September 2008, The Wall Street Journal
‘Crisis on Wall Street as Lehman totters, Merrill is sold and AIG seeks to raise cash’…
This is not mere a headline of another market crash but is an awakening call for the investors, who are having a feeling that more they invest more they will earn. Greater will be the risk… higher will be the return…. All that is required is just putting money into the stock market.
Financial crises have been an unfortunate part of the industry since its beginning. Bankers and investors are very well aware of the fact that business is so large, so global and so complex, it is naive to think such events can ever be avoided. But then too what is required is proper knowledge, review of finance and investment with plan i.e. target value. If we look into the financial crisis of last 30 years we will find few things in common. There is excessive exuberance, poor regulatory oversight, dodgy accounting, herd mentalities and, in many cases, a sense of infallibility.
- (1)Savings and loans crisis – 1980s
There were banks involved in lending long term loan and accepting short term deposits at fixed interest rate. Suddenly an act was passed in 1989 which rose the interest rate on deposits being offered by other institutes. This decreased the deposits and so liquidity. Thus many of the banks become insolvent.
According to William Black (litigation director for the Federal Home Loan Bank Board and deputy director of the Federal Savings and Loan Insurance Corp, 1980)
“The credit crisis is a continuation of the savings and loan crisis.”
- (2)LatAm sovereign debt crisis – 1982
The main culprits, Mexico, Brazil and Argentina, borrowed money for development and infrastructure programs. Since their growth rate was high at that time bank gave them loan at a very easy rate and thus debt quadrupled in just seven years as interest rate on bond payments rose the currencies plummeted.
- (3)Junk bond crash – 1989
When the UAL deal fell through, it helped trigger the collapse of the
junk bond market. The UAL deal failure resulted to the drowning of the stock and the market crashed. Blind investments got drenched.
There was a sudden devaluation in value of Mexican peso due to which there was massive interest rate crisis and finally bond failed. There also banks were in the practice of lending money at very low rates of interest. But due to certain policies change value of peso fell steeply and due to high lending and failure in return lead to 11% debt and finally the currency collapsed.
- (5)Asian crisis – 1997 to 1998
Similar to the crisis that happened in Latin America in 1982. Thailand currency, the baht collapsed, spreading across the region with South Korea, Indonesia, Laos, Hong Kong and Malaysia. Because of their strong economic performance throughout the early 1990s. Even after the warning issued by IMF they didn’t maintained their reserves and due to a higher stipulated growth rate they invested further. They owed a huge amount of debt to foreign entities that it couldn’t pay even before the currency plummeted. Moreover after the recovery of US economy, investors moved to US market and due to high divestments, they lost a chance to recover. US$40bn bailout was provided by the IMF. Only after a year similar event happened in Russia (1998)
- (6)Dotcom bubble – 1999 to 2000
In this case, it was a bull rush into the technology and internet-related stocks. By year 2000 the economy had slowed and interest rate hikes had diluted the easy money and many of the companies sunk. Kay Steffen, head of syndication and corporate broking at DZ Bank stated, “
Everyone knew this was something that was not sustainable, but it’s not always easy to take that view and resist all the different groups that want in on the market”
- (7)Global financial crisis – 2007 to 2008
Every time a bank makes a loan, new money is created. They used this money to push up house prices. People were into this buying and selling of property to make easy money but interest had to be paid on all the loans that banks made, thus debt rose more than income, eventually some people become unable to keep up with repayments and they stoped repaying their loans, this decreased the liquidity of several banks and finally major banks collapsed.
The Greek economy was one of the fastest growing in the Eurozone from 2000 to 2007 but a steep rise in the deficit and being more service sector dependent laid the foundation. Moreover there was a huge tax evasion. Which finally increased the debts to manifolds.
Thus here we can see that even after the proper root cause analysis of the crisis of the past the behavioral aspect of people hasn’t changed. If we are taking all these events on a whole we will get that there are several common causes/ responsible for such crisis. They are:
- (1)Leverage: In order to increase the return of investment the banks are in the habit of increasing their leverage to the alarming extent.
- (2)Big players: There are certain firms, banks which are so big and systemically important that they are never expected to fail. But sometimes more flexibility and risk leads to their catastrophic failure.
- (3)Liquidity: It is important because it is the ability to convert an asset to cash quickly and will allow the investor to get back his/her investment when required.
- (4)Taxes: Government should promote long term investment rather than a short term investment. As it will maintain the uniformity in the cash flow, more will be the injection and dejection of funds more will be instability in market. Also elimination of the subsidy over the debt based investment should be discouraged as it will check the debts when already a debt is pending at the backend.
- (5)Reckless spending and borrowing: There should be a curtailment. Deficit should be controlled.
- (6)Mixed political economical system : Here the government is having heavy hand on monopolizing money, and when it comes to credit and financial exchanges, it tells banks and underwriters what to do, how to do it, and when to do.
- (7)Investment fund managers: Invested without adequate due diligence.
- (8)Credit Rating Agencieswho overrated junk securities as investment-grade quality and misled investors about the risk and the value of these investments
- (9)And last but not least, Homebuyerswho took loans they could not afford to pay back and blamed the banks for predatory lending
On a whole if we want to determine the responsibility, whether it is in the name of Government or Banking Institute, then according to former Treasury secretary Hank Paulson "It has happened with every financial crisis, it has from the beginning of time. Financial crises stem from flawed government policies.... I'm saying there's plenty of blame to go around. But the root causes are this was a huge credit crisis. Why do they borrow too much, save too little? There are flawed government policies. People pile on the banks and they (bank) work to correct the mistakes.”
Whereas, According to The official U.S. government report (2008) ‘there was a lack of transparency of the balance sheets of the major financial institutions, coupled with a tangle of interconnections and perceived to be “too big to fall”, caused the credit market to seize up. Trading ground to a halt’.
So, on a final note take your call, when, where, how and what to invest.