Financial Crisis

Okay, okay. So everyone around your water cooler has been discussing impending financial doom for the past few days. What gives? Well, when financial instability merges with the truth-telling power of CNN.com, it means all types of crazy crap is on the horizon. Let me help you make sense of it all.

First, read today's article by Paul Krugman. I've seen better writing from him, but this will do in a pinch.

What's been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time -- in particular, financial instruments backed by home mortgages -- have shut down because there are no buyers.

There's some confusing stuff later in the article - Bear Stearns? BNP Paribas?? WTF are those, right?

Well, to get you up to speed, there are some things you need to know. Remember LTCM (which Krugman also mentions in the article)? Of course not, wikipedia to the rescue:

Although success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. However, in May and June 1998, net returns from the fund in May and June 1998 fell 6.42% and 10.14% respectively,reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the Russian Financial Crises in the August and September of 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged, a quintessential Black Swan Event . By the end of August the fund had lost $1.85 billion in capital.

The company, which was providing annual returns of almost 40% up to this point, experienced a Flight-to-Liquidity. In the first 3 weeks of September LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage. Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail-out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.

LTCM was basically the first hedge fund to go down like a fiery inferno, but fortunately, this was the late 90s and the Fed was able to orchestrate a bailout. It also demonstrates one of my favorite Keynes quotes, "The market can stay irrational longer than you can stay solvent". My other favorite quote if his is, "In the long term, we are all dead".

Before I continue, I'd like to point out that 22 of the top 25 hedge funds (asset-wise, not leverage-wise) do not have wikipedia entries. Where's your information asymmetry NOW?? Oh yeah, someone's leveraging it against you as I type this!

But enough about the past, let's talk about now. So Bear Stearns is one of the largest financial movers and shakers in the world. 2 of their hedge funds got a wee bit carried away purchasing assets which were backed by subprime mortgages. Unfortunately for them, subprimes have a, ahem, less than prime return on investment - lots of defaults. So now everyone is afraid to take on the risk of the subprime market after this...well, guess what that does to people with subprime credit who want to buy a house? They can't get one! The housing market stagnates! OH NOES!!!

So what might happen? Well, we're afraid of debt, but China seems to love our companies for some reason (hint: Chinese companies learn not only from our mistakes, but also from our comparative transparency, which Chinese companies struggle with), and they are trying to buy part of Bear Stearns! Everyone loves China...well, except for protectionist politicians, but that's only like 98% of them anyway.

Well I started this blog entry in an attempt to inform you, and I have failed miserably. I just wound up ranting and piecing together incoherent arguments, didn't I? I just wasn't in the mood to write about this, but I felt like I had to say something, even if that "something" wound up being a bunch of random characters and links. Fortunately for you, loyal reader, there is much to read on this issue today, and I promise to have it all sorted out after the weekend.

Just read the Krugman article and check out the Times - sometimes that's all you can ask for.