The 2008 Financial Crisis Explanations

By Greg C.
Thanks for downloading and reading this Ebook. In this Ebook, I want to try my best to explain the current financial crisis issue to you in laymen text. I want to share what I think with you and get your feedback if possible. I will also share and publish my articles in the following websites: You are welcome to visit them constantly and your support to my publish is very important and appreciate. Thank you.

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Contents: 1: Financial crisis understanding from the ground up (Part 1) 2: Financial crisis understanding from the ground up (Part 2) 3: Financial crisis understanding from the ground up (Part 3) 4: Financial crisis understanding from the ground up (Part 4)

1. Financial crisis understanding from the ground up (Part 1) What is going on to the global financial market? This probably is the question being asked most frequently in the mean time. I am not an economist. But I do really concern about the current financial crisis and the economy like the other people. I want to understand the current situation. I want to see the complete picture. Therefore, I try to understand and analysis the whole event in a simplified way, and prepare to express my idea in laymen text. Let’s start thinking from the ground up In the society, reasonably, trades among people are negotiated by the participants as a fair exchange of goods and services. However, it is not easy to match the same values of different goods and services every time. Therefore, money appeared. What is money? It is a recognized medium of exchange, agreed by all the participants. In other words, it is an IOU or a credit for the seller and a debt for the buyer. For example, A sells goods in the market. When B comes to buy the goods from A, B gives an IOU to A as an exchange. With that IOU, A can buy goods back from B or other parties with the equal value. The IOU is the money. It gives people a flexible way in trading. As money is a credit that is widely accepted as a medium of exchange, therefore, we need a central place to have the control on money, such as to standardize the appearance, to control the amount of money supply to the market, etc. This is the government, or the Federal Reserve. Having a central control is very important, because this can enable us to measure the value of a good or service against another, based on what each sells for in the market. How many bottles of beer are equivalent in value to a pair of sport shoes can only be determined in the market place. Once again, money is credit. Every dollar of credit is matched by an equal amount of debt. You work hard and get paid with an IOU worth the amount $1000. Then you can use this to exchange for goods and services. As you can see the importance of money, immediately, maybe the next question you will ask is: Why not print more money? Will our country be wealthier in that way? This is a good question. It should be explained by an example. Let’s suppose the government suddenly print out a huge amount of money, and then give every person a certain amount of that money. What would people do with that extra money? Some people will use that to pay the debt, some will save the money up, and some will spend that. Let’s assume some people are going to buy a notebook from Dell. If the supply of notebook remains unchanged, but the demand suddenly increased, then obviously Dell will raise the price accordingly. On opposite, if Dell wants to keep the price unchanged, then they need to manufacture more notebooks. However, there are many limitations to increase the productivity, such as the increase of costs of labors, materials and

transportation, etc. When the maximum capacity of production is arrived, then the price of the notebook will increase unavoidably. So, similar to all other goods and services, print more money will only cause the raise of prices, which is inflation. Finally, the supply and demand will back to the point of equilibrium again. Therefore, money is just a medium of exchange, it is a tool. The responsibility of the government or the Federal Reserve is to keep the supply of money in a reasonable balance with the needs of producers and the availability of goods and services. You can imagine that this is a very complicated work and required a wide range of knowledge in the economy and finance area. Next, let’s think about the bank What is bank? A bank is a business that provides financial services, usually for profit. The basic services provided by a bank include receiving deposits of money, lending money and processing transactions. A bank accepts deposits from customers like you and in turn makes loans based on those deposits. Every fee you pay to your bank enables them to reinvest in themselves, giving them more money to loan to the others. Banks are in business to make a profit. Their profit generally comes from the difference in interest paid to depositors and the interest earned on loans. Making loans helps banks make money. Banks will offer other financial services to make additional profit, services provided usually include: * Taking deposits from their customers and issuing checking and savings accounts to individuals and businesses * Loans to individuals and businesses * Home loan * Cashing cheques * Mutual Funds * Signature Guarantees * Facilitating money transactions such as wire transfers and cashiers checks * Issuing credit cards, ATM cards, and debit cards * Selling insurance products or investment products * Stock broking * Storing valuables, particularly in a safe deposit box * Cashing and distributing bank rolls * Consumer & commercial financial advisory services * Pension & retirement planning

