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Table of Contents:

credit crisis of 2007 / 2008 What should entrepreneurs be doing? What caused it? Financial Innovations extended the troubles... Video:  what caused the credit crisis?  What happened next? September 2008:  near collapse of financial markets: A dose of pessimism:   How the crisis on Wall-street will spill over to Main-street How the government should be involved: Effects of the (USA) credit crunch: Global effects Is there "decoupling"? Not safe yet - my "titanic" theory, and the danger I see ahead China uses the Credit crisis to avoid market reforms Subprime crisis in the US, and what its effect is on China Subprime crisis may ‘pause’ China reforms Effects on Venture Capital and Private Equity News: Links

 

 

see also:  subprime lending,  Financial markets,  Double bubble trouble - two bubbles burst in the USA,  structured finance,  financial innovations,   securitization of mortgages

 

 

credit crisis of 2007 / 2008

 

 

What should entrepreneurs be doing?

 

great advice here: Angel Investor Ron Conway Emails His Portfolio Companies Over Financial Meltdown

 

 

What caused it?

 

Leading up the "credit crisis" of 2007, we first had a housing market boom in the USA.   The root cause of the housing boom was the low interest rates which can be traced back to the early 2000's...

 

After the internet bubble burst, there was a following bursting of the Telecom market, and a small recession in 2001, then the terrorist attacks, and massive corporate accounting scandals (Enron, etc).  The result?  In order to spur the economy out of recession, the Federal Reserve cut interest rates, and excess liquidity flowed into the market.  But,  Americans had lost their appetite for risky internet stocks (due to the internet bubble bursting) and for the stock market in general (due to the Enron scandals), and for anything foreign (due to the terrorist attacks of 2001).  

 

But, with extra money to spend (due to the rate cuts), and few "safe" options to choose from, they parked their money in "safe" assets such as real estate. 

 

Why was there so much extra liquidity?  Its not just because the Fed was cutting rates, but also largely because China (and other emerging markets) were lending massive amounts of money by buying up US debt (in a process to keep their currencies undervalued vs the USA).   This, mixed with the Feds rate cuts led to extraordinarily low interest rates to boost the economy, and led many Americans to re-finance their mortgages, and to invest in real estate.  In response to this flood of cheap money (and the wrong belief that real estate was a "safe"investment) ....the asset bubble went up and up. 

 

In Miami, we saw housing prices nearly double in 5 years as everyone and their sister became housing speculators, building up condos, knocking old hotels down to make room for new skyscrapers. 

 

Then came along the financial innovators that got greedy.  In an effort to extend credit to more and more people, they found out a way to offer "subprime lending mortgages", which were essentially mortgages with rates that were (initially) ridiculously low, and teased people into signing up.  Most people signed up these mortgages with the intention of "flipping" their property (reselling it again in a few years for a massive profit), so they really didn't worry about ever having to pay the actual interest payments after the rates went up.  As long as house prices continued to climb, it was a sure way to make lots of money. 

 

The main risk was that house prices might not continue to rise, and if that happened, these "subprime borrowers" would get stuck with a house they couldn't afford (and were unable to "flip"). 

 

And guess what happened?  House prices stopped climbing, and buyers started to fear a bubble.  And people (lots of people) got stuck with expensive mortgages they couldn't afford.  Defaults started rising. 

 

 

Financial Innovations extended the troubles...

 

The story would end there, except that the financial innovations involved selling off that subprime debt in fancy investment vehicles, and much of it was shelled out to greedy investors looking for slightly higher returns.  The ratings agencies gave AAA ratings to some of this securitized mortgage paper, and banks all around the world bought into it. 

 

In the past decade, there has been a boom (especially in the USA) of structured finance, in which banks offloaded their risk to specialist vehicles such as "conduits".  Because they had innovated a way to remove the risk from their own balance sheets, they therefore didnt need to worry as much about the credit worthiness of their borrowers (for homes).   But, when the subprime lending crisis broke out, they quickly discovered that the risk was not entirely removed from their company, and that it could come back to bite them.  And, bite them it did, with the troubles coming right back to their balance sheets.  In this manner, the banks mispriced the credit risk of their customers.

