Tobold's Blog
Tuesday, May 19, 2009
Understanding the financial crisis


If you happen to be struggling to understand how this huge financial crisis we are all in could have happened (don't worry, you aren't alone), I can only recommend to read My Personal Credit Crisis in the New York Times. There an economics reporter of the New York Times, well qualified to have known better, explains in detail how he got deep into debt up to the point where he is waiting for the foreclosure on his mortgage. He explains exactly how with not much disposable income after alimony payments he still managed to borrow half a million dollars, which he then obviously couldn't pay back.

It somehow reminds me of a 20 year old film called Rosalie goes shopping, which explains that: "When you're $100,000 in debt, it's your problem. When you're $1,000,000 in debt... it's the bank's." You just need to add that if *everyone* is a million dollar in debt, then it's the world's problem. If everybody used to spend (income + X%), then not only need people to go back to spend only their income, but they need to spend (income - Y%), with the Y% used to pay back the debt. The combined total is the spending and thus GDP falling by (X+Y)%.

I'm not very optimistic that this will be over soon, because I suspect the banks still have a lot of skeletons in the closet, for example in the form of credit card consumer debt. A recession means rising unemployment, which usually hits people most who already had the most credit risk, and causes them to default on their debt. It might take years before the mess is completely cleared up. And once the banks balance sheets and everybody's personal debt is "back to normal", whatever that is, we need to start paying back the trillions that our governments are now spending on our behalf to rescue the economy.

While the temptation is big to blame somebody for the mess, in the end it was a case of collective insanity. You need to be crazy to borrow half a million dollars on not sufficient income to pay it back, but there need to be a whole lot of crazy people involved in you actually getting that loan. I just hope that this scars us permanently with the lesson that you shouldn't live beyond your means. But like any major crisis, some people whose personal finances were perfectly in order will suffer too, because they lost their job, or their savings, or both. It just is very hard to explain to somebody that he just got fired because his company was exporting goods that a buyer on a different continent couldn't really afford, and now stopped buying.

Nevertheless there will be an even greater number of people who will come out of this crisis with not too much of a loss. 10% unemployment is a catastrophe for many, but it means that the other 90% still have a job. If you *were* saving instead of living on credit, you probably lost money from your investments, but if you weren't speculating wildly, most of those losses are on paper only. Working in a company during a crisis can be unpleasant, and many perks, bonuses, and pay rises will disappear or become much smaller in the years to come. But at the end of the tunnel many of us will emerge a bit poorer and a lot wiser. Just fasten your seat belts, this might be a bumpy ride.
Another link -- this one is a well-done flash animation:
THANK YOU for the name of the movie "Rosalie Goes Shopping" -- watched it years ago but could not remember the title!

-- Tipa
I learned the hard way about credit card and unsecure debt while I was in college. I'm now working to get it paid off so I can actually start my life the right way.

My girlfriend and I are talking marriage, and there are two things we both totally agree on in regard to debt management: no credit cards (we will live entirely within our means) and no small business enterprises (I was screwed in that, too).
We are definitely living in interesting times.

Living within your means and curbing the Want Monster are the only good way to get by.

There are a lot of things that have yet to sort out, and plenty of fraud to wash out of the system. It will be an interesting few years.
We pulled a major payoff on some big debt credit cards with taxes this year.

We kept low interest and some Zero interest transfer cards for emergencies only.

We also started several straight up Savings accounts, with no investment in markets.

The wife borrowed against her 401k, thus actually paying herself back in interest to offset the losses.

Overall, I think it worked quite well, and I am still in the game financially and with the wife being in the medical field and I am in a "religious" non-profit...our jobs will be around for a while..

Cause everyone needs medical care or religion (even if you don't practice it)
I would disagree that it is just collective insanity, Tobold, but rather that it is systemic. The very core of the issue is that unregulated financial markets and capitalism simply don't mix well.

The problem is that the financial industry is driven by risk. Risk=Profit. As a result, when one firm takes a risk and it pays off, say, taking on some sub-prime mortgages with high interest rates that ARE being paid off, then all the other firms are forced to become riskier as well to keep up. Being publicly traded means that they don't really have the power to say "Guys, calm down, we aren't going to be risky like them, we want safe investments", because you are actually saying "Guys, calm down, we aren't going to be profitable like them, we want low return investments." You can see why this won't work very well. Financial firms that play it safe are either smaller than competitors or hemorrhage investors when the getting is good, like in the mid-2000s it was.

