www.time.com (Mar 19 2009) 'How AIG Became Too to Fail', Retrieved 25 September 2009, from http://www.time.com/time/business/article/0,8599,1886275,00.html
http://roomfordebate.blogs.nytimes.com (January 29 2009), 'Bonuses for Bad Performance', Retrieved 23 August 2009, from http://roomfordebate.blogs.nytimes.com/2009/01/29/bonuses-for-bad-performance/
www.time.com , '25 People to Blame', Retrieved September 25 2009, from http://www.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877319,00.html
Gandel, Stephen (January 31 2009) 'Why Your Bank is Broke', Retrieved September 25 2009, from http://www.time.com/time/business/article/0,8599,1874702,00.html
Gandel, Stephen (February 26 2009), "One Bad Bond', Retrieved September 22 2009 from http://www.time.com/time/magazine/article/0,9171,1881974,00.html
Fox, Justin (February 19 2009), 'Pay Wall Street Less? Hell, Yes', Retrieved September 22 2009 from http://www.time.com/time/magazine/article/0,9171,1880637,00.html
Sunday, September 27, 2009
Friday, September 25, 2009
So Bonuses: Should it Remain?
After analyzing the finance industry I think it is pretty clear that for the past few years financial institutions has been focusing on short term results.
And during the boom periods like the recent housing boom, issuing sub prime mortgage bonds and lending to everyone and anyone is a good strategy because so long as house prices were high any mortgage defaults would be absorbed by the resale/remortgaging of property at a premium. However when the housing market crashed banks had no where to turn (apart from government) to cover the loss.
Financial industry assess performance by looking at the companies immediate result. In order to have investors happy they must ensure their respective companies are performing.
And I blame the characteristics of the financial system as the primary cause of the mess that we are in right now. Regulators had made the financial system become so liberalized that companies are almost able to do whatever they want. Regulators needs to set up rules ensuring that banks will have enough reserves to cover themselves in such situations, they need to somehow deter banks from taking on too much risks.
As for the issue of compensation and the bonuses that got paid out; I am still of the opinion that salary is dictated by the supply and demand. So the market will ultimately correct itself if current salaries are too high.
As for the issue of bonuses; I still believe bonuses should remain. In order to grow we need individuals to be innovative and think outside the square. However financial companies need to try and eliminate the 'every man for himself mentality' and have employees concerned for the companies long term well being and not just their own gains.
To achieve this employees would need to shoulder the risks of the decisions that they make. Whether it is issuing long term stock of the company as a substitute for cash payments.
This is certainly a complex issue but if companies are somehow able to create an environment that promotes long term growth and stability, the economy will go a long way in avoiding another major financial crisis.
And during the boom periods like the recent housing boom, issuing sub prime mortgage bonds and lending to everyone and anyone is a good strategy because so long as house prices were high any mortgage defaults would be absorbed by the resale/remortgaging of property at a premium. However when the housing market crashed banks had no where to turn (apart from government) to cover the loss.
Financial industry assess performance by looking at the companies immediate result. In order to have investors happy they must ensure their respective companies are performing.
And I blame the characteristics of the financial system as the primary cause of the mess that we are in right now. Regulators had made the financial system become so liberalized that companies are almost able to do whatever they want. Regulators needs to set up rules ensuring that banks will have enough reserves to cover themselves in such situations, they need to somehow deter banks from taking on too much risks.
As for the issue of compensation and the bonuses that got paid out; I am still of the opinion that salary is dictated by the supply and demand. So the market will ultimately correct itself if current salaries are too high.
As for the issue of bonuses; I still believe bonuses should remain. In order to grow we need individuals to be innovative and think outside the square. However financial companies need to try and eliminate the 'every man for himself mentality' and have employees concerned for the companies long term well being and not just their own gains.
To achieve this employees would need to shoulder the risks of the decisions that they make. Whether it is issuing long term stock of the company as a substitute for cash payments.