 

Video:  what caused the credit crisis? 

very funny...but close to accurate...

 

 

 

What happened next?

 

But, with people defaulting on a massive scale on their mortgages, there were banks everywhere that had worthless paper.  But, since most of it was "off balance sheet", the problem was that banks no longer trusted lending to each other because nobody knew who to trust.  This lack of trust has caused the commercial paper industry to freeze up, and the federal reserve bank (and central bankers around the world) were forced to come to the rescue.  

 

Where will it end ...?  add your comments here....

 

 

September 2008:  near collapse of financial markets:

 

A dose of pessimism:   How the crisis on Wall-street will spill over to Main-street

 

So far, there has been a disconnect between the crisis on Wall Street, and the relative economic growth on "main street".  While Wall Street seems to fall from one crisis to the next, the US GDP growth actually accelerated more than expected in the 3rd quarter of 2008, and has performed relatively better than our neighbors in England and the European Union.  With that relative success story of the US "real" economy, we have seen a recent appreciation of the US dollar vs the Euro, and increasingly we hear analysts applaud the growth of the real economy, even as the financial sector narrowly averts disaster. 

 

But, it may be way too optimistic to assume that main street American economy wont suffer as a result of the financial credit crisis.   Normally, I am not pessimistic in this blog, but in this case I believe that the US economy is ready for a severe contraction in the near future, and Im going to outline my rationale behind this thesis:

 

This economic crisis will not be confined to Wall Street, and will soon spill over to Main street as well. Why?  The perfect storm is coming (vs the US consumer):

 

Less credit available to you and me:   As a result of this mess, there will surely be less credit extended to consumers in the USA.   What this means for consumers is that it will be more difficult to afford a home, a car, furniture, appliances, etc.  If you live in the USA, and if you became accustomed to living off of cheap and available credit, then you're in for a rude awakening.  Consumption is about to become less affordible.

 

Increased cost of borrowing:  obviously as lending standards become more stringent, and as banks scrutinize borrowers balance sheets more thoroughly, the cost of borrowing money to finance homes, cars, appliances,etc will become more expensive.  As a result, Americans will feal less wealthy as it becomes clear that their paycheck goes less distance to funding their desired lifestyles.

 

More regulation of the financial markets:   Clearly there will be increased regulation of the financial markets as a result of this mess.   But, I fear that regulators and politicians will overdo the regulations.  They may not be wrong in calling for more regulation, but in doing so there is the danger of undercutting the very system they are hoping to protect.  The impact of more regulations is that there will be more costs, and less profitablity of many investment banks.   Less profitablity of banking business models means less competition, less money, and less credit for the rest of us. 

 

Political election year:   the trouble is that this crisis hits us just at the US is entering an election, and so the result is that every action is not just financial, but is political as well.   As both leading candidates try to out-do each other in their "outrage" agains the "greed of Wall street", there is the real risk of creating political backlash against the very capitalist system that underpins our economy.  Calls for regulation are reaching a defining pitch as the two candidates both try to position themselves as the "candidate of change"  As a result, it only increases the probablity that increased regulation will be slapped onto the financial markets, and with a greater chance of over-shooting such regulation, and hence harming the financial markets (and consumer credit) in the future.

 

Increased unemployment:  In recent months we have seen a worrying trend of increased unemployment numbers in the USA.  On the surface, you see many bankers out of jobs, but why is this occurring in the "real economy"?   The hope was that the increased exports due to the weakened dollar might offset losses in other parts of the economy.  But the export sector has not grown fast enough to make up for these other losses, and as a result, increased unemployment has become one of the main concerns of the Fed.   The unemployment numbers taken in isolation are not necessarily a cause for utmost concern, but if you consider them in concert with the falling credit situation, mortgage mess, and other factors...it is worrying...especially if you are an investor betting on the health of the US consumer to pull the US economy through this financial crisis.  Increased unemployment, combined with falling housing prices, and a reduction of consumer credit....watch out!

