In God We Trust - All others must pay cash



The once amusing quote in the title has now become a poignant summary of the current state of financial affairs.

Everyone now agrees that the present financial crisis was caused by excessive sub-prime lending. But like most phenomenon of significant proportions, its causes were far more numerous, complex and non-linear. I use the term non-linear to describe how each incremental push, insignificant by itself, became a shove and then an irresistible force in the mutually reinforcing presence of other tiny pushes. And its not just that all the effects added up; they magnified each other and then added up.

In earlier times, a borrower's credit-worthiness was judged on two parameters: earning potential and trustworthiness. The innovation of sub-prime lending (which isn't actually new) weakened both these pillars. Earning potential was deemed not to be of too much importance because, as the logic went, the increase in the value of assets (the houses) would enable the borrower to get access to cheaper credit, thereby increasing his ability to repay. In a sense, it was believed that the houses would pay for themselves, by virtue of their increase in value. This attractive scheme greatly expanded the reach of credit, enabling many more to enjoy the pleasures of immediate consumption. But abandoning prudence would have severe consequences. The small chance of house prices stagnating, or declining, was not factored in the sub-prime lending scheme. And when that happened, the shit hit the fan.

That brings us to the weakening of the second pillar: trustworthiness, a more indirect but far more devastating effect. Let us assume for a moment that trust and character didn't have a direct role to play in the sub-prime mess. That is, lets say all the borrowers had every intention to repay and genuinely believed that they would gain the ability to do so in the future. But when, as a consequence of the folly of all involved parties, defaulting of loans began on an unimaginable scale, when prestigious financial institutions failed dramatically, and when stock markets went in a free fall around the world, thats when the trust truly eroded. I'm talking about the trust of lenders (the common people who put their savings in banks and markets) in the ability of the financial system to reward them for forgoing present consumption and taking the risk of giving their money to those who need it for creating value. That lack of trust has spiraled out of control, so much so that companies with excellent track records and revenue generation capabilities (fundamentals, as they're called) and who routinely use short-term loans from money markets (called commercial paper) to meet the gap between the time they sell things, and when they get paid for them, are not able to raise cash through them. Its not that these companies don't have cash to run their daily operations, they do. But they park their funds in investments that give a higher return while raising money for day-to-day operations from commercial paper, which they get at low interest rates due to the low risk of default. This widespread erosion of trust, however, has made that avenue increasingly nonviable, leading to one of the contributing factors in the ongoing 'liquidity crunch'. With pressures on both the demand side and the supply side, the lowering of both production and consumption levels has resulted in lesser economic activity and lesser growth. And hence the looming global recession.

Comments

  1. Very well put...
    Wonder how greed veils wisdom and prudence... The so called infallible big shots of the finance world came down like a pack of cards. The higher the risk the higher the return but also steeper the fall.

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  2. That was insightful. Extremely well-put.

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  3. I'll keep watching this space :)

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  4. Yahan bhi economics :(..... Ab to supply demand chod dey, FM time now :D

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  5. Excellent article.. Erosion of trust has got quite a lot to do with the incentive systems thats prevalent in most financial institutions too.. On a related note, check http://www.prospect.org/cs/articles?article=republic_of_the_central_banker -- a historical perspective into this trust - central bank nexus

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