This is certainly a complex issue but if companies are somehow able to create an environment that promotes long term growth and stability, the economy will go a long way in avoiding another major financial crisis.
The Economic Crisis in a Nutshell
So in case my previous entries proved to be a little bit too complex to read I will summarize everything I said into a few paragraphs.
The worldwide economic crisis occurred because consumers borrowed to fund their spending. On average in the US (numbers in NZ are also quite similar) individuals spent more than 130% of their income. The spending was finance by the wealth effect; relying on house prices to finance spending. But as the housing market became oversupplied with houses, price of houses plunged, individuals were unable to sustain the lifestyle they were accustomed to and unable to pay off the debt that they have accrued.
The financial industry- this is made out of commercial banks (i.e Citigroup or ASB), investment banks (consultants i.e. Merill Lynch) and insurance companies (i.e. AIG).
So Commercial banks were the ones that provide loans to businesses and individuals. Commercial banks are at fault because they were lending money without properly assessing the borrowers ability to pay back. They are also at fault for vastly expanding their lending activities without raising any additional capital.
Investment banks were the ones which packaged these high risk bonds for commercial banks to issue. So when the housing market crashed, investment banks were still in possession of these bonds that were completely worthless causing investment banks to lose a major revenue source. Investment banks are at fault for packaging the sub-prime bonds and exposing banks to a great deal of risk.
Being aware of the possibility of these sub-prime bonds may falter, banks took out insurance. Insurance companies stay in business by diversify their risk, however in the case of insurance companies and sub-prime mortgage bonds, insurance companies wrote multiple policy covering different banks for exactly the same risk. So companies like AIG were protecting companies from systemic risk. So as the sub-prime bonds began to lose its value, banks simultaneously made claims with their insurers. The insurance companies simply did not have reserve needed to pay for all the claims.
Therefore if it wasn't of government assistance, insurers like AIG would not have been able to pay claimants like Citigroup bank and in turn Citigroup would not have been able to pay its depositors and bond holders. Deposits and bonds is a banks' promise to pay and if that promise is broken then the whole financial system becomes a total sham.
GENERAL OVERVIEW
The worldwide economic crisis occurred because consumers borrowed to fund their spending. On average in the US (numbers in NZ are also quite similar) individuals spent more than 130% of their income. The spending was finance by the wealth effect; relying on house prices to finance spending. But as the housing market became oversupplied with houses, price of houses plunged, individuals were unable to sustain the lifestyle they were accustomed to and unable to pay off the debt that they have accrued.
HOW THE FINANCIAL SYSTEM CONTRIBUTED TO CRISIS
The financial industry- this is made out of commercial banks (i.e Citigroup or ASB), investment banks (consultants i.e. Merill Lynch) and insurance companies (i.e. AIG).
So Commercial banks were the ones that provide loans to businesses and individuals. Commercial banks are at fault because they were lending money without properly assessing the borrowers ability to pay back. They are also at fault for vastly expanding their lending activities without raising any additional capital.
Investment banks were the ones which packaged these high risk bonds for commercial banks to issue. So when the housing market crashed, investment banks were still in possession of these bonds that were completely worthless causing investment banks to lose a major revenue source. Investment banks are at fault for packaging the sub-prime bonds and exposing banks to a great deal of risk.
Being aware of the possibility of these sub-prime bonds may falter, banks took out insurance. Insurance companies stay in business by diversify their risk, however in the case of insurance companies and sub-prime mortgage bonds, insurance companies wrote multiple policy covering different banks for exactly the same risk. So companies like AIG were protecting companies from systemic risk. So as the sub-prime bonds began to lose its value, banks simultaneously made claims with their insurers. The insurance companies simply did not have reserve needed to pay for all the claims.
Therefore if it wasn't of government assistance, insurers like AIG would not have been able to pay claimants like Citigroup bank and in turn Citigroup would not have been able to pay its depositors and bond holders. Deposits and bonds is a banks' promise to pay and if that promise is broken then the whole financial system becomes a total sham.
