Lost in outer (financial) space:
Getting the big picture of the US financial crisis

By Jon Fernquest

As the minutes tick away towards the opening of financial markets and trading on Monday morning in the US, no one really knows what is going to happen.

Finance firms and markets face a liquidity problem of unprecedented proportions:

...there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up...so everyone tries to get rid of their securities causing prices to fall rapidly...the paradox of deleveraging (Source: economist Mark Thoma)

The US Treasury Department under secretary Henry Paulson has demanded a blank check of $700 billion for starters to deal with the problem

So what exactly is this crisis all about, anyway?

The US crisis started out being about subprime housing loans. Somehow things have gotten a lot more complex.

Households failed to make their home loan payments on time (default) and then the bank took their home away from them (foreclosure).

Last week the complex but unregulated market for derivatives in the US created by financial engineers or quants employed at high-flying investment banks were at the center of the storm.

By buying a credit default swap derivative anyone can become an insurance company, even if they don't have enough money (adequate reserves) like an insurance company does to pay insurance claims.

As of Sunday evening there is now no such thing as an investment bank anymore. Investment banks were given permission to take deposits to prevent their collapse. Investment banks have now become regular commercial banks.

Events have moved so quickly since Wednesday that it is hard to keep track of what is happening. There are some informative summaries of events:

1. Freakonomics Summary (See NY Times)
2. A Black Wednesday on Credit Markets (See Yahoo Financial)
3. Paul Krugman's summary in "Cash For Trash" (See below).

(Update: Safe haven short-term US government debt has rcovered from last week, a good sign).

Here is the article in full:

---

Paul Krugman: Cash for Trash

The Paulson plan is not acceptable in its present form: September 22, 2008

Cash for Trash, by Paul Krugman, Commentary, NY Times: ...Henry Paulson's $700 billion rescue plan for the U.S. financial system..., as far as I can see, doesn't make sense. ...[And] what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis "contained," and then offered a series of unsuccessful fixes — justifies the belief that he knows what he's doing? ...

So let's try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities...

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. ...

3. Because financial institutions have too little capital relative to their debt, they haven't been able or willing to provide the credit the economy needs. [credit crunch]

4. Financial institutions have been trying to pay down their debt by selling assets,... but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the "paradox of deleveraging."

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets... How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4... Even that isn't clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I'm not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital..., it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don't go to the people who made the mess in the first place. That's what happened in the savings and loan crisis... It's also what happened with Fannie and Freddie. ...

But Mr. Paulson insists that he wants a "clean" plan. "Clean," in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this ... that Mr. Paulson is also demanding dictatorial authority, plus immunity from review "by any court of law or any administrative agency," and this adds up to an unacceptable proposal.

I'm aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications... Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I'd urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don't let yourself be railroaded — if this plan goes through in anything like its current form, we'll all be very sorry in the not-too-distant future.

(Source: New York Times op-ed section quoted in Economist's View, 22-09-08, link)

---

Vocabulary:

Banking and financial market vocabulary

a bubble, a financial bubble - when asset prices are overvalued ภาวะฟองสบู่ นั่นคือ เมื่อทรัพย์สินมีราคาสูงกว่าีมูลค่าจริง

the bubble bursts - overvalued asset prices fall suddently to their true value ฟองสบู่แตก  เมื่อราคาทรัพย์สินตกลงอย่างรวดเร็วมาอยู่ที่ราคาที่เป็นจริง

the bursting of the housing bubble - after the price of houses in the US rose to a level far above their actual economic worth through speculation, suddenly people realised this เมื่อคนอเมริกันตระหนักว่า ราคาบ้าน / อสังหาริมทรัพย์ในอเมริกาถูกปั่นราคาจนสูงขึ้นกว่าค่าความจริง  

outer space - the area beyond the earth's atmosphere where the stars and planets are นอกโลก

unprecedented proportions - bigger than ever before, biggest in history  ใหญ่ที่สุดในประวัติศาสตร์

a default - when a borrower fails to make their loan payments in time การขาดการชำระหนี้

a foreclosure - when the bank takes away the real estate from a borrower that the bank loaned money to การยึดทรัพย์สินที่จำนองไว้

surge in defaults and foreclosures - an increase in defaults and foreclosures  การเพิ่มขึ้นของการผิดนัดชำระหนี้และการยึดทรัพย์ที่จำนองไว้

plunge in the prices of mortgage-backed securities

financial institutions with too little capital สถาบันการเงินที่มีเงินทุนหมุนเวียนน้อยเกินไป

derivatives - futures, options, swaps, etc (a financial asset that "derives" it value from other financial assets such as stocks, bonds, commodities, interest rates, exchange rates, and stock price indices; See Economist Glossary and Wikipedia)   