Financial crisis understanding from the ground up (Part 2) What is the relationship between the Federal Reserve and banks Firstly, here is the quote of definition from the Federal Reserve homepage

What is the Federal Reserve System? The Federal Reserve System, often referred to as the Federal Reserve or simply "the Fed," is the central bank of the United States. It was created by Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role has evolved and expanded. What are the Federal Reserve's responsibilities? Today, the Federal Reserve's responsibilities fall into four general areas:
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conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers maintaining the stability of the financial system and containing systemic risk that may arise in financial markets providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments systems

So, Fed is the central bank of United States. Together with other banks, it is so called a ‘banking system’. There are many interactions between the Fed and other private banks. Generally speaking, private banking businesses are run freely as a profitable business while the U.S. government, through the Federal Reserve System, oversees and regulates the activities of the private banks. The gold standard Gold standard is a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. A county under the gold standard would set a price for gold, say $100 an ounce and would buy and sell gold at that price. This effectively sets a value for the currency; in our example $1 would be worth 1/100th of an ounce of gold.

Historically, most currencies were based on physical commodities such as gold or silver. However, the gold standard is not currently used by any government, having been replaced completely by fiat money Fiat money Almost every country, including the United States, is on a system of fiat money. Unlike gold standard, fiat money do not have any intrinsic value. It is not linked to any physical reserves. It is used only as a medium of exchange. Recall from the beginning of our discussion about money. In fiat money, the value of money is solely set by the supply and demand for money and the supply and demand for other goods and services in the economy. The prices for those goods and services, including gold, are allowed to fluctuate based on market forces. The amount of fiat money does not limited by the available gold resources in the earth. This is also one of the reasons why the gold standard was replaced. As you can see, fiat money is based solely on the faith of the government. It is not linked to any physical commodity; it will then have risks of becoming worthless due to hyperinflation. If people lose faith in a nation's paper currency, the money will no longer hold any value.

Financial crisis understanding from the ground up (Part 3) Traditional commercial Bank vs Investment Bank The simplest definition among them is: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank does not. A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC). We have mentioned the definition and how a traditional commercial bank makes profit in before. So, how about investment bank(I-bank)? An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. For example, if company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank typically does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client. Besides, the investment banks also maintain broker/dealer operations, maintain markets for previously issued securities, and offer advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities. Mortgage Most home buyers have to borrow money in order to purchase their home. Few have enough money sitting in the bank, or in other easily saleable assets, to pay the entire cost of the home at once. The home loan they receive is called a mortgage. Generally, A mortgage is loan you use to purchase a home, or some other piece of property. The amount you borrow is called the principal and each mortgage payment is a combination of principal and interest. The property remains in the possession of the borrower, but it may be reclaimed by the lender if the loan and interest are not paid as agreed. Mortgage or home loan is one of the major sources where commercial banks can generate profit. Subprime mortgage What is a subprime mortgage? Besides the conventional mortgage which we have just talked about, there is another kind of mortgage known as subprime

mortgage. A subprime mortgage is a type of loan granted to individuals with poor credit histories, who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate. Subprime mortgage crisis As mentioned before, subprime mortgage present a higher risk because those borrowers are more likely to default on their loans since they already had financial problems before taking on the loan. Therefore, after a subprime loan is issued to homeowners, those issuing banks would sell these subprime loans to other investors, to compensate for the high risk. These investors include other banks, I-banks, funds and financial institutions. As subprime loans typically pay higher yields, so it had attracted a number of mutual funds and hedge funds to invest in them. This kind of selling and re-selling of subprime loans or the subprime loans packaged products among the financial parties have created a very complex network of relationships. It can be imagined that, it is not easy to estimate the risks and the responsibilities of these products. Also, it is not easy to estimate how serious will the consequence be once there is problem in any party inside the network. The story kept going. However, the bubble started bursting in 2006. In late of that year, many subprime mortgages have become delinquent as homeowners run into financial difficulty. A number of hedge fund companies and investment banks that invested in subprime loans incurred millions of losses

