Wall Street vs. Main Street

While the problems were limited to banks and financial institutions, the general public just read about it in the news but their lives were not immediately affected. However, banks are so important to the economy and general functioning of the nations’ economic activities, it was impossible to limit the problems in the financial services to the sector itself.

One of the things banks do extensively is to lend to each other. That is commonly known as inter-bank lending. On any given day, a good number of banks need to borrow amounts of money on very short-term to cover their funding shortfalls. For the banks that have excess cash or liquidity, this is a very profitable business, when compare with just having the cash sitting around doing nothing. For those who have to borrow, this is a convenient way to obtain funding at very short notice. For the inter-bank market to function, financial institutions have to trust each other. Although the inter-bank lending is generally short-term, mostly overnight, you still need to have the confidence that the borrowers have the ability to repay the next day. As more institutions were forced to admit they were having problems with sub-prime exposures or other asset classes, fewer and fewer banks were willing to lend, no matter how short a time frame and no matter how high a rate.

Accounting 101: Here’s a quick reminder what happens when a bank make a loan to a client, it is marked as an asset on its balance sheet. And if they borrow money, even by accepting a deposit from a customer, it is marked as a liability. Meanwhile the cash position changes according to the amount of cash coming in or going out of the bank as deposits and loans are made.

When financial institutions have (or expect to have) funding difficulties, the first thing they can do is curtail or stop asset growth. It is a simple case of making the balance sheet balance. Stopping lending affects everybody, from the largest corporations to the individual customers. If you were a corporation, there may be new projects that you hope to be funded by a project loan from your bank or may be just a general revolving credit facility to tie over expected payment mismatches in general operations. If you were an individual customer, you may want to a loan to finance the purchase of a new car or buying a new house or just a quick overdraft. After years of cheap credit, thanks to the banks’ ability to offload loans via securitization, credit suddenly became very expensive because of the seizure of the ABS and interbank markets.

The problem was a lot more wide ranging than just the availability of credit. For years, certain economies (e.g. the US and the UK) have enjoyed strong consumer-led growth. This growth has been fueled by the available of cheap credit. As developed economies delegated more and more of the manufacturing to developing nations, e.g. China, South Korea, Taiwan and many other east Asian countries, the money borrowed by the average US or UK citizens is not spent on products produced in their own country, so cash was leaving their home countries to those which produce the products. This created structural imbalance in their economies, particularly the current account deficit. Additionally, cheap credit has allowed certain banks to grow to become multiple times larger than the domestic economies, e.g. Icelandic and Irish banks.

When banks stop lending to each other, companies and individual, and unless they have a pile of money readily available, they have a problem - they can’t spend on anything until they get the money. That led to a fall in consumption, a fall in confidence, a fall in investment and a fall in output - a recession. For some economists, a recession is just an economy correcting itself, but for people who live in it and companies that operate in it, a recession is not a nice thing. It means people losing their jobs, companies going bust and massive uncertainty for everyone. That’s not good.

The logical question to ask is, how come a problem that started in the banking sector (lending to US sub-prime borrowers), led to a problem in the economy? Let’s go through the chain again:

Brokers making mortgages to people who have questionable abilities to service the loans; Banks made massive numbers of mortgages; they offloaded them off balance sheet and these were securitized and sold to investors; Rating agencies provided ratings to the securities based on historical data; Investors ‘delegated’ their risk management to the rating agencies; Securitized assets were unrealistically priced based on flawed ratings and incomplete performance data; Individuals, companies and banks overleveraged on cheap credit;

So when credit seized up, the bubble burst and led to a recession. Unlike previous bubbles, which were all asset bubbles, this was a credit bubble.

For those who originally couldn’t afford their homes while they had jobs, the recession was the final straw. They face foreclosures because they haven’t kept up with their mortgage payments. They lost their jobs because their employers’ businesses were suffering during the global recession. Before you know it, these have no jobs, no homes and very little assets to support them. It is entirely understandable why these folks are angry with ‘bankers’.

However, before everyone (including politicians) begin to shout out their agreeing chants, you should consider the following ‘apology’ from ‘a banker’:

Bankers take it on the chin for screwing up the world

'We're sorry we listened to your pension fund managers demanding we made higher profits, in order to drive up our share prices and raise the value of your savings.

We're sorry Gordon Brown didn't give the Bank of England powers to take away the punch bowl by raising interest rates in response to rising house and share prices

We're sorry we lent you four times your salary to over-pay for your new house.

We're sorry we lent the guy who bought your old house a 100% mortgage on that over-inflated price you were so happy about at the time.

We're sorry your son didn't stay living with you until he was 28 whilst he saved up a 15% deposit.

We're sorry he got that 'cool' job producing adverts for the latest mobile phones instead of becoming a boring swot, studying engineering, and actually making things.

We're sorry we allowed your sister to re-mortgage and build that conservatory.

We're sorry your daughter ever got a job in retail, selling stuff that was mostly bought on credit.

We're sorry your brother-in-law made such good money fitting kitchens in buy-to-let flats that we all now realise should never have been built.

We're sorry we lent you the money to buy a new BMW even though, given your finances, you should have stuck to a second-hand Focus.

We're sorry we gave you a second credit card to buy that 42" plasma TV instead of saving up for it.

We're sorry the media created a world where those who saved instead of spending on emulating "celebrities" were classed as boring.

We're sorry we joined in with the public, the media, and the government in believing that house price rises were both a good thing and a one-way bet (Hands up - that was truly dumb).

We're sorry. We've learned our lesson. We promise we won't do it again.

Source - Unknown

The bottom line is: everyone played his/her part in this whole fiasco - the individuals, the brokers, the bankers, the rating agencies, the investors, the regulators, the government, the whole lot of them. Every single last one of them had a hand in this mess.