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 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.