Global Economic Meltdown Explained (or at least I try)

A friend of mine who's a journliasm professor wanted someone to explain the global economic meltdown. This is what I wrote. So for anyone who needs to have the current situation explained, here's what I wrote to her:

Paul Krugman, new Nobel Prize winner for Economics (and op-ed writer for the New York Times) wrote on Sunday:

"The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

What can be done to stem the crisis? Aid to homeowners, though desirable, can’t prevent large losses on bad loans, and in any case will take effect too slowly to help in the current panic. The natural thing to do, then — and the solution adopted in many previous financial crises — is to deal with the problem of inadequate financial capital by having governments provide financial institutions with more capital in return for a share of ownership."

So basically what happened is this:
Historic lows in interest rates, while Alan Greenspan was chair of the U.S. Federal Reserve, led to more affordable mortgages. Suddenly, people who never have been able to buy their own home were able to get a mortgage. Great, right? Wrong. The problem was that many of these "sub-prime" loans were based on the interest rate. Once the rate went up, many, many people could no longer afford to keep up with the payments. This led to foreclosures and bankruptcies.

The banks thought that they would be REALLY clever and bundle these "sub-prime" loans together and sell them as investments. Not a lot of people, including executives at the banks themselves, understood how they worked. But they appreciated that the returns were great, and so they didn't care. But just as people got caught out by the rise in interest rates and defaults started skyrocketing (see: Summer 2007), the banks realised they had worthless investments. These are the "Toxic Assets" that people keep talking about, and are now owned by the US government. The assets are worth something-- not a lot, but something-- but no one knows just how much because they were such a new and unusual investment vehicle.

(For more information, and a hilarious explanation of the sub-prime mess, go to www.businesspundit.com/sub-prime/)

Meanwhile, the banks who had the greatest exposure to these mortgage-backed securities were the ones that got into the most trouble (see: Bear Stearns, RIP Feburary 2008 and Lehman Brothers, RIP September 2008). But as these investment houses failed, the bigger problem began: banks began to be hesitant to loan money to each other. Banks loan money to each other every day-- this is how the market is financed. But when that line of credit froze, suddenly the banks found that they couldn't do all the trades that they needed to because they couldn't get the cash to do so.

(Still with me? I hope so)

Now, it's late September 2008. Governments realize that they have to do something. In the past, a central bank (like the Federal Reserve) could lower interest rates and that would get things moving again. It didn't work. Central banks could loan money to banks to get capital moving again in the markets. It didn't work. In cases of really dire circumstances, several central banks, like the Fed, European Central Bank and the Bank of England could do a coordinated rate cut to get things moving again. That didn't work this time either.

The equity markets are important for many reasons (and not just because it gives CNBC something to talk about), but they're important to most people because they're retirement savings are tied up there in their 401k. For people our age, it doesn't matter: we've got another 25 years of working ahead of us, so this decline in the last month won't hurt us in the long term. But for people like our parents, who have a lot of their net worth tied up in stocks, this is really bad news as it's unlikely to recover anytime soon.

After all those things that usually did work didn't work, the G7 had to take the extraordinary move to part-nationalize some of their banks. This cheered everyone up, and the markets had one of their best days ever on Monday, 13 October, posting 11 percent gains. While the equity markets-- like the New York Stock Exchange-- had this big bounce up, it remains to be seen if credit will finally be loosened up enough between banks to get credit moving again.

While all this was going on, people are still watching the economic reports to see what the overall economic situation is. Nearly everyone is in agreement that a global recession will take place. (Very important: While lots of people throw the word "recession" around the technical definition is this: You need two consecutive quarters of negative GDP (gross domestic product) to take place. That hasn't happened yet, but it will).

Things are dire, make no mistake about it. The big question is this: have we hit the bottom, or do we still have farther to go?