this dearth of funds?
We live in a time right now that is ever changing. Where just a few months ago the United States thought that the economy was in good standing and most consumers were all going out and buying whatever their hearts desired. Then, like an avalanche, the stock market lost over 50% of its total volume in less than one year’s time. People’s retirement fund suddenly disappeared, or did it. The question is, where did all the money go that was going through our financial system just over a year ago? The answer to this question is not black and white and what you will find that there is a lot of gray areas, areas where we may not know where the complete answer to this question lies, or if there even is one. The reason that this topic has become so important is that if the money just disappeared, is there a chance of it reappearing? Is it still safe to invest in an economy that can leave one penniless without warning? What you will find in this writing is information on these topics and how the banking crisis has contributed to this loss of funds.
Part of the reason that the money that was in the financial sector has seemed to disappear is because stock prices have a lot to do with valuation. What the public, or investors, perceive as the price of a stock is what people pay for it. This can be compared to having an appraiser go to your home one week and have it be appraised for $250,000, and then having another appraiser go to your home the next week and have his appraise the house as being $215,000. The question is if you have just lost $35,000 in one week, or was it just what someone feels your house might be worth if it were to be sold that same day. Stocks act in much the same way. Investors may think that a stock is worth so much, so they pay that price for it, but one influx of bad news and all of a sudden that same stock is valued at a much lower price. So, using this same information we can apply this to the market crash. In some ways there was no money being lost because there was only speculation on what people perceived the stock to be.
Another point to consider is that prior to these tough financial times banks were giving home loans to anyone that walked in the door. With more and more people moving into houses they couldn’t really afford, it was only a matter of time before this caught up with the banks. As the stock market started to go down, there were many people that started to lose their jobs and that could no longer their mortgage. Also, houses that someone originally bought for $400,000 suddenly dropped in value to $250,000. So people were paying a mortgage on a house that was only worth about half of what they originally bought it for. When the house was revalued, the homeowner was responsible for the $150,000 that was lost due to revaluation of his home.
Trillions Disappear in Stock Market, but Where Did Money Go? http://www.foxnews.com/story/0,2933,436435,00.html
Where did all that 'lost' money go?
http://www.msnbc.msn.com/id/27122758/
Market meltdown: Where did all the money go?
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2009/01/01/BUQT1522JD.DTL
Paulson on the State of the Financial System
http://www.foxbusiness.com/story/markets/industries/finance/text-paulson-state-financial/
Global recession - where did all the money go?
http://www.guardian.co.uk/business/dan-roberts-on-business-blog/interactive/2009/jan/29/ financial-pyramid
Who caused the recent crisis we are experiencing right now? Government, business, who is to blame?
Understanding why the current crisis is occurring is vital to learn from the mistakes of the past. If we can learn from these problems then they can be avoided in the future. Also, by understanding why we are here, it can help us get out of this recession.
There were several factors that led to the financial predicament that we currently find ourselves in. The true underlying cause was simply greed. Firstly, home mortgage lenders gave mortgage loans to people who should not have qualified for the loans in the first place. This provided extra profit margins for the mortgage lenders. They were able to do this because they took a risk based on the previous performance of the housing market. In the recent history, housing prices had skyrocketed. For example, my parent’s house tripled in value in the course of seven years. The lenders gave subprime loans to these unqualified people in hopes that the value of their house would increase in value as much as it had in the past. When the housing market slowed and house price fell in value, it caused the general public to default on the loans in a widespread basis. With everyone defaulting on loans simultaneously it started the downward spiral of the financial crisis.
There were also mortgage-backed securities that were given the highest security rating. They seemed to be very safe and so many people invested in them, especially those who were looking to retire soon. When all of the mortgages began to default, it put huge stress on the financial institutions that sold these securities. This blow crushed firms like Lehman Brothers. As these big firms began to deteriorate and as the government tried and failed to keep these big firm afloat, the public began to get scared. As banks increased their reserves and as the general public desired to save more than they spent, it caused further retraction in the Market. All of these factors came together in a Perfect Storm type setting and left us in the situation we are in now.
To find more information about the financial crisis, an objective website to look at is with the Heritage foundation. They have done all sorts of economic research that is available to the general public. http://www.heritage.org/Research/Economy/