The Financial Crisis - What and What Now?

Most of us are aware that the world's financial markets and economies have been severely hit. The good news is that today, the markets have taken some form of recovery.

Some students have been asking me about the causes and possible remedies. This article by the 2008 Nobel Prize winner in Economics, Prof Paul Krugman, lays out the points very succintly.

Gordon Does Good

Not explicitly mentioned in the article is how the crisis was already long-expected although not many anticipated the severity of the situation - with top investment banks and even AIG declaring huge losses.

Essentially, the crisis started with the "bursting of the housing bubble". What does this mean? Well, for the past few years, banks have been freely lending to borrowers who really cannot pay back their loans. (A common term used for this is 'subprime lending'). The loans held by the banks were then bundled together as another form of financial instrument or asset and sold to investors, including top investment banks and insurance companies.

A very simple example: Mr A, Mr B and Mr C all have housing loans with Consumer Bank H. What Consumer Bank H then does is bundle together all of these loans as an asset e.g. "Bond 1" and sells this to Investment Bank Y. The trouble is that Mr A, Mr B and Mr C actually have no means to repay their loans, and once they default on their loans, Consumer Bank H is in trouble and worse still, Investment Bank Y's so-called asset is worthless (and is known as a toxic asset). On an economy-wide level, this is the bursting of the housing bubble.

What Prof Krugman mentions in the article is absolutely correct: the cause is the bursting of the housing bubble; the effect is that banks do not have the capital (i.e. money) to provide people and companies with the credit they need to continue their businesses. And in turn, economies suffer.

The solution therefore as mentioned in the article is actually quite straightforward -for the short and medium term time period - provide banks with the capital they need to lend so that businesses can resume, the economy can gain momentum again and confidence in the markets can be restored. This is the approach taken by the British Government and now followed by the rest of the other governments.

What the US government proposed initially in their financial bailout was absolutely illogical. They wanted to spend US$700billion to purchase the toxic assets - the assets which are essentially worthless because the borrowers cannot repay their loans. Why would anyone want to do that and who will buy these assets in the future?

What the British Government has done, for example, is to invest / buy shares worth US$64 billion in the top banks like Royal Bank of Scotland, thereby injecting capital into these banks and helping these banks run smoothly again, and in a few years' time, when the economy is better, sell their share of the banks to potential investors. Doesn't this sound wiser? It is good thing that now the US government is following the British Government's lead.

Let's hope for better days ahead. It's definitely looker brighter now.