 

Less financial innovation:  Normally...if a segement of our economy were to go into recession, then most analysts would say that they need more innovation and that innovation would be the key to pulling that industry out of trouble.  But, the exact opposite is happening in the finanial industry.   There is an overwhelming fear of all financial innovations as banks, regulators and investors pull back from all complex financial innovations.   While it may be true that financial innovation got ahead of financial regulation, it should also be pointed out the financial innovation was very important to the developmet of western-style finance in the past decades.   Yes, we developed financial instruments that made it increasingly difficult for regulators (and ratings agencies) to understand them.  Not even professional money managers at the best banks seems to have fully understood the implications of some of these innovations.  But, in reacting to the financial crisis of 2008, there is a risk of significant backlash against many of the financial innovations that underpin the very foundation of western-style finance.  Going after these tools may make us all alot safer, but also alot poorer if regulation is not enacted with great care and understanding of how these tools work in transferring risk.  There is the risk that if financial-innovations become out of fashion, then it may become more difficult for companies to transfer risk to third parties.  With less tools to transfer risk, there will be less risk taking.  With less risk taking, there will be less lending, and a slower economy.  By this means, there is the risk that a lack of appetite for financial innovations could lead to a weaker US consumer with less purchasing power.

 

Weak currency:  Over the past year or two, the value of the US dollar has trended downward.  The makes it more expensive to purchase foreign goods, and increases pressure on inflation.  While recent months have seen a somewhat reversal of this trend, the overall price level of the dollar is still low on (recent) historical comparison, and has the effect of weakening the purchasing power of the average US consumer.  If the dollar were to suddenly appreciate, we would clearly see relief in this area.

In Summary:

 

There is a "perfect storm" brewing that is about to turn on the US consumer.   While in the past, it may have been possible for US consumers to save little, consume lots, and put the bill on their cheap credit cards, those days have likely come to an aprupt end.  In the past, the US economy was running on credit.  Savings rates were way too low, and most analysts agreed that the main driver of the US economy was the US consumer, fuelled by access to cheap and available credit.  But, that suddenly changed

 

But, when looking at the US economy as a whole, I think that most analysts havent yet taken this dramatic change in (upcoming) consumer behaviour into their calculations (for growth of the US economy). 

 

My theory is that the age of consumption for the US economy is about to be over.  The local savings rate is way too low, as most economists have long agreed.   But with the sudden interruption in the credit markets, US consumers will find it very difficult to continue speding as they have in the past.   We are suddenly going to find our lifestyle way too expensive to afford.   With less credit available, it will become more difficult to afford a home, to purchase a car, to lease a car, to purchase appliances, furniture, etc. 

 

Since most of these "big-ticket" items are only purchased when they are needed, the impact of this sudden change will not be felt personally by most consumers for many months.  But, there will be a gradual awakening by US based consumers to the new reality.  This will happen as car leases expire, and consumers find it much more expensive to get new ones.  It will happen as furniture needs to be replaced, and 0% interest over 3 years financing is no longer avaliable.  My bet is that most US based consumers are still living in the old reality and have not woken up yet to the changed environment.  When they do, consumption patterns wil change, and the US real economy will contract.

 

If I were an investor today, Id be betting against companies that supply products on financed credit to the US consumers.  Furniture, appliances, and especially cars.

 

Please share your comments here...

