Presentation on theme: "The Global Financial Crisis, in Brief.. The root cause was runaway borrowing and debt based on the inflated value of “assets” Plus the lending of."— Presentation transcript:
The root cause was runaway borrowing and debt based on the inflated value of “assets” Plus the lending of money to people with poor credit records. The so-called “sub- prime market.” If we are looking for a basic cause, this is it.
The huge trade imbalances between the consumer countries, and exporters like China, meant that those countries had lots of money to lend. Financial institutions borrowed this money and loaned it on to banks, who, in turn, loaned it to people without taking real care about whether those people could afford it.
Borrowing reached astronomical levels and now the ratio of debt to GDP in the UK and the USA is 300% This is “living beyond your means,” or borrowing more than you can afford to pay back. Now 20% of everything produced in UK and USA goes simply to paying interest, and that does not consider the fact that the principal must also be repaid.
Cheap money was produced by the very low interest rates banks offered because they had access to so much money. The process fueled an astronomical rise in the price of houses. Houses were now being bought, sometimes in multiples, because the value of the house was expected to increase rapidly, not because people needed to live in them. Is this true of Bulgaria?
The process of buying houses simply to sell them again at a profit, is called “flipping.” If the bank thinks this is what you are going to do, then they are less concerned about your long-term ability to pay off the loan. This only works as long as house prices are rising steeply. It all depends on confidence, because the real housing market is a secondary factor (i.e. people want to live in them)
The middle-man, the realtor, saw huge profits in this. They told people that the “best investment” was the huge, 5-bedroom house, because they showed the best return on investment. They performed well because that was what everyone was told that, which created its own market. These are the most expensive houses, and paid the best commissions to realtors!
As the price of houses increased, those who had bought a house were able to borrow against the increased value by re-financing. They took out “Home Equity Loans” and got further into debt. All this works as long as people have confidence that this will continue for ever, which it cannot. We are moving rapidly away from the “real” value of the houses.
We call this type of unsubstantiated rise in values a “Bubble.” Like all bubbles it will eventually burst. As we saw, this has happened many times because of human greed, but nobody seems to learn from the past. Remember, there are many players: Builders, developers, realtors, banks, financial institutions… Then comes PANIC
House prices start to go in reverse, and there is no market. Banks want their money back. Borrowers cannot afford the mortgages they have, which they had taken out on the prospect of selling the house at a big profit. The banks are now carrying huge, unknown debt. Finance companies want back the money they loaned to the banks.
Worse still, many of the original mortgages had been bundled together and sold many times to other banks around the world. This gave the US crisis a global dimension, and banks around the world had to write-off billions of $ in assets. Without assets, they cannot lend, which is why governments are throwing billions of $ at them. These mortgages were insured, and the insurance companies went broke.
A major problem was that the banks had no idea of how many bad debts they had accumulated, and so they dare not lend to anyone. That causes a credit crunch and starts a recession, which puts people out of work, and they cannot afford their mortgages. And so it becomes a downward spiral. This further reduces confidence. And so on…
Once confidence in the banking system is reduced, people want to get their money back. Huge numbers of people line up to withdraw all their deposits. This is called a run on the bank. Banks lend more money than they have, and so if everyone comes at once for their cash, the bank goes broke. The UK government had to take over their biggest mortgage banks.
Banks have: Nobody depositing money A lot of worthless assets Everyone wanting their money back Financial institutions demanding repayment of their loans. A general decline in the value of their other investments No money to lend and unknown debts. The Icelandic banks virtually collapsed completely, the currency lost more than half its value in a week, and all the banks were taken over by the government.
The economy quickly slows down. People become unemployed, and default on their homes. Businesses go broke. Share values collapse, and people stop spending because they see their savings evaporate. We enter Recession, with little growth, or even decline. Business cannot borrow to expand.
Economists always believe everything is about to get much better! Don’t believe it.
The economy comes to a stop because there is no money available to drive it. Retailing is hurt because people cannot spend, or are afraid to spend. Businesses cut prices as far as they can, reducing profits, and even then may not sell their products. This is called Deflation, and is the opposite of Inflation. This is deadly if it is allowed to continue and will lead to a Depression
This crisis “feeds on itself” and it is difficult to say when it will stop, or what will stop it. Key elements: liquidity, confidence, dealing with the huge private and corporate debt. “Getting the economy moving again.” Stabilizing the housing sector. Creating jobs. Attracting deposits back into the banks. Making lending possible again.