Understanding the vocabulary of the global economic crisis

Here are some of the important words and concepts

Bank panic – When investors fear that their bank does not have enough money to pay them, they go to the bank and take their money out. When a large number of investors try to withdraw their money, this may cause the bank to collapse or to close permanently. In the current crisis there have been several times when worried investors rushed to their banks, and a number of banks have gone out business across the world.

In Iceland the collapse of the banking system led to loans by the International Monetary Fund, Denmark, Finland and Norway. The collapse of the banking system in the small country was a surprise for many.

But there were several factors in the collapse.

Credit was easily available. The economy had taken off and construction had helped the economy prosper. But most importantly, changes in regulations had allowed the banks to expand, to operate under new systems and to do business beyond Iceland.  As a result of the deregulation, the banks expanded to the U.K., the United States, Europe and elsewhere.

One lesson from the collapse in Iceland was that countries need to be able to supervise foreign firms that do business in their country.

Bear market – This is when stock markets are in trouble. The markets are declining and investors are worried about the future. Pessimism is common. A bear is an investor who sells stocks with the hope that they can be bought back at a less expensive price.

Bull market – The opposite. Here, the market is growing and investors are earning money. Confidence encourages investors and the stock market is flourishing. A bull takes advantage of the market’s boom and buys stocks, hoping that their value will go up.

Bonds – Large companies issue bonds. So do governments and institutions. The bonds pay interest. To measure the safety of investing in the bonds, they are rated by companies. But this crisis showed a problem with the system.

Companies that had high bond ratings had serious financial problems that were either not detected by the auditors or rating companies, or the companies ignored the dangers.

Credit crunch – In order for an economy to thrive, it needs credit. With credit, businesses are able to borrow money which allows them to get their operations underway. But when there is no credit, businesses cannot begin new projects. They do not have the money that they need to finance them while they are in the midst of their operations. When there is less credit, it is more difficult and expensive to borrow money for businesses. Also it is difficult to find a low interest rate on a mortgage.

Suggestion – What has been the impact on credit in your country? How have interest rates changed? Are banks making fewer loans? What percent of major banks’ loans are in trouble or are in default? What do commercial business groups say about the availability of credit? What has been the impact on investments?

Credit default swaps (CDS)_ – This resembles the insurance someone might buy to protect their property. The buyers of credit default insurance pays premiums to protect them in case their investments default. The insurance is used for municipal bonds, corporate debt and mortgage securities.

Here is where it becomes complex and risky.

These contracts are traded or swapped from one buyer to another. When the system began a number of years ago, it seemed quite safe. The contracts were based. The chance of failure was little.

As banks, government and investors eventually learned, there are several problems with credit default swaps.

The problems:

They are largely unregulated. There is no certainty about how much money is involved with credit default swaps, and they have led to a false sense of security for banks and investors as the financial system began to collapse. CDS were sold to people who had no interest in the original loan and were able to buy the credit default swaps. For them it was an investment only.

It become a form of gambling that the investment would not go bad, and that the money to pay off the loss would be available.

Credit default swaps grew because of the expansion of Collateralized Debt Obligations (CDOs). Again, the idea seemed simple and safe. Banks bought debt – home loans, credit card loans and other forms of credit. They combined the debt into one package and sold it. But to make sure they didn’t lose money, they took out insurance. Here is where they relied on credit default swaps.

In the U.S. CDOs became popular because they offered higher yields than other investments. Because CDOs can be sold several times, it is often quite difficult for owners of the CDOs to know exactly what they own. And this, according to the Congressional Research Service, a U.S. government research arm, is one of the problems that help the financial crisis expand in the U.S. The level of debt and the amount of risk was not clear to investors and regulators.

AIG and the impact of risky credit deals

The collapse of American International Group also known as AIG is an example of the destructive power of credit default swaps.  It is also an example of the international nature of this kind of dealing in risk and risk protections.

AIG is a company that provides insurance to businesses.  It once was the world’s largest insurer. It also is involved in other businesses in the U.S. and world-wide.

But as news reports have explained, the company dealt heavily in credit default swaps as the global market for these risky dealings grew. And when the investments collapsed and it came time to pay for them, AIG was crippled.

The U.S. government quickly began putting money into the company.

Why?

Because AIG provided insurance for thousands of companies in the U.S. and around the world. The Americans continued to put money into the company as the depths of its losses – largely from credit default swaps – continued to climb.

In March 2009, the U.S. government  increased its support to the company after it said that it had suffered a loss of more than $60 billion in the last quarter of 2008. The loss was the largest recorded by a corporation in U.S. history.

