Saturday, October 11, 2008

Current financial crisis:a preliminary approach (II)

Since mid September, the financial markets has been under severe stress , due to the uncertainty arising about the lasting impact of the mortgage sub prime markets default in the US..
Although expected for some , and unexpected for others (unfortunately the most), this crisis ( the most severe since the last depression (1929), will teach quite a lot of lessons concerning key variables concerning global economy equilibriums.
Economic History is already rolling on , and the analysis about the implications and consequences of this default, crisis has already begun. Thus ,it is important to review the underlying causes of this situation ,as a first step before going into deeper implications. Causing factors, can be traced back to both macroeconomics and microeconomics.
Macroeconomics factors :
a.- Liquidity surplus in the banking system due to lower interest rates starting in 2001, fuelled later into this decade by “oil dollars” ,which Banks (investment and commercial ones), had to recycle into the markets, which allowed a massive allocation of mortgage loans ,to those considered by traditional financial standard , risky customers, the so called NINJA segment (No income, no jobs, no assets).
b.- Twin deficits: current account and fiscal deficit, which implied sooner or later an adjustment either by dollar depreciation , or expenditures reductions throughout interest rates increases. This unbalances ,were considered since the mid of this decade , for many organisms ( ) ,and economists ( ),to be a source of risk for global economy.
This initial condition(a) , created the first round of effects on the demand side, specially housing markets and other goods as well. As demand for houses went up, so it did its prices, which reinforce the second round effect, because this higher prices (between the year 2000 and 2006, houses prices doubled), backed higher demand for loans and credits, to increase consumption expenditures.
Microeconomics factors:
a.- Deregulations in the Banking industry ,which did not take properly into account the systemic risk , as a prudential restriction.
b.- Financial Management models, based on short run profit, therefore high risk portfolios .
c.- Lack of scrutiny, on the side of those organism aimed and acting as a risk filter for the whole system to be accountable.
d.-Speed of financial innovation which left the existing regulations outdated.-
This microeconomics factors , were the incentives for the creation of new financial instrument backed by those Ninja mortgage assets(collateral), which were rated as a secures ones, such that investment banks trade them all over its world branches and commercial partners. Along the way, financial gains artificially increased, and paper made wealth , looked as a substitute of real wealth, therefore the bubble was on .
As it is well known among economists ,macroeconomics has its microeconomics foundations .In this case, it meant both conditions matched to one another, to amplify the magnitude of the impact on aggregate demand. Thus ,It was a matter of time, for this bubble to burst .