Every firm takes on more and more and more and more risk, even if they disguise that risk through derivatives to get to sleep easy at night, until finally one firm takes a risk that backfires and that firm is suddenly in deep trouble, lots of debt, and looking at it's books only to see a bunch of troubled or toxic assets. The other firms look around and realize that while only that first firm fell through the thin ice, the entire lake is now breaking up and they are screwed as well.

Some have argued that the problem was TOO much regulation. That the US government put in laws to help the poor by forcing the poor innocent banks to give bad loans. Sadly, this isn't even remotely true. There was always a profit incentive to give these types of loans, and the problem attitude extended far past those that were affected by the bills, like the aforementioned finance journalist who wanted a $500,000 home.

The sad fact is that financial firms simply play a lopsided game. They are easily able to pay vastly more than governmental institutions can for potential regulators, so the best and the brightest are almost always on the side of industry, and the minds that would be making regulations are now finding out ways to get around regulations.

It isn't as simple as "We need more regulations on the financial industry!", which is a knee jerk reaction. What we need is more smart minds on the side of governments world wide who can control regulation on the financial industry without going overboard, and actively understanding the industry while not being beholden to it.
I am fortunate in that none of my immediate family are big on consumerism and no one was totally laid off. My brother and mother have lost some work, but neither are anywhere close to being in a crunch.

Personally I feel that the financial industry should be treated as a utility: publicly available, heavily regulated, and not so driven by greedy assholes.
As we are told, the way out of the crisis is for people to spend lots and stimulate the economy.

Except, nobody wants to spend lots because of the crisis.

The way out of this seeming catch 22 is to stop stressing people out about the crisis, i.e. stop saying crisis every 2 minutes. Crisis.
Personally, I've had the opposite of everyone else in this crisis. I've gotten a new job, made money on my investments, and will be paying off a mortgage years ahead of schedule. I place it all on living a debt free life (outside of a mortgage), living within my means, and holding myself responsible for what happens.

I strongly recommend people check out and feel better about this situation than what the government or the media attempts to lay upon us.
I think a lot of the consumer credit crisis is down to banks (reasonably) wanting to charge for loands in proportion to the risk involved, but taking crazy steps to avoid making the actual risk and actual costs clear to the lender.

Its the misinformation, deliberately forcing people to incur extra bank charges (ie. by sending letters out late or not sending at all), that needs to be cracked down on.

People being silly and not understanding the risks of stretching finances to the limit or defaulting on secure loans ... that they need to learn themselves.

I totally agree that risks and profits are a big part of equation. But there is no conspiracy, or fundamental flaw of capitalism. The problem is simply that humans, as a race, are incredibly bad at risk assessment.

I'm not kidding you, it is a scientifically proven fact that humans are extremely bad at evaluating chance and risk, especially for low probabilities of high-impact outcomes. That actually has become a defining factor of the human race. If people would be able to assess risk and chance correctly, they would not land on the moon, fight wars, or even buy lottery tickets.

If you could understand risk, there would be nothing wrong with having both low risk, low profit, and high risk, high profit investments. The problem was the illusion of low risk, high profit investments. I lost 20% on an investment which had "absolute return" in its name, and where the broker swore to me that it would always yield 2% more than the money market, in good times or bad. In reality stuffing my money under my mattress would have given a better yield.
Well said :) I am fortunate enough to have little debt, and available cash to invest in the cheap market.

On a unrelated note, this post in my RSS feed completely killed my Outlook. I had to delete it to get outlook to start responding properly. I have no idea why :P
Nope, looks like my RSS feed is just messed up. *Sigh*.
I think we can blame someone - we can blame banks like Northern Rock and Lehman Brothers for engaging in unethical and idiotic practices like giving out mortgages to people who had absolutely no way of paying them back all so they could sell them on as part of securities and make a fortune.
I disagree Tobold. It isn't just that we are bad at assessing risk. Even if we can identity risk perfectly, because the markets are driven by a need for more profit, they will still have a need for more risk. The second a major firm takes on more risk than it's competitors is the day those competitors need to start taking on more risk.