An article from Time magazine explains the reason for the support:

“The best case for the bailout seems to be that nobody has the faintest idea what the consequences of AIG’s failure for financial markets would be, but the fear was that it could lead to total chaos. The biggest fears had to do with the credit-default swaps, which AIG appears to have sold in large quantities to practically every financial institution of significance on the planet. RBC Capital Markets analyst Hank Calenti estimated Tuesday that AIG’s failure would cost its swap counterparties $180 billion.”

http://www.time.com/time/business/article/0,8599,1841699,00.html

September 18, 2008, Time magazine

See other news sources listed

Deflation – When the price of goods and service drop markedly, then the economy is undergoing deflation.  The major cause of deflation is a lack of demand. People are not buying. In the global depression in the 1930s, deflation was a major problem.

Deflation has its friends and enemies. It hurts those who borrow money at high costs and interest rates and then have to pay back the money when its value is deflated. As an economy spirals downward, deflation usually is part of the downward cycle. It takes place in economic recessions and depressions. As prices drop, jobs are lost and investments shrink – these are all measures of an economy in decline.

Default – When you cannot make payment on a credit agreement, you are in default.

Derivative – This is a contract where the investor agrees to buy or sell a commodity at a certain price. In the current global economic crisis, and previous crises around the world, derivatives have played a key role. They have been praised for raising higher levels of earnings or profits  and at the same time for bringing uncertainty and upheaval to financial markets.

How?

The concept goes back to ancient times. For years farmers have used derivatives as way to protect themselves against a drop in the price of their product.

But there is a history of economic problems that were linked to the use of derivatives.

The financial crisis in Mexico in 1994 and the crisis in East Asia in 1997 were partially the result of derivative trading. Again, the problem was that amount of money involved in the derivatives was not clear to regulators. That is, because the money was not kept on the banks’ accounting books, it was not clear how much risk they faced. In other cases, derivatives have been used to hide debt that should be reported in the company’s financial records.

A derivative is guess on what something will be worth in the future. But the guess became more impressive in recent years as investment firms used mathematical models to predict the ways the derivative would make money for investors.

There were two problems here. The market was not the same as before. History could not be applied. Investors were bundling together debts and creating investments – risky investments. The mortgage markets in the U.S. were full of mortgages that had little security.  The calculations that drove investment companies, banks and others to rely much more on derivatives were based on formulas that were not linked to the new realities of the U.S. economy.

Richard Katz, writing in Foreign Affairs magazine, in March 2009, offered this explanation of the role of derivatives on the crisis.

“Today’s financial derivatives often turn the insurance principle on its head, causing shocks to be amplified and transforming derivatives into what the investor Warren Buffett has called “financial weapons of mass destruction.””

Hedgers and hedge funds – The growth of hedge funds has added to the problems of the global economy. This is because they are largely unregulated, and there is no way to following their transactions easily or clearly. Hedge fund companies use large amount of money to invest and to buy companies. Typically their goal is to find their profits early and then move on. Critics say hedge funds leave a vacuum behind them as they try to reap profit only, but do not invest in building companies. Supporters say hedge funds make companies more competitive and provide more earnings for investors.

To avoid loses, some investors hedge their investments. They sell a futures contract that locks them into selling their stock on a specific day and at a certain price.

This news article about hedge funds from Bloomberg news shows the impact of the crisis on hedge funds.

“Hedge fund managers on average lost 18 percent of their clients’ money in 2008, for the worst performance since at least 1990, according to Hedge Fund Research Inc. Combine the losses with investor redemptions, and total hedge fund assets have been cut almost in half. TrimTabs Investment Research estimated hedge funds held $998 billion at the end of the year, down from $1.9 trillion a year earlier.”

As the economic crisis expanded in the U.S., hedge funds were greatly at risk because they had invested so heavily in the new kinds of investments such CDOS and SIVs. (see other references)

Leverage – When you borrow money in order to make an investment you are leveraging. If you buy a house and put down 10 percent as a deposit,  then you are are using leverage. The expectation is that you will gain more by taking the risk. The opposite is deleveraging. This when you try to have your loans returned. It is when the bank tries to reduce its banks to lower its liabilities.

Liquidity – This is a measure of how easily you are able to convert what you assets into cash. Some banks and investments have faced a liquidity crisis during the current economic decline. They have not been able to provide cash to cover their debts and other obligations.

Nationalization – There are several ways that this process can take place. One way is when the government says that it must control an industry, such as oil, and seizes the government in order to put it under state control. Socialist-led governments have often taken control of private companies and put them under the state’s leadership in order to change the economic system.

But in the current economic crisis, some governments have stepped forward and sought control of banks in order to prevent them from collapsing and harming others. The amount of control varies as governments have used different strategies to bring stability to the banks. The U.K. nationalized Northern Rock bank in February 2008.

Per Capita Income – This is the average of how much persons earn in a country. It is the total income divided by the population.  But this number can be deceptive.  It does not tell us what are the extremes or how the income is spread across the population. That is, it does not show the distribution of income. Median income is a better measure because it provides a look at how the income is spread across the population. Real income is also a good measure because it adjusts income for inflation.  And so, wages may be up 20 percent this year. But when adjusted for inflation, and compared to wages last year or five years ago, the figure may be very different.  In times of economic change, median income is helpful to understand new patterns of income and income gaps between individuals.

