'The important aspect to crises, however, is that they clear out the economic and financial deadwood. During a financial crisis those firms with poor strategy and non-viable business models are exposed. Many fail.'

'The bottom line is that people who make poor investments or have poor business strategies should lose their money.'

Yes & Yes

Q. Why have the central banks allowed it to happen? After all, they are supposed to be the experts?

Q. Why are they bailing out the companies that failed as per the above? Surely it is better to get rid of the deadwood.

The questions that inevitably crush my own thinking on these issues are very childish. Unfortunately my brain won't allow me to go any further until they are answered.

"The OECD has claimed the sub-prime crisis will eventually cost between US$350 billion to US$420 billion while the IMF estimate the eventual cost to be almost US$1 trillion."

Where have these billions gone?

Who had them, but has them no longer?

Who has them now?

What happened to cause them to move from one to the other?

Is there anybody out there who can explain this in terms that a twelve-year-old can understand?

DialecticBlue

Two good questions!

04 April 2008 -
IMF stated that Aus property is 25 percent overvalued.
(see link to article ‘Risk of Local Property Correction High’):

http://www.news.com.au/business/story/0,23636,23482668-31037,00.html

21 April 2008 -
RBA bought A$780 million of mortgage-backed bonds in its biggest purchase of this type of debt to ‘support the nation's dormant home-loan securities market’ (see link from an article by L Cochrane & S Raja, Bloomberg):

http://www.bloomberg.com/apps/news?pid=20601081&sid=aegfyWnNxJyE

In the article it was stated RBA is attempting ‘to kick-start the mortgage-backed securities market’.

RBA now has bought a total ‘$2.35 billion of Australian mortgage-backed bonds in lending agreements.’

RBA chief Glen Stevens said (Apr 15) during times of unusual market duress, central banks should be prepared to move beyond the normal scope of operations to provide liquidity against a broad range of assets.

According to Stevens, Fed Reserve & European Central Bank officials said this month that the recent credit crunch is still unfolding and that banks have been urged to speed disclosure of losses and improve the way they value assets.

So, let me see if I understand.

04/04/08 - Property prices in Aus are deemed 25% overvalued by IMF

15/04/08 - The banks ‘have been urged to speed disclosure of losses and improve the way they value assets’.
In layman's terms - "the BANKS are DODGY"

21/04/08 – RBA buys a new record amount of Mortgage–Backed Bonds

Sooo. The banks are shy to lend to one another. Why is that?
Do they know something about the valuations of the other banks they are not telling us?

Lucky for us we have the spinner, rather, RBA in our corner.

What will be the outcome if things go pear-shaped?

Banks will also find it hard as they come off high interest [say 2010] rates to lower rates, because there will still be billions of dollars locked in at the old rates where the Banks must continue to pay the high rates. Australian banks can securitise there mortgages to more liquid overseas banks if liquity becomes a plom; i.e., sell say a $10 billion dollars of loans to another bank for $9 billion dollars. In the 1970s when liquidity was the Banks offered Commercial Certificates of Depsot at very high interest rates [18%-23%].

Banks can also be cunning with non disclosure to the RBA by leaving the principal of a large corporate loan as an ordinary loan account [not declared unproductive]and tranferring the interest only, which is declared, to an unproductive designation.

Our exposure to sub-prime is minor compared to the US. Managing maturity transformation when rates fall is more problemic for Bank profitability and the economy.

Briefly, the crisis has its immediate origins in the turn away from producing goods to gambling. Thousands of production type firms have disappeared in the US such as industrial giants like US steel. Speculation instead of producing goods led to a situation where fraud, manipulation and outright criminality have become a central feature of the process of wealth accumulation. When the share market bubble burst in 2001, some of these methods came to light with the collapse of Enron and WorldCom. It saw the emergence of the fraudulent practices associated with “teaser rates,” “liar loans” and the packaging of debts of dubious quality into exotic financial instruments. This has resulted in tens of billions of dollars being wiped off the value of mortgage-backed securities held by the banks and investment houses, which no amount of interest rate cuts or additional credit will restore; such as Merrill Lynch, Citigroup, and now the collapse of Bear Stearns. In Australia, the international credit crunch triggered by the US sub-prime crisis since last August has already produced a trail of high-profile collapses by heavily-leveraged companies, including ABC Learning Centres, Centro Properties, finance companies RAMS, Allco and MFS, and stockbrokers Opes and Lift. For a whole historic period there has been an attempt to deny the scientific analysis of Marx that the development of capitalist society is governed by objective laws which necessarily lead to a social and economic crisis, posing the need for a higher form of social organization. But those laws, hidden from view in the “normal” operation of the capitalist economy, have now come to the surface in precisely the manner described by Marx, just as the “law of gravity ... asserts itself when a house falls about our ears.” Millions of people’s lives, their welfare, their jobs, the future education of their children, are dominated by the workings of a system over which they have no control and over which no one has any control. That is, the market rationality for the individual bank or financial institution produces social irrationality and madness.

