1 Year After The Demise Of Lehman

One year ago on the 15th of September 2008 Brothers filed for bankruptcy. Reuters has created a great multimedia recap of the financial crisis 1 year after the collapse of Lehman Brothers.

Read more here

Same Old Hope: This Bubble Is Different

This time is different.

That’s what people argue every time a bubble inflates, and what they think every time they lose money when it pops. But year after year, decade after decade, century after century the process repeats all over again.

Not long ago, the housing bubble burst and brought the global economy to a standstill. Now investors, recognizing that bubbles tend to come in bunches, are on the lookout for the next market to fizzle. Possible candidates are the capital markets in China, commodities like gold and oil, and government bonds in heavily indebted countries like the United States.

Bubbles are episodes of collective human madness — euphoria over investments whose skyrocketing values are unsustainable. They tend to arise from perceptions of pending shortages (as happened last year, with the oil bubble); from glamorized new technologies or investment frontiers (like the dot-com bubble of the 1990s, the multiple railroad bubbles of the 19th century); or from faddish cultural obsessions (like the Dutch tulip bubble of the 17th century).

Often they are based on legitimate expectations of high growth that are “extrapolated into the stratosphere”. Such is the fear over investment in emerging markets like China. “I am a long-term bull on Asia, but right now it’s premature to be celebrating the ‘Asian Century,’ like some investors seem to be doing,” said Stephen Roach, chairman of Morgan Stanley Asia.

But a sovereign debt bubble — which many argue is driving the acceleration in gold prices — could prove far more dangerous. So many countries, like the United States, are running up such large national debts as a percentage of their overall economies that they could risk eventual default. Even without outright default on their obligations, the value of government bonds sold to finance these deficits could plunge, costing investors a lot. Debt crises are usually associated with developing countries, like Brazil, Argentina or Zimbabwe. But they can affect big, rich economies too, where the scale of global damage can be much greater.

The depth and breadth of the pain unleashed by the recent housing bust have led political leaders and central bankers to reconsider their duties to preempt, rather than just respond to, potential bubbles, and the same is true with the potential bubbles that economists foresee today. China has started to tighten monetary policy to rein in the hype surrounding its equities. Politicians in the United States, while torn over the means, are discussing ways to bring the deficit until control. The G20, at its coming meeting in Pittsburgh, is expected to address ways to calm financial frenzies. The solution may involve additional regulation, guidelines for financial compensation and possibly requirements for more market transparency so that, at least in theory, investors can better judge what they are taking on.

But however stringent such new regulations may be, economists say, they cannot completely defeat human nature. Investors will continue to be hypnotized by get-rich-quick deals, seeking investments that magically double, triple even quadruple without toil or trouble.

Ultimately, bubbles are a human phenomenon. Sometimes, people just get a little crazy.

PS: This is a summary of an article from the New York Times. View the original here (Registration required)

How Credit Default Swaps Became a Timebomb

A Credit Default Swap is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity."

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.

Such exotic financial products are extremely profitable in times of easy credit, but when markets reverse, as has been the case since August 2007, they amplify risk considerably.

Read about the role Of Credit Default Swaps (CDS's) in the Financial Crisis in a great 3 part article
Link to Part 1

Link to Part 2
Link to Part 3

US T-Bills Giving Zero Return

On 9^th December 2008 the US Government sold $30 billion in four-week Treasury bills at zero percent. In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager to park money in the world’s safest investment, United States Government debt, that they agreed to accept a zero percent rate of return. Investors shaken by the losses in the markets are pouring cash into government bonds from every corner of the globe.

Why is this significant? I will get to that but first some key facts:

• A T-Bill or a Treasury Bill is a short-term debt obligation backed by the U.S. government with a maturity of less than one year.

• T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year)

• Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. US Government Treasury bills are regarded as the least risky investment in the world.

