Tuesday, November 25, 2008

Economic Crisis 2008 - Explained

Feel free to correct me where I am wrong, but here is my understanding of the complex contributors to our current economic crisis. Clearly, no single person or group is to blame. It is the culmination of poor accounting practices and unsound policies in several markets working together. Do not think for a minute that it is somehow not the "1929 Stock Market Collapse" for our time.

The fundamental unit for the current crisis is the housing market. The housing bubble allowed homes to be purchased for much more than their "real" value. The money that was lent on these homes was indisputably provided by the lenders and received by the seller. Where this money was spent is entirely at the discretion of those that received it, even if they are greedy capitalists. Unfortunately, much of this money was invested back into the overpriced and overstocked real estate market.

The multiplier for the crisis is the financial instrument called the Credit Default Swap. Let's make a comparison using common, household situations like Life Insurance. When Skip is raising his children, he takes out a Life Insurance policy for $1 Million. This is important because his children are directly benefiting from his salary, leadership, and housework. This is covered by the insurance company because they are investing his payments into the markets for returns that will cover their outstanding policies.

The first risk they take is when they start wagering that Skip is healthy enough that he will live until the policy has expired (if Term Life) or is fully funded by Skip (if Whole Life). The benefit of this wager is to lower premiums and thereby bring in additional business. By itself, this risk is usually well-calculated, but still can result in the failure of an insurance company. As a simple example, a large group of healthy wage-earners could suddenly be impacted by a natural disaster, bankrupting the insurance company. The remedy for this is to insure people across various geographical locations.

The second risk is when the insurance company decides it can continue to sell life insurance to Skip's children when they start earning their own money. There is no longer a need for Skip's income and help. There is merely a desire for payout on Skip's death. Originally it was accepted in order to cover the costs of burial or cremation. But, it has grown to where it is wholly discretionary. In our example, Skip's 3 children each take out a $1M policy on Skip. Now the Insurance company has grown, due to the ability to offer more payouts. If we only look at the boom to the industry, without acknowledging the increased risk then we increase the likelihood of unforeseen, and thereby catastrophic, failure. Let's assume now that we have one-fourth of the people affected by the aforementioned natural disaster. The payout is the same as before, if there are now 4 policies on each person. We have increased our risk by 4, but not increased our premiums to accommodate that risk. More likely, we have decreased the premiums further because we have increased our income by doing so.

The third risk adds another multiplier. Investors, watching the growth in the insurance company, decide to invest directly into the company. Bear in mind that insurance companies rely on the markets to store and grow their income. Premiums paid by the policy holder are minor compared to the income earned through investments. These premiums are critical, mostly as an indicator of the health of the company. Now the investment company makes money when the insurance company makes money. The only risk to the system is the death of a lot of healthy people, like Skip. But, we have spread that risk across geographies and income levels.

Now we see what really happened. Instead of insuring Skip against death, we are insuring Skip's mortgage against foreclosure. When the housing bubble burst, many homes were lost. More importantly, the rating of the lenders and insurance companies were reduced. Once this happened, their ability to invest and be invested in was reduced. With a reduced income stream, some of these companies failed or were in danger of failing. The investment companies that had invested in these companies now had to be downgraded also.

Remember Skip's children in the original example? They are still there. Multiple policies were issued against the mortgage companies ability to pay. When one group started to have trouble, it rippled across many others. There was no oversight or regulation on the insuring of loans, investments, and the companies that engaged in it. Until we hit this crisis, it was unclear how extensive this practice was or the impact it could have. In addition, it is far removed from most people so it was not a priority when some people called attention to it.

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