johncee1945,

Also, when non-US MNCs expatriate devalued US dollar assets, this impacts on their consolidated balances.

A very wise person once said to me, "Pericles, you can often tell how little someone really knows, by the number of tall, grey words they use to explain themselves."

People, I can read this sort of stuff in the papers every day:

mr nobody >>...during times of unusual market duress, central banks should be prepared to move beyond the normal scope of operations to provide liquidity against a broad range of assets<<

Oliver >>...Australian banks can securitise there mortgages to more liquid overseas banks if liquity becomes a plom;<<

(Actually, that one might not have quite made it to the pages of the Fin Review.)

Oliver again >>Managing maturity transformation when rates fall is more problemic for Bank profitability and the economy.<<

johncee1945 >>the packaging of debts of dubious quality into exotic financial instruments. This has resulted in tens of billions of dollars being wiped off the value of mortgage-backed securities held by the banks and investment houses, which no amount of interest rate cuts or additional credit will restore<<

I hear the words. I understand most of them individually, and also in complete sentences.

But as I understand it, for every loser in the market, there is a winner. Every seller has a buyer.

So, once again: If the OECD reckons the sub-prime crisis will eventually cost between US$350 billion to US$420 billion, where did this money go? Who had it before, and who has it now?

Anybody?

Pericles,

- Part One

Addressing your question:

- As a first approximation, let us consider a system. It is a complex system. Lots gears, wheels and springs. We might call it a [mechanical] watch. The watch is produced for $50, and, sold to a wholesaler for $70, who, in turn, sells it to a retailer for $90. The retailer sellers the watch to a consumer for $130. The consumer takes the watch home and splat! The consumer hits the watch with a hammer. The value is gone. Poof! Not transferred.

- As a second approximation, let us think of a Bank, as a system:

It needs to acquire capital to lend. Deposits are liabilities to Banks and debts assets, contingent on borrowers repaying loans. Banks must fund loans and lend at a sufficiently high margin to meet operational costs and make a profit. When interest rates fall, the Bank may still have billions of dollars in liabilities at rates higher than the lending rates [this might happen in Oz in three years?]: Remember IBDs/Term Deposits at old rates are still held. If there is a credit squeeze and banks cannot lend to each othter, the matter is worse. Perhaps, this is a future situation to be faced by Aussie banks. Point is, it is a bNING system. The value of the system is diminished, not transferred.

-Lastly:

A bit of economic history is that going back 3-5 years, the US Fed and advising economists saw the US system slipping. They had to choose between either, the US dollar or the housing market taking the brunt of the downturn. Housing was chosen at I time when exposure to sub-prime was high [25%?].

US mortgages were hit hard. Low income earners and high credit risk clients suffered under sub-prime. Loans became higher than the security [mortgages] underlying them, pressuring lenders. Banks funding liabilities [operations and deposits] becomes hard, because of the global credit squeeze and lenders’ portfolios of creditors [loans] is weak [loans not repayed], while the banks have to pay depositors. Like the above watch, the system collapsed and bank values are lost, not transferred.

I don't know the OECD data but the above gives, an idea, I hope, on how the system works and how value can be lost.

Hope I been of at least a small help :-).

Cheers.