Thursday, September 24, 2009
Trust is Paramount
Most people pay their loan.
Even now during times of economic hardship it is estimated that only 7% of all borrowers are behind on their loans. So it does not make any economic sense if banks only lending out capital that is in their possessions.
Prior to 2004 the capital requirement on loans not backed by deposits were capped at 15 to 1. This meant that banks were able to lend up to $15 for every dollar in their vault. After 2004 however that cap was removed and banks were able to increase their lending without raising extra money. So a high proportion of banks were lending up to $30 for every dollar they had.
So banks attained a fair chunk of their capital through sub-prime mortgage bonds and banks were approving more and more loans without raising any more capital. By working under these parameters it did not take a high percentage of mortgage default before banks started to run short on money. So without going further into specifics that was exactly what happened to banks. If it wasn't for government bailouts, banks would have been completely broke taking the depositors money with it.
Therefore to put in a nutshell, this financial crisis threatened the public's trust in the whole banking system. Without the peace of mind that money is safe in a bank vault, people would end up storing all their savings under their bed.
The whole financial system is way too vulnerable to greed and excessive risk taking. Unless the financial system gets a drastic overhaul, the public will continue not trusting banks and stop providing the capital business needs to grow.
Without trust in banks the world will stumble back into the Dark Ages!!
Even now during times of economic hardship it is estimated that only 7% of all borrowers are behind on their loans. So it does not make any economic sense if banks only lending out capital that is in their possessions.
Prior to 2004 the capital requirement on loans not backed by deposits were capped at 15 to 1. This meant that banks were able to lend up to $15 for every dollar in their vault. After 2004 however that cap was removed and banks were able to increase their lending without raising extra money. So a high proportion of banks were lending up to $30 for every dollar they had.
So banks attained a fair chunk of their capital through sub-prime mortgage bonds and banks were approving more and more loans without raising any more capital. By working under these parameters it did not take a high percentage of mortgage default before banks started to run short on money. So without going further into specifics that was exactly what happened to banks. If it wasn't for government bailouts, banks would have been completely broke taking the depositors money with it.
Therefore to put in a nutshell, this financial crisis threatened the public's trust in the whole banking system. Without the peace of mind that money is safe in a bank vault, people would end up storing all their savings under their bed.
The whole financial system is way too vulnerable to greed and excessive risk taking. Unless the financial system gets a drastic overhaul, the public will continue not trusting banks and stop providing the capital business needs to grow.
Without trust in banks the world will stumble back into the Dark Ages!!
Tuesday, September 22, 2009
Subprime Mortgage/Toxic Assets/Junk Bonds
These terms are bandied about on the news all the time, but do you know what these terms really mean?
If not allow me to quickly enlighten you of what they are;
As mentioned on my previous entry commercial banks needed to find alternative ways of raising capital in order to be able to keep up with other banks and offer competitive lending rates.
One way of generating money, banks used the performances of existing mortgages and packaged it as bonds for people to invest in.
Prior to the financial crisis, the housing market was experiencing a boom with record house prices. And as a result Sub-prime bonds were extremely popular for investors. Sub-prime bonds contained a pool of mortgages that were considered 'High Risk'. By high risk it means that the bond consist of a portfolio of mortgages where there is a high chance of the mortgage defaulting.
If not allow me to quickly enlighten you of what they are;
As mentioned on my previous entry commercial banks needed to find alternative ways of raising capital in order to be able to keep up with other banks and offer competitive lending rates.
One way of generating money, banks used the performances of existing mortgages and packaged it as bonds for people to invest in.
Prior to the financial crisis, the housing market was experiencing a boom with record house prices. And as a result Sub-prime bonds were extremely popular for investors. Sub-prime bonds contained a pool of mortgages that were considered 'High Risk'. By high risk it means that the bond consist of a portfolio of mortgages where there is a high chance of the mortgage defaulting.