22/9/2551
a quant - a person who works in finance using numerical or quantitative techniques (See Wikipedia)  

financial engineering, computational finance - using math and computers for finance (See Wikipedia on computational finance and mathematical finance)

investment banks - banks that traditionally specialised in finding initial funding for companies, not longer exist as of Sunday (See Wikipedia) วาณิชธนกิจ

credit default swap (CDS) - a derivative that is essentially insurance against the possibility that a borrower will fail to pay back a loan (See Wikipedia)  

adequate reserves - money set aside for a special purpose (for example, paying insurance policy holders if they have an accident and make a claim) เงินสำรองที่เพียงพอ

make an insurance claim - ask your insurance company to pay for damage you were insured against เรียกค่าเสียหายจากบริษัทประกัน

pay insurance claims - when an insurance company pays money to people for damage they were insured against  การจ่ายค่าเสียหาโดยบริษัืทประกัน

credit - borrowed money, loans (See glossary) เครดิต  เงินสินเชื่อ เงินกู้

a credit crunch - when businesses and households can't get loans anymore, banks suddenly stop lending and bond market liquidity disappear after investors and holders of capital seek to avoid risk (See glossary)  

a vicious circle - one problem leads to another problem that makes the first problem even worse making the problem bigger (amplifying problem), this repeats over and over again in a cycle until the situation gets extremely bad bad; a series of events that reinforces itself through a feedback loop toward greater instability (See Wikipedia) วงจรอุบาทก์

break the vicious circle - stop the cycle of ever greater problems  ยุติการขยายปัญหาออกเป็นวงกว้าง

a paradox - a contradiction, a situation with two facts or qualities that exist together (contradict each other) สถานการณ์ที่ขัดแย้งกัน

paradox of deleveraging - when all financial institutions try reduce leverage and pay down their debt by selling assets this drives all asset prices down and makes their financial position even worse and leaves these institutions with even more debt relative to their assets than before:

"As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a "stampede to liquidate" is a severe economic slump." (Source: Paul Krugman) (See original article cited in Time)

debt deflation, collateral deflation - when the collateral used to secure a loan or debt decreases in value, this can lead to a loan recall or restructuring of the loan agreement (See Investopedia) การที่หลักทรัพย์ค้ำประกันมีมูลค่าลดลงกว่ามูลค่าที่ใช้ค้ำประกันเงินกู้

leverage - leveraged investments borrow money to get higher returns but also risk losing more if the price of the asset declines or returns are far below expectations อำนาจที่เพิ่มผลทางการเงิน

reduce leverage - reduce the percentage of borrowed money used in an investment 

pay down debt - reducing the balance of a loan (remaining principal) to reduce your level of debt and leverage ชำระเงินกู้

principal - the amount of money lent or invested to earn interest (See glossary) ต้นทุน

resolve the crisis - solve the problem causing the crisis, put an end to the crisis แก้ปัญหา

X crippled by Y - X was damaged severely by Y so that it can no longer function properly

a windfall - money received unexpectedly (often by luck) (See glossary)  เงินที่ได้มาอย่างไม่คาดฝัน

an intervention, a government intervention - the government takes some action in markets to solve a problem (these markets usually function with only minor government involvement) การเข้ามาแทรกแซงหรือแก้ไขปัญหาโดยรัฐบาล

General vocabulary

doesn't make sense - what they say is not logical, not persuasive or convincing ไม่เข้าท่า

not acceptable in its present form - has to be changed, improved, revised, made better (then it can be accepted) ไม่เป็นที่ยอมรับ  ต้องการการปรับเปลี่ยนแก้ไข

contained - control and prevent from increasing and spreading (for instance, the government managed to control the outbreak of Avian flue and prevented it from spreading)  จำกัดบริเวณ

contain a financial crisis - prevent a financial crisis from spreading ป้องกันการเกิดวิกฤตเศรษฐกิจได้

declared the financial crisis contained

knows what he's doing - has the skill, knowledge, and experience necessary to do what he is trying to do  มีความรู้ความชำนาญในสิ่งที่ทำอยู่

think this through for ourselves - don't accept what he says, go through the details of the argument ourself to check to see if it is true หาข้อสรุปเอง

with no strings attached - no restrictions, can do anything you like อย่างไม่มีข้อจำกัด

a quid pro quo - something given in return for what a person has done (two people in an agreement or contract each provide a "quid pro quo") ยื่นหมูยื่นแมว

dictatorial authority - power to do anything he wants without opposition อำนาจเบ็ดเสร็จ

the sky is falling - a big disaster is happening  ความหายนะครั้งใหญ่

railroad, railroading through - force something to happen กระตุ้นให้ผ่านการพิจารณา (อย่างผิดๆ)

let yourself be railroaded - let someone force you to do something you don't want to do (because you feel it is dangerous, for example)

Posted by Jon Fernquest at 06:00 AM | Permalink | Comments (0)