Understanding the Global Financial Meltdown

By Nick Li

I confess to not being an expert on financial economics or monetary policy, so I have no original thoughts about the current financial crisis gripping the world. However, I have been trying to inform myself about what is going on. In this post I would like to suggest a few resources for non-experts to get acquainted with the origins and solutions to the current crisis, and I will attempt to describe in layman’s terms a few of the options.

The main features of the current crisis are the

-bursting of the US housing bubble

-a series of failures by major global financial institutions that were overleveraged, heavily invested in housing-related assets, and full of opaque credit derivatives that make assessing the likelihood of failure or the real value of assets very difficult

-a subsequent credit freeze around the world, with sharply increasing interbank lending rates reflecting a fear of banking failure that is gradually working its way to non-financial industries and consumer credit

-a massive global stock market drop (including non-finanial companies) reflecting this uncertainty and fears of a global economic downturn in the real economy

An excellent resource for understanding this crisis is the series of panel discussions among experts at major US universities. I attended one such panel discussion myself at Berkeley last week, and learned a fair amount. Much (though not all) of the exposition is non-technical, while at the same time going into much greater depth than major magazines and newspapers. The following videos are available for viewing

Berkeley

Harvard

Princeton

MIT

For those who prefer reading, one of the best sources is the recent conference at Jackson Hole, sponsored by the Federal Reserve Bank of Kansas. I particularly recommend the article by Kashyap, Rajan, and Stein which includes a nice non-technical introduction to the current crisis along with an unconventional proposal for overhauling capital regulation.

Finally, in terms of where we go from here, I recommend a series of very short articles written by a group of academic and private sector economists that was published this morning in anticipation of the G7/G8 meeting in Washington this Saturday. The authors generally agree that we need concerted and coordinated (1)recapitalization of the banking system, (2)fixing of the interbank loan market, perhaps by guaranteeing interbank loans, and (3)coordinated macroeconomic stimulus through lower interest rates and tax cuts/increased spending.

So, briefly, what are the proposals going around?

-coordinated cuts to interest rates. This happened yesterday morning, as the Fed, Bank of England, ECB, Bank of Canada, Swiss and Swedish Central banks all cut interest rates by half a point. There is still some more room to go down (especially in Europe) but the general consensus is that lowering interest rates won’t help much, since the interest rates bank charge each other reflect a widespread default risk that is not tied to the central bank interest rates.

-The Troubled Asset Relief Program (TARP) is the $700 billion dollar program approved in the US. It gives the Treasury Secretary Henry Paulson enormous latitude to spend the money, including buying actual mortgages directly, buying mortgage backed securities (so called "toxic waste" assets) from financial institutions, or directly injecting capital into banks and acquiring equity.

-The Bank of England has a $90 billion plan that involves bank recapitalization and guarantees for interbank loans

-A series of bailouts of major financial institutions all around the world, involving either short-term loans or outright nationalization (giving money to the firm in return for ownership, as in the case of Fannie Mae and Freddy Mac and AIG).

-Presidential candidate John McCain proposed a plan that would use some of the $700 billion from TARP to buy up mortgages directly at FACE VALUE and then renegotiate the terms of the mortgage to prevent more foreclosures. This contrasts with the views of many that mortgage lenders who made risky loans should be forced to take some of the losses and that the government should pay the (much lower) market value for the mortgages. Paying face value amounts to giving a large subsidy to the shareholders of the banks and mortgage companies who made risky, foreclosure prone loans, while paying market value would allow a given amount of money to buy up a much larger number of mortgages and prevent more foreclosures.

-Increasing deposit insurance for households to prevent bank runs

-Some proposals include guaranteeing interbank deposits and interbank loans, to unfreeze the credit markets and get banks to resume lending to each other and to corporations.

-One debate over the Paulson plan is whether the government should directly buy the troubled assets or whether it should recapitalize banks directly. The idea behind buying troubled assets directly is that no one really knows what these assets are worth, and this creates uncertainty and fear of default. There is no market for these assets right now. If the government set up an auction and bought these, we could develop a market for these assets and we would be able to assess which banks were failure risks and which weren’t, and act accordingly. The criticism of this plan is that it takes a while (we have to set up the auctions, and get the expertise to try to assess the value of these assets which even finance departments of major banks have been unable to do), we don’t know what is the right price to pay, and hence we risk either paying too little (and thereby not helping the banks) or too much (and thereby giving a subsidy to bank shareholders). And there is no upside – if we end up paying too much, basically giving the banks a handout, and the economy recovers taxpayers are stuck with the debt. The alternative plan, which is sometimes called the Elmendorf plan (after Brookings Economist Doug Elmendorf) or the Swedish plan (after a similar program carried out by the Swedish government in 1992) and now the Brown plan (because it is similar to the actions undertaken by the UK yesterday) is basically nationalization. It amounts to directly injecting capital (money) into troubled banks by buying new shares. If the government acquired enough shares it would effectively own the bank. In the US, this proposal has been gaining acceptance because it can be done much faster than the auctions for troubled assets, and because taxpayers would gain in the upside because they will own shares in the banks and can benefit if/when there is a recovery. In the US it is quite likely that the government will not want to buy a controlling interest in these banks, to avoid the appearance of nationalization, but it may be forced to in some cases. The idea behind this plan is that banks have been forced to sell of assets because (1)the value of their portfolio has dropped, and (2)they cannot get short-term loans, and (3)they have minimum capital requirements. These assets are thus sold at "fire-sale" prices below their long-term value. If banks had enough capital/money on hand, they could afford to hold onto these assets until they regained some of their value, and wouldn’t be forced to sell them. They could also resume making loans that are profitable and satisfy their capital requirements. Because the government gets an equity stake, it would share in all of the benefits of the recovery. Such a plan, like the troubled asset purchase plan, might be voluntary and might not apply to all banks – just to the ones that are considered important and not allowed to fail by the government.

We’ll have to see what comes out of the G7/G8 meetings this week. This crisis is a long way from over and may lead to some major changes in the international financial system as well as in governments around the world. These are interesting times to be an economist…

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2 thoughts on “Understanding the Global Financial Meltdown

  1. I hold the opinion that the best explanations for almost anything come in analogous form. Might be a part of excess consumption of Russian Literature and Fiction, or a truthful statement. Either way, it is worth checking out the following link for an extremely good analogy to explain the financial crisis in less than 6 minutes.

    http://ca.youtube.com/watch?v=eb_R1-PqRrw%20

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