The last few weeks have introduced several new terms like “subprime” & “liquidity crisis” to the global markets. I shall attempt to demystify the issue using layman parlance. I am not an economist by training, maybe a closet one, therefore I interpret this from a layperson’s point of view. The issue at hand is not subprime but liquidity as I shall briefly explain why.
1) Everyone lives on borrowed money to acquire assets (property, car, education, business) at one time or another.
2) At one point, the interest rate on borrowed money was low. It was cheaper to borrow than save money in some countries.
After Sept 11, the then US Federal Reserve (Feds) Chairman, Alan Greenspan drastically slashed the federal rates (inter-bank lending rates) to 1% to prevent the US economy from slipping into a recession. Japan, having crawled out from a decade-long economic depression was also only charging borrowers a token interest rate of 0.25% for many years. The Bank of Japan (BoJ) has since raised the interest rates to 0.5% today. Investors would borrow JPY to invest in high-yielding products such as the Aussie and New Zealand Dollars, which fetch around 6% and 8% respectively. (This is known as the yen-carry trade situation). Even Japanese obasans and ojisans (grandmas & grandpas) were doing this because it is so simple provided one can stomach the forex fluctuations. The low interest rates fuelled several years of frantic borrowing and buying globally, causing asset inflation. This is why property, commodity, stock prices as well as the AUD/NZD have spiralled upwards dramatically in the last few years.
3) To exacerbate this liquidity problem, stirred China, the dragon that has been hibernating for decades has decided to put its trillion dollar reserves to good use. This sparks off yet another asset inflation with the mainlanders feverishly buying up property and stocks. All for a good reason too … the inflation rate in China is 3.4% but saving money in a bank only fetches 3% interest. Read: If I don’t spend the money now, I would only be able to purchase lesser goods and services in the future.
4) Back home in the US, US banks were previously willing to lend money to ordinary folks with little financial means or poor credit history. These folks who might be living from paycheck to paycheck were hoping for a windfall gain to pay off their loans from the booming property market several years back. The early buyers and sellers are probably sitting on handsome gains plus one or two pieces of property. However, like the game of musical chairs, you better find a chair to sit on when the music stops.
5) Banks were able to repackage these loans (the CDOs/CMOs/CLOs .. some call them toxic waste) into exotic funds (read: structured products) and sell them off to other banks/investors (folks like you and me). This is financial engineering, essentially turning liabilities into assets. Nobody knows who ends up with these funds until they do financial housekeeping. Same reason why DBS has to come out to restate their CDO exposure last week. The Goldmans, Lehmans and Bear Sterns of the world are admitting they have skeletons in their closets. Some banks may no longer exist and funds may be liquidated (read: sell at lowest possible price).
6) In economics, we learn what is commonly known as the multiplier effect. If the banks’ reserve ratio is 20%, the bank can effectively loan out 5 times of its deposit. Imagine the multiplier effect on multi-million dollar loans over several years. This is the same reason why the central banks say the subprime problem is only contained to US$35B but strangely, central banks across US, Europe and Japan have to pump in several times that amount (and increasing as we speak) into the monetary system to solve the liquidity crisis.
7) The fundamental issue is that lending has stopped. Imagine what happens when banks refuse loans for property and businesses. No loans, no funds, no more crazy buying. According to the laws of demand and supply, prices must surely drop. This describes our current situation; property, stock and commodity markets would fall (sometimes sharply) to revert to its historical means (read: reasonable prices).
I believe we have not seen the worst of this issue. The magnitude, velocity and ferocity of the global markets meltdown would determine whether the US economy has a soft landing or severe recession in 2008. The global economy is pretty fragile now and all it takes is one wild card to bring the house down.
How does this affect us in Asia?
Although the US is 8000 miles away from Asia, it is an irrefutable fact that the US economy is a major consumer and importer of products and services. Asian countries export more than 50% of its products to the US. Rising giants like China and India are net exporters not importers. If the US economy slows and stops importing, it would affect Asian economies indirectly. Hiring would freeze. Jobs would be cut or offshored to lower cost countries. Businesses might go bust due to cashflow problems. The list goes on however, I do not wish to sound like a soothsayer proclaiming the end is near. Read my post on “Bin Laden Trade” – some folks are making huge bets that the global markets are in for a rollercoaster ride.
What can you do to protect your investments?
Take a financial rain-check. Ask yourself if your recent property or stock purchase is really investment or speculation. Set a cut-loss target below which you would sell your assets. However, if you are sure that you have made a sound investment for the long haul, then put on a crash helmet and brace yourself for an uncomfortable ride. The situation may worsen before it gets better.
Where we go from here is anyone’s guess. I believe the subprime problem would work itself out in the short term so long as the central banks keep pumping in money or cut interest rates to calm the markets. The urgent task at hand is to restore confidence back to the monetary system and financial markets. However, this is not a panacea as it might lead to a bigger bubble in the future if the culprits are not taught a lesson (moral hazard situation, read the next article on this topic). History has taught us many lessons, but humans have selective memories. I fear a much bigger bubble is in the making, the 800kg gorilla … the plot thickens as we speak.
Admire the way it has been explained,so lucid and comprehend able.Will benefit even a layman who does not have an iota of knowledge about recession.