The formula for the calculation of the yield on T-Bills is:

Significance Of T-Bill Yields

In itself the zero percent interest rate is no reason to panic. This is good news for American taxpayers in general. Low interest rates on government debt allows the United States to finance its $700 billion bailout of the financial system very cheaply. But it also underlines stubborn anxiety in the financial markets that could keep world economies sluggish for years to come. This extremely cautious approach reflects concerns that a global recession could deepen next year, and continue to jeopardize all types of investments.

High demand for government debt rather than corporate debt could stifle economic growth. Even though Central Banks all over the world have reduced interest rates, borrowing costs for companies remain stubbornly high. Corporate bond rates have been surging to record levels which makes it more expensive for companies to raise money. And when companies can't raise money, they often have to cut costs, sometimes through layoffs.

The worry is that the government will become the most attractive lender and borrower in the market — crowding out others in the private sector.

PS: Daily Treasury Yield Rates are available at the following website:

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

The Collapse Of Iceland

Iceland is on the brink of collapse. Overnight, people lost their savings. Prices are soaring. Once-crowded restaurants are almost empty. Banks are rationing foreign currency, and companies are finding it dauntingly difficult to do business abroad. Inflation is at 16 percent and rising. People have stopped traveling overseas. The local currency, the krona, was 65 to the dollar a year ago; now it is 130. Companies are slashing salaries, reducing workers’ hours and, in some instances, embarking on mass layoffs. The country's banks are practically insolvent and the government has been forced to assume their liabilities. The are reports of people were buying up supplies of olive oil and pasta because supermarkets don't have the foreign currency needed to import more foodstuffs.

Just a year back Iceland’s economy seemed white-hot. It had the fourth-highest gross domestic product per-capita in the world. A 2007 United Nations report measuring life expectancy, real per-capita income and educational levels identified Iceland as the world’s best country in which to live. So, how did this happen? Can an economy crumble overnight? What went wrong in Iceland?

Iceland is an unlikely player on the global financial stage. Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Most of the banking system’s assets and liabilities were denominated in foreign currencies like the Euro, the Dollar etc. Money was cheap, so banks, companies borrowed freely. So far so good, but what triggered the collapse? The answer - Lehman Brothers.

Lehman Brothers collapse and the subsequent bankruptcy meant that many money-market funds (funds that invest in short term commercial bonds) who had invested in Lehman's bonds lost money. This led to a loss of trust in the money markets and the interbank market froze. Iceland's Glitnir Bank was among the first casualties. Like fellow Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent, but when foreign short-run credit lines closed, Glitnir had to request a short-term loan from the Central Bank of Iceland, which refused. The government forcibly nationalized the bank. This triggered a sovereign debt downgrade and a sharp further fall in the already depreciated krona. Short-run funding for Glitnir and Landsbanki evaporated. Iceland's currency markets shut down and the krona's value collapsed. The Central Bank tried to peg the value of the krona, but the attempt failed and the peg was abandoned in just a day.

The whole system was basically a house of cards, since long-term loans were being funded by short-term borrowings. When Iceland's lenders refused to roll-over the money they had lent, the banking system collapsed. Iceland built its extraordinary wealth on the crest of the worldwide credit boom and now the crunch is sweeping it away.

Worry About The Credit Crisis

What is the most important part of a house? Is it the garden, the living room? Maybe it's the kitchen. Actually, it is the electrical wiring and the plumbing - the bits you cannot see. So it is with financial markets. The stockmarkets are the most visible part of the system. The money markets, however, are the plumbing of the system. Normally, they function efficiently, allowing investment institutions, companies and banks to lend and borrow trillions of dollars. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty mess.

First, the problem. It is widely assumed that central banks (The Reserve Bank of India, for example) set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). Normally, these are only a fraction of a percentage point above the official interest rates.

In the last few months the spread between the Libor and the Fed Funds Rate has widened to almost 200 bps(basis points). The width of the margin reflects investors’ worries about the strength of the banks. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman.

Why do these markets matter? First, the rates on loans paid by many consumers (floating rate home-loans, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would worsen.

Deprive a person of oxygen and he will turn blue, collapse and eventually die. Deprive economies of credit and a similar process kicks in. So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.