Suggestion – Make sure you are using different measures. That way you will have information and data that you can use to compare and contrast.

Protectionism – This is a very old method for countries to protect or to shield themselves against foreign competition, foreign products or the impact of foreign market. In today’s world, protectionism takes place when countries put high tariffs or taxes on products that come from outside their economy.

They may also put in place quotas on goods coming from outside their country. Or they may keep out companies that provide services such as banks or insurance companies. In the current global current there has been talk of growing protectionism. That is, political leaders have talked of protecting their economies by controlling imports or exports or by imposing controls over foreign banks and investors.

Suggestion– How open is your country’s economy to imports? What is your economy’s exposure to foreign investment and ownership? Do these situations have any impact today on how your economy is surviving the current global economic crisis?

Recessions and Depressions – A nation’s economy is in recession when the gross domestic product falls for two successive quarters. The gross domestic product is the total of goods and services produced by a country.

The last time the world faced a depression was in the 1930s’. The crash that struck Wall Street  (the name for the major stock exchange in the U.S) in the U.S. in October 1929 swept around the globe. Shares on the U.S. stock market fell 89 percent from their highest point in no time. The U.S. economy continued to slide downward for the next three years.

Japan suffered a banking crisis in the early 1990s and several Asian countries faced similar economic difficulties in the late 1990s. In 1987, the U.S. stock market underwent a major decline.

But none of these more recent crises match the problems created by current crisis.

After the global depression of the 1930s’ governments created protections to avoid the kind of problems that took place. That is, they enacted regulations over banks and stock markets to avoid sudden crises and to allow officials to monitor how businesses and banks operated.

But those protections were not able to stop the current crisis because some of the changes in the ways of doing business. These changes include: the growth of hedge funds, of credit default swaps and collateralized debt obligations,  of the failure to regulate these innovations, and of the inability to track money kept in offshore banks. As a result, there was an almost invisible system for regulators and businesses.

Short Selling

This is a centuries old practice that has raised controversies over the years, and did the same during critical moment in the global economic crisis. Supporters say it is merely a way of measuring the worth of a stock. Critics say it can lead to the collapse of the stock market, and cause havoc.

Britain briefly banned short selling when stocks dropped dramatically in 2008. The U.S. did the same and Australia took more dramatic steps to control short selling.

Short selling or “shorting” is when someone sells an asset that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the item at a lower price. Short-sellers hope to profit from decline in the price of what they bought.

The short-seller will “borrow” or “rent” the securities to be sold, and later buy the same  securities for return to the lender. If the security’s value falls, the short-seller benefits   from having sold the borrowed securities for more than he later pays for them. But if the security price rises, the short seller loses by having sold them for less than the price at which he later has to buy them. The practice is risky because prices may rise without bound, even beyond the net worth of the short seller. Hedge funds and large scale investors have used short-selling to reap major profits.

A structured investment vehicle (SIV) is another tool that was created in the late 1980s. It relies on some of the same strategy involved in shorting. It is based on a complex mathematical model meant to guarantee the safety of the investment. But the models failed as the economic realities grew more serious in the U.S. in the last few years. Banks that were heavily involved with SIVs suffered significant financial loses.

Sub-prime mortgages.

This is considered one of the major reasons for the financial collapse of the U.S. and other major economies. A sub-prime mortgage is one where the person making the loan does not have the same amount of income or assets to receive a regular mortgage. As a result, they have a higher interest rate.

The term also applies to credit card and other loans to persons who normally would not qualify for a regular loan. They borrow from a sub-prime lender. The collapse of the global economy has severely hurt lenders of these loans to more risky borrowers.

In the last decade, there was a marked increase in sub-prime mortgage in the U.S. One reason is that mortgage companies expanded the rules that allowed home owners to qualify for mortgages. But another reason is that some mortgage companies took advantage of persons with low incomes or credit problems to sell them mortgages that they could not realistically afford. There has been much talk about mortgage owners who should not have taken out mortgages. But the explosion in sub-prime mortgages was also due to companies that took advantage of homeowners with agreements that they could not afford.

These mortgages were then sold in bundles to banks which often sold them again to other banks. The result was that interest was passed from one to another. But the system collapsed when the homeowners could not pay for their mortgages. This led to the collapse of banks and investment companies that bought these sub-prime loans. And the collapse was felt far beyond the U.S. because the mortgages had been turned into securities that were traded widely.

Suggestion: Were banks and investment companies in your country involved in buying mortgage-backed securities? What percent of their foreign investments were in mortgage-back securities? Why did they invest in these securities? What are the rules in your country for creating investments that group together loans?