I mean, yes, obviously it would dispel the illusion of low risk, high reward propositions, but I would hypothesize that knowing the risk doesn't stop people from taking the chances.

Think of it this way. 50% is a pretty well understood chance. It is a coin flip. People can grasp it pretty well. If asked to bet on a 50% chance, you will find that a good amount of people are willing to take that, depending on the stakes. But even at very high stakes I doubt you will discover that not a single person will take that risk.

In a competition where you have 10 beans and you have the option of betting 5 beans with a 50% chance of 100% return, when a person takes that bet and is successful, they are winning. Everyone else will lose unless they take that risk or devise some other manner of getting some beans.

Obviously that is a horrible, hole-filled analogy, but sue me, it's 1 am here. I'm just trying to get across what I mean.
I was brought up with a very old-fashioned ethos regarding debt. In England in the 19th century paupers were sent to the workhouse, a grim Victorian combination prison/slaveshop. The fear of falling into debt was still strong in my grandmother's generation and she taught the family "never a borrower nor a lender be".

A bit extreme perhaps but the "when I die I want to be $50 000 dollars in debt" has led us to a somewhat sorry economic state.

I think this is the tip of the iceberg too, what about national debts? US balance of payments deficit - shudder
Tobold's point on risk assessment is very, very true.

There's a fascinating TED talk on the subject from Dan Gilbert (author of the amazingly depressing but also fascinating book "Stumbling on Happiness") -
This comment has been removed by the author.
Gah. Broken link. is the talk.
Unfortunately our political system doesn't allow politicians to tell the truth, bacause they'd be voted out.

From time to time recessionsa re a good thing. They allow 'bad' businesses to be flushed out. However the government have persistently stopped this from happening ('green shoots' wtf!) and the longer they persist in stopping the imbalancing correcting the worse thing will be.

Eventually we'll all have to swallow the pill (whoevers fault it is) and allow future generations to learn from our mistakes. History shows they won't though.

So prepare yourselves. Get ready for hyper-inflation, mass unemployment and social unrest. Buy gold and silver. Grow your own vegetables and pay down your debt.

Good luck.
The reporter is, of course, an idiot. As you say, he should have known better. That link is just a list of dumb ways to self-inflict wounds.

It cannot help that his wife filed for bankruptcy twice since 2008. So now 3 times. It is not like the reporter got caught by something sneaky. He walked into it with gaze averted, holding hands with someone who had already done it twice.

The system already deals with banks that give bad loans: they don't get much of their money back. People who take dumb loans go into bankruptcy. Banks who give dumb loans should go into bankruptcy, if you want the system to right itself, but there seems to be a great political effort to prevent that, which means profit is privatized while risk is socialized. Bad call, that.
Caleb, I think you're missing the point.

Whilst you're correct that firms woefully underestimated the downside, all chasing increased profits, the chain had to start somewhere.

And that was with individuals (and companies, not just the banks) who took out loans which were too big.

So whilst the banks and other financial institutions bear some responsibility, I personally lay most of the blame at the door of the people who thought they could get something for nothing.

It's a bit like eating too much fast food, then trying to sue MacDonalds for selling it to you.
Everything Tobold's original post says is completely backwards.

Everyone being in debt is not the world's problem currently, it's the world's SOLUTION - according to the prevailing financial system.

Since money is actually 90% debt, the more governments and business pay off debt... the LESS money there is.

The government will only pile on quadrillions on top of trillions. It's called the credit monster. In fact, some analysts say not only does the United States have a way to pay back China if they called us on it, there is no way for them to.

We all live beyond our means, that's the way the banks set it up. Do you know what the insider term for people who pay off their credit card bill promptly is? "Deadbeats."

That's right. They don't want you to pay off your credit and will try to trip you up if you do. They know that people won't pay back at roughly the same rate as the interest they charge.

It's not their money to begin with to loan. But it is counted as an asset.

Tobold mentions 10% unemployment, however the real stats are in underemployment, or the even more elusive people who have given up. It absolutely does not mean that the other 90% have a job at all. Read the fine print.

I don't think it will be a bumpy ride at all; More a smooth course to oblivion. Which is even more frightening. Because no one understands or cares.
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