 

 

How the government should be involved:

 

When private banks no longer are willing to lend money to each other, there is a credit crisis.  In response to the recent credit crisis, we witnessed a situation where investors were only willing to invest in US Treasuries.   Even the "safe" money market mutual funds came under attack as investors fled and poured money into Treasuries.  As a result of a massive "flight to safety", the yield on US treasuries has dropped to record lows. This happens when everyone wants to buy these assets, which drives up the price, and has an inverse effect of driving down the "yield to maturity".    With all this money pouring into US government bonds, there is little credit left over for banks to lend to eachother.  The US Central Bank has the responsiblity (unlike the ECB) to act as the "lender of last resort" in a situation where there is a banking freeze, and if US banks are unwiling to lend to each other.  In this function, the US Central Bank has been acting exactly as it should have by lending to banks when they wont lend to each other.  Think about it....if investors decide on a mass scale that they only want to pour money into the government, then its the governments responsibility to turn around and invest that money back into the market.  This is why I dont understand the argument put forth by congressmen (and many in the media) that they are against a government bailout of the markets.   This argument makes no sense, because the Fed and the Treasury are acting as they should.  If investors are only willing to pour money into the Treasury, then its the resonsibility of the government to turn around and offer that liquidity back to the market.  In this function, they compensate for the dysfunction and fear in the market just as they are intended to do as the "lender of last resort".

 

 

 

Effects of the (USA) credit crunch:

 

Less money to lend, less money to borrow

 

After the subprime lending crisis in the US, banks became more fearful that borrowers may not be as credit-worthy as they may appear.  As a result of deleveraging, there was a subsequent reduction in credit available to all borrowers.  This led to a fear of recession (Possible recession in 2008)

 

 

 

Global effects

 

One of the biggest effects is that companies in emerging markets that need to raise new money will find it more difficult to do so.   Per the Financial Times (09/2008): "Of the $111bn in bonds that will mature between now and the end of 2009, $24bn worth are held by junk-rated groups that have almost no hope of tapping a market that has become averse to risk."

 

Is there "decoupling"?

 

Other than countries that were direct buyers of US asset-backed securities (mortgages), I don't see much of a contraction of credit in emerging markets. 

 

Let's look at Brazil for example;  In May of 2008 (6+ months into the "credit crisis"), I see no contraction of credit conditions at all.  In fact, there is an ongoing explosion of credit available to consumers in Brazil (even if the industrial credit markets are still as tight as ever).  On the consumer side, however, it appears as if Brazil is swimming in available credit, in spite of the so-called "credit crisis".  Maybe the troubles are not as global as some analysts are predicting.  Not directly anyways.

 

Mexico is another example.  According to a recent article from the Economist magazine, lending in Mexico "has ballooned.  Credit to the private sector has nearly tripled since 2001, while consumer credit has increased by around seven times."  This is hardy a global credit crisis.  Again, it seems to be localized just to banks that were buyers of mortgage backed securities, or other financial innovations.    But, in Mexico, the article goes on to explain that there has been an increase in the sophistication of the credit markets, as there has also been a massive growth of mortgage-backed securities markets, and improved credit ratings systems.  But, in contrast with the US, there has been a very minimal housing price increase (even less than inflation). 

 

So, in spite of a credit crunch, it appears as if the phenomenon is mostly US-based one. 

 

 

Not safe yet - my "titanic" theory, and the danger I see ahead

 

Emerging markets are not out of the woods yet.  see my "titanic theory" here...My skepticism about the “decoupling” argument:

 

In a recent article in the Economist; “The Bank of Japan consensus seems to be that the worst of America’s financial turmoil is now over, but that uncertainty now hangs over its real economy, with risks for Japan. Export volumes to the United States are falling, while the growth in exports to Asia and Europe is slowing. A stronger yen is beginning to squeeze company profits.”

 

In other words, the initial shock of the impact may be over, but the real trouble may be just about to begin. Think about the initial financial crisis in the USA as the moment when the Titanic first struck the ice berg. At that moment, serious damage was done, but the real life effects were not felt until much later. As the real economy in the US slows, and as the credit conditions contract, we should expect to see a slowdown in the US consumer market (who are big consumers of imported Japanese, and Chinese goods, for example).

 

Then, in order to spur the US economy out of the doldrums, the Fed has cut interest rates, which has only increased the downward pressure on the value of the US dollar. With a weaker US dollar, we have seen the benefit in the US of increased exports, which is helping to narrow the current account deficit (a good thing).