Financial crisis understanding from the ground up (Part 4) The current financial crisis The public have a common understanding that the subprime mortgage crisis has leaded to a far more serious consequence, so called “the financial crisis” recently. To be exact, It has been going on for seven months. But how will that be happened? This is the question. The subprime load crisis is relatively simple to understand. People bought homes they couldn’t afford, and now they are falling behind on their home loans. This has caused the loss of related financial institutions. However, the amount of loss is not the major cause of the financial crisis. US government has already announced to take over Fannie Mae, Freddie Mac and AIG, and have injected the capital over that amount into the market. Besides, the majority of homeowners are still doing just fine. The conventional mortgage market is still healthy. So, how is it that a mess concentrated in one part of the mortgage business: the subprime loans, has frozen up the whole credit markets in United States? How would that crisis caused such a big impact to the stock market, causing the collapse of Bear Sterns, lehman brothers, etc, and left the economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression in 1923? In order to have a big picture of this incident, I think this could be explained in this way. First of all, behind the whole financial crisis, there are actually 3 major components: the subprime mortgage, Leverage (or gearing), and the Credit Default Swap(CDS). We have mentioned about subprime mortgage before. So, what is leverage? In the finance industry, leverage is a common way to use in such a way to magnify the outcome of the investments. This can be done by various financial instruments such as options, futures, margin or borrowed capital, to increase the potential return of an investment. At present, many investment banks use leverage to operate more then 20 times of their capital. For example, if bank A have an asset of 5 billion, then 30 times of leverage means that bank A can operate 150 billions of money, in which most are borrowed. It is obvious, if there is 5% of profit in the investment, then bank A has a profit of 7.5 billion. However, on the other hand, if there is 5% loss in the investment, then bank A loss all it’s 5 billion of asset, and still owe the lender 2.5 billion. The third component is CDS. What is CDS? As explained above, the operation of leverage is very risky. So some bankers think of a way to take insurance on these leverage. This insurance is called CDS. It is a specific kind of agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of

regular periodic payments. For example, Peter borrows $100 from John. John wants to get insurance on this $100 debt in case Peter was unable to return the money. The John goes to Jane and asked for Jane to insurance that debt. Jane agrees to do so if John is willing to pay her an insurance fee of $5 per year. That is exactly the most simplified scenario of CDS. Now, apply that in the world of banks. Recall the example of “bank A”. Bank A operates a leverage of 30 times. To reduce the risk, it goes to bank B and asked for bank B to do CDS insurance. After analysis the market data, bank B knows that the breach of contract case is less than 1%. Therefore, bank B is willing to take that insurance to earn the insurance fee. However, this is not the end of the story. Although bank B agree to accept the insurance, it can not have the insurance fee immediately. At the same time, some other banks such as bank C, bank D, etc. are interested to these CDS contracts. So bank B is willing to re-sell them to other banks to have the cash immediately. This is the scenario. The CDS contracts being sell and re-sell continuously among different financial sectors. In the mean time, the market value of the CDS has reached 62 trillion. However, you may see that, all the banks A, B, C, etc are making money. So, where is the money comes from? The money comes from the revenue generated by the subprime mortgage business. So why the honey moon period can continue in the previous few years? It is because the real estate prices keep rising in the previous few years. In that period, home owners and buy and re-sell the real estates easily, who can earn good money at the same time. It just likes snowball or bubble. The market keeps rocking until 2006. When the downturns came, the prices of the real estates dropped. People who are lack of financial ability was unable to pay the high interests of those subprime loans. In that case, the subprime mortgage market started collapsing, which in turn affecting the CDS market. Banks and financial institutions who are involved in those products is unavoidably being affected. In fact, nearly all I-banks and most of the commercial banks are involved in this storm, or more appropriates, the tsunami.

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