The high risk of failure is counterbalanced by the high interest rate offered by banks. As house prices continues to rise, high risk Mortgage bonds is an acceptable risk for investors to take. For example if one mortgage defaults, the high price banks will receive from the resale of the house will offset the costs of loan defaults
So as the US housing market boomed these bonds became extremely popular with investors and banks continued issuing these bonds to investors and used their money to finance more loans. Thanks to High Risk Mortgage Bonds, the finance industry made an absolute killing!
Mortgage bonds are made up of thousands of home loan, so even if there are a significant batch of dodgy loans, the value of these bonds should be protected through diversity. As banks continued to prosper, people in the financial industry became increasingly cavalier in the way they package their Mortgage Bonds. To make these bonds even more attractive, bankers offered even more generous interest rates by packaging bonds consisting only of mortgages with poor credit rating. And then to achieve profitability banks seemingly gave out loans like as if they were going out of fashion. Therefore on many occasions banks gave out loans to people that had no means of paying back the loan.
Again taking such high risk is sustainable when property prices are high. However when there is a price boom, there is bound to be a price bust. With an oversupply of houses in the market, housing prices started to fall. So without high house prices, when loans go bad the value of mortgage bonds will fall.
An increasingly frequent sight in the United States
An increasingly frequent sight in the United States
So in a nutshell, the economy is in this mess because when people started defaulting on their loans these sub-prime bonds essentially became worthless or TOXIC. And since sub-prime bonds represented billions of dollar of a banks capital, the banks capital stock essentially got wiped out.
And since every bank in the US acted the same as one another, before any government bailouts were given out, all banks were essentially skint for cash. This in turn freezes the credit market halting economic growth but more importantly it threatens the public's trust in banks.
And since every bank in the US acted the same as one another, before any government bailouts were given out, all banks were essentially skint for cash. This in turn freezes the credit market halting economic growth but more importantly it threatens the public's trust in banks.
Friday, September 18, 2009
How did we get into this pickle?
If you want a good yarn on why the banks are in such a dire state I would recommend you to click on this Time article 'Why your Bank is Broke'But if you want a brief-ish overview please read on
First off, to try and illustrate how corporate salary is not the leading cause of the economic crisis we must have some understand of how this current recession came about.
To understand the cause of the recession, we need to understand a little about the banks and the financial climate it operates.
The everyday bank has two basic functions; deposits and loans. Banks will take in deposit in which they would pay the depositor an interest, lets say of 3%. So far banks to make a profit they would use that money and lend it to someone else for a higher interest rate.
Banks used only use bank deposit to back up all the loans they gave out. Today banks operate in a very competitive financial market. Prior to the economic downturn banks would continuously try to outdo each other by offering borrowers very competitive rates. So in order to remain competitive, banks needed to continue offering borrowers cheap capital and it needed to find an alternative to bank deposits as a means of raising money to loan out.
Banks were able to raise additional capital by backing loans with their previous earnings and by issuing bonds to investors. And its these bonds that are the primary cause of most of the problems the economy faces today.
Thursday, September 17, 2009
Don't Blame the Player, Blame the Game!!
People working in the financial sector play a crucial role in the economy; our financial well-being is hinged on their actions. Investment Bankers and Commercial Bankers provide capital necessary for the economy to grow. Without capital businesses would not be able to provide jobs, create new technology and improve the quality of life.
We should acknowledge the vital role in which people working in finance play and that they would need to be compensated accordingly.
There is no arguing that the greed of many financial workers contributed to this economic crisis, however as the heading says “Don’t Blame the Player, Blame the Game!!’.
In my upcoming entries I will illustrate how the financial institutions’ emphasizes on short-term success and the inactivity of financial regulators to curb Wall Street’s risk-taking was the real contributors to the financial mess that we are in.
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