 

But the reduced value of the USD has led to reduced imports. Slower consumer demand mixed with a weaker US dollar, and its clear that China and in other SE Asian “tigers” that focus on “export oriented growth” models, will suffer. Maybe the suffering wont be as deep as it would have been in the past due to diversification, but if you take away the significant export market of the USA, then many countries around the world will surely see reduced exports of consumer goods to the US (it will take as long as it takes for global supply chains to be re-configured). The impact? No longer can emerging markets focus on exporting to the US, but instead are forced to compete with the US producers in the global marketplace.

 

But, amid the financial crisis affecting the developed world, we are seeing a bull market run in countries such as Brazil. Why?

 

Business in Brazil is booming because the world is demanding more and more commodities. Right? Yes, partly this is true, but at the same time, there is also a boom in the commodities markets that is partly fueled by speculation, and partly fueled by a global capital flight to “safety” as investors flee the wreckage in the US market, and hope that they can find “safety” in the commodities markets.

 

This displacement and speculation may be effecting the commodities markets positively for now, but like all bubble markets, you should be careful if it bursts.

 

If the US market is like the “titanic” ship that is sinking, and the “iceberg” impact was the initial financial crisis in the US, then commodities countries such as Brazil can be thought of as the dry-spot on the boat where passengers congregate in order not to get wet in the other parts of the ship. Remember the scene in the movie where the musicians continued to play, in spite of the rising waters, and in spite of the clear personal dangers lurking?

 

As investors flock to the commodities markets in hopes of finding “safe haven”, it is wise to be wary of analysts that predict that this time is different because of the rise of middle classes in India and China that will always need more raw materials to feed the booms that are going on there. Although there is some very strong logic involved in these arguments, it is also a bit of wishful thinking by those who hope that the Titanic isnt really sinking, and that hope that global speculation in commodities markets is justified. While it may be true that the global demand for commodities will only increase over time, it is also foolish to ignore the influx of speculators and displaced global investors that are rushing to “dry land” in hopes that they wont get wet.

 

Remember, when the Titanic goes down, everyone gets wet! It’s best to be in a life boat, wearing a life vest, and not joining in with the band to enjoy the party.

 

read more about  decoupling

 

 

 

 

 

China uses the Credit crisis to avoid market reforms

 

 

Subprime crisis in the US, and what its effect is on China

 

Interestingly, the subprime lending crisis in the US, and the ensuing credit crisis has given the Chinese another excuse to avoid opening up their financial market to Western banks.  This is a shame for two reasons, (1) it would benefit the chinese consumers, and (2) Western governments want to open up China to capitalism and their banks in exchange for opening up their markets to Chinese products

 

Subprime crisis may ‘pause’ China reforms

April 2 2008:  Hank Paulson, the US Treasury secretary, acknowledged on Wednesday that the fall-out from the subprime crisis in the US had “no doubt” given the Chinese “pause” about the benefits of financial liberalisation.  read more from  FT.com

 

    see more:  Changes are happening in China

 

 

 

 

Effects on Venture Capital and Private Equity

 

Private equity deals have been more difficult to close, and some Mergers and Acquisitions have been more difficult to finance.  Both in the US and around the globe...

 

 

News:

 

European private equity takes a tumble

The credit crunch took its toll on European private-equity deals during the fourth quarter of 2007. Deals plummeted from $65 billion in the third quarter to $35 billion in the last three months of the year, making it the worst quarter for private-equity investments in several years. Morningstar/Dow Jones Newswires (01/28)

 

Asia falls off in M&A and IPO

Billions of dollars of Asia's private-equity deals have been canceled in the last few weeks, causing some market furor. Loans are becoming harder and harder to obtain, causing buyers to pull back from previous agreements, and fears of weak reception have numerous IPOs falling through. Wall Street Journal/Dow Jones Newswires (01/24)

 

 

 

 

 

 

 

 

Links

 

• underlying trends that are shaping our world today
• Online Real Estate business models 
• Real estate - online  
• Real estate business models   
• Real estate  

• subprime lending