Pericles,

This article seems to get to the nub of it:

http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article3422322.ece

THE CRISIS IN FIGURES

Number of families with a sub-prime mortgage: 7.2m

Proportion of sub-prime mortgages in default: 14.4%

Sub-prime loans outstanding: $1,300 billion

Sub-prime loans outstanding in 2003: $332 billion

Percentage increase from 2003: 292%

Proportion of loans approved without fully documented income: 43%-50%

Number of sub-prime mortgages that will have their interest rate reset this year: 1.8m

Typical rise in monthly payment (third year): 30%-50%

Sub-prime share of all new mortgages in 2006: 28%

Sub-prime share of all new mortgages in 2003: 8%

Number of homes not in foreclosure whose value will decline in 2008-9 as sub-prime foreclosures lower the prices of surrounding homes: 45m

Value of that decline: $233 billion

And on it goes.

I was aware from October 2007 who was paying for this... That was when we took our first direct hit from the sub-prime crisis in the form of lower bonuses. The employer is a bank. The rational : “we all have to share the pain”.

Then, interest rates started to go up.

It depends where your pain points are but I was up on the central coast of NSW for the weekend and I couldn’t help but notice that every second holiday house is For Sale.

As the reality of margin calls bites, those who have legeraged equity in their homes to borrow, are disposing of their non-performing assets. For those who have leveraged equity to refinance their existing mortgages, their only non-performing asset is the house they live in.

Author’s conclusion:

The bottom line is that people who make poor investments or have poor business strategies should lose their money.

I wonder if he was thinking of those dodos who could afford their mortgage living next door to the low-income, low-doc borrower who couldn’t.

Where is the money going? The currency safe-havens to start: the Japanese central bank is cleaning up. As the assets are liquefied, whatever’s left converts into cash, to take advantage of higher interest rates. All the money seems to be flowing back…to the banks.

This is one of those posts where the comments are as good as th article. The article itself is of the usual "the market is self-correcting" variety. And it uses the usual nondescript phrases like deadwood and so on.

But the reality is that the sub-prime loan criss in the US is impacting on real people with real lives. One indicator of the impact may be that the number of Americans living on food stamps has recently increased from 26 million to 28 million. This in the richest country on earth!

Another problem is that banks are afraid to lend to each other. They don't know who might go belly up. So the interbank market is drying up. This makes it very difficult for the global financial system to function adequately.

This idea of self correcting is a bit of a furphy. Bush senior stepped in to rescue savings and loans. The Fed has intervened to save Bear Sterns. Why? Because in their judgement to let these institutions go to the wall would have had far greater ramifications than the cost of rescuing them.

What happens in financial markets is important, but we need to also look at the real economy. In the US it was my understanding manufacturing output fell in the last quarter. (Correct me if I am wrong.) And it is true as Sinclair says that this is not the Depression. In fact the stock market crash in 29 was preceded by fall in the real economy, ie the financial market followed the real or productive economy.

TBC

Marx identified two trends - the business cycle or boom and bust, and the tendency of the rate of profit to fall. Both are inherent in the way capitalism is organised. Credit can for a while prolong the booms, but in doing that it can deepen the slump. And cyclically the system goes into free fall like the Depression of 1930, and 1890. (Economic historians can pick me up on his.) This is because the profit rate plummets (again because of the way capitalism is organised, this is inherent to it.) Historically profit rates in the US and Australia are much lower than in the 1960s (which partly explains all this speculative investment like hedge funds looking for higher but riskier returns. Sub-prime loans were another way of satisfying that risk taking, for a time anyway.)

Speculation may also be one of the factors behind the food crisis. As investment opportunities in debt and equity markets dry up hedge funds and other risk takers look to get high returns elsewhere. gambling on food prices is one profitable market at the moment. Profitable for hedge funds, but not for the hundreds of millions starving. That's the reality when you a system based on production for profit rather than to satisfy human need. There's enough food to go around; it's just that hundreds of millions can't afford it. We have to be clear about this. Phrases like a self correcting market in the food crisis context mean letting people starve. What an indictment.

I think there are a a coalescing of factors going on - the food crisis, the financial crisis, a possible US recession, wars a round th world - that offer us a glimpse of the reality of global capitalism. it is not pretty, nor will it be self correcting without inflicting pain on billions.

Anyway, it is too early to judge the impact of the financial crisis in the US on the global economy or even the US economy although I think it fair to say the US economy is close to recession, if not in one.