From the NZ Herald 18th September 2008
It is an age old question. As budding economists we all ask it of our parents some time around the age of 7 or 8. Why don’t they just print some more money?
We are quickly told why that doesn’t work. Money is worthless unless backed by something of real value.
Unfortunately this childhood lesson is one that Wall Street seems to forget every few years.
Somehow the intensity of greed at the height of a market bubble is such that traders catch a kind of collective amnesia.
Market bubbles are always bad news. People lose a lot of money when they burst. But when it is a bubble based around the internet stocks or even commodity futures like oil and gold the fallout is limited to distinct segments of the global economy.
They can be sectioned off and dosed with some fresh government regulation and a securities commission enquiry or two.
When the product which is the focus of the speculative bubble is cash itself – as it is in this case – then the problem is far more serious.
Ironically it is the fallout from the collapse of the tech sector at the start of the decade that contained the seeds of the current meltdown.
As a response to the dot.com bust – and the additional panic caused by the World Trade Centre attacks of 2001 – the US and other central banks around the world slashed interest rates.
The aim was to give the wobbly economy a boost.
But as time wore on the cost of borrowing cash remained low. A global property boom created demand which was happily met by all manner of lenders.
As one astute commentator put it – they started lending to people like the characters from the TV show My Name is Earl.
At that point they were always headed for trouble.
Private Equity companies also thrived on cheap debt. Leveraging a deal to the hilt became a badge of honour. The aim was to buy underperforming companies using someone else’s money fix them up and sell them for a massive profit. The returns on a leveraged deal are exponentially greater than a deal done with the actual pile of cash available to the investor. But so are the risks.
As debt was increasingly transferred and sold around financial institutions it became a commodity.
Then some smart cookie investment bankers took it a step further.
They packaged up a parcels of debt that were supposed to have a fixed rate of return and traded them as products in their own right.
Because these were new, they were unregulated. And despite the risks everyone and their grandmother’s dog got in on them – including banks like ANZ in New Zealand who sold them to unsuspecting mum and dad investors as sensible investment products.
Then the property boom ended. In the US property prices tanked and suddenly the sub-prime lenders realised their debts weren’t worth anywhere near as much as they thought they were. The My Name is Earl people began to default on the loans.
The sub-prime lenders ran out of money fast and went broke.
That might have been the end of it were it not for the fact that the more reputable banks had been buying and on-selling sub-prime debt products.
Suddenly Wall Street and a number of European banks were caught in a vicious cycle. The debt products were so complicated no one knew how to value them. They were no longer tied directly to real assets. Or if they were those assets were worth far less than the debt.
Banks began facing up to that reality by writing down the value of the debt products they owned. In other words they admitted these products weren’t worth what they thought.
Billions disappeared from their balance sheets. Every time one bank wrote down the value it affected the value for other banks.
Suddenly the investment banks that were in trouble because of the amount of worthless debt product they owned started running out of cash. They had been spending more than they had – because they thought they had a lot more than it turned out they really did.
Banks like Bear Stearns and Lehman Bros needed to borrow more just to survive.
But as the crisis grew those who still had cash to lend became risk averse. The cost of borrowing sky rocketed.
As Lehman found out at the weekend there was no one left to come to the rescue.
In the space of just over a year Wall St’s mood has switched from one of wild reckless abandon to one of miserly paranoia.
In a healthy system confidence and reasonably priced credit is vital to keep business humming.
Business needs credit to grow, to develop new and exciting products which in turn boost economic output and create jobs and wealth for ordinary people.
Luckily in this part of the world the Asian and Australian banks haven’t completely gone into their shells.
In fact they are still feeling bold enough to cut rates – albeit marginally.
We can watch events in the US with a certain amount of detachment, knowing we are still one step removed from the worst of it.
Our markets are down but most of our companies remain in good shape. Now is not the time to panic. But then, even if things do get worse, there is never any point in panicking.