I have been getting a lot of friendly inquiries from friends on whether I can decode the crisis in the markets and explain it to them in plain English !!! The media has created such a ruckus along with the falling markets that everyone and anyone is suddenly worried sick of the economy, the markets, recession, their jobs, salaries and whatever else you can think of !
So what is happening ? I do not want to type a long explanation or bore you with technical explanations, but will try and explain the problem in plain English ! There are few issues that have built up over the last 10 or so years:
1. Banks have lent more money than they collected as deposits and spread their hands all over the world in the name of globalization !!! For example, banks in America borrowed money from banks in Japan at 1% interest, gave the money to people in India at 7% and pocketed the 6% difference. This worked till the currencies, especially the US dollar were stable. When the US$ started falling like crazy, the 6% profit turned into a 2% loss and suddenly, all banks started scrambling for money, thus leading to chaos.
2. Banks have lent money to people they should not have lent at all. This was the essence of the sub-prime crisis. People who earned low salaries and others with less than stable income were given loans at slightly higher rates to buy homes. When they could not pay back the EMI's, the banks had to pick up the house and sell it off. But by then, the houses had lost half their value as the housing markets were terribly down.
For example, I buy a house for $100,000 with a down payment of $5000. Since my job is not stable, the bank makes me pay a higher interest of 10% which I agree. After making payments for a year, I see that the housing rates have collapsed and now my house is worth just $50,000. So I stop paying the EMI's, the logic being I do not care about the $5000 I put as down payment, or the $6000 I paid as EMI all year. If I get out now, I lose $11,000. If I stay on in the house, I have lost $50,000 of the house value. So I let the bank take over my house.
The problem for the bank is that it has a $100,000 liability on its books against a property worth just $50,000. Multiply the problem with a few millions houses and suddenly, the bank's financial s are looking terrible and the stock markets are thrashing the bank stock !!!
3. Banks have lent money to each other by holding securities that have shaky fundamentals.
To take a example, the bank mentioned in point two wanted to raise money. So it sells bonds that are backed by its own name and offers 10% return on the bonds. Since the bank had run great for over 100 years, other banks and folks like you and me buy the bonds and hope to get the 10% return.
When the bank starts to ruin its books from point 2, the stock market thrashes the bank and suddenly the investors are worried and want to redeem the bonds, even if at a loss. Since the bank has no money to offer, its rating get thrashed and the stock gets battered even more, thus completing the cycle of downfall of the bank.
Some banks also raise money from other institutions by offering their own stock as collateral. If a institution lent money to the bank in our example and took the bank stock as collateral, the institution is now holding a security that is not worth the paper it was printed on. And along with the original bank that went down, the institution that lent money against the bank's stock is also going down !
Finance is built on trust, and suddenly that trust has been replaced by fear all over the world. That is the essence of the entire problem ! Banks everywhere in the world are not willing to lend money to other banks and they are not willing to take any kind of security that the companies are willing to offer. When there is no money in the system, everyone postpones their buying and investing decisions, thus leading to even lesser money in the markets.
And the problem gets deeper till it gets us to the shit hole that we are all in currently !!!
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