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Economics is an intertwined discipline. It is the study of the decisions we make when faced with scarcity. It is something we all engrossed in right to the slightest detail of our lives and encounter with almost every time we have to decide. Our decisions have a profound effect on our surroundings and if combined with a group of individuals have some serious ripples that tend to last generations. One small change in our eating habits and the future generations either encounter a lifestyle downfall or an uplift from a major disease. Change in our spending habits and the future generations either reward us for our astuteness or reprimand us for us foolishness. But one thing is for certain, the economy is connected almost like a giant spiderweb and every decision made has lasting repercussions that are manifested across a larger time scale.
We look back to 2008, where quality of life has been degraded to such an extent that confidence among the people is at its lowest. The money printer is at its full swing and extra stimulus is being injected to save big banks. Well, we have arrived at this stage after many seeds are sown across a larger time frame. These decisions and actions taken by the government, the people and large financial institutions ultimately lead to the largest banking crises the world has ever seen. 2008 is remembered in books as a time of pain and its repercussions are bound to last generations, the effects of which we are saying today as well. Ill investments, decreased financial literacy and a backward shift in progress along with lack of opportunities are just to name a few. How has all of this started and are we suffering an extension of it?
Maybe we greased it too much…
It all boils down to the shift in economic outlooks of humans when looking at the world around us. We as a civilization have shifted economic decisions from the efficient market and natural forces of supply and demand to some suited individuals sitting in a room and heavily influenced by a political mandate. Instead of material prosperity, value is ascribed to be abstract obtained through the arbitrary decisions of people. The market is a voting machine in the short term and a weighing machine in the long term where only those end up having intrinsic value who stand the test of time and provide tangible value. Instead of letting the market decide and allocate resources, centralized powers have found it in their interest to the big daddy.
A snowball never caused any harm, it is the avalanche that is devastating. 2008, the year we remember to be miserable, shocking and disappointing started with good intentions. The 2000 internet craze, corporate accounting scandals like Enron and terrorist fears across America has led to decreased in confidence in the economy and activity has reduced to a large extent. The stock market crash of the 2000s has left people scrambling for cash and everyone feels a degraded quality of life. This is where the first seed is sown. The federal reserve lowered interest rates from 6.5% in May 2000 to 1% in June 2003 effectively making borrowing easy.
Now, when you open the pot, whose not going to come rushing in for their food? Especially when it’s free. Borrowing is made so cheap that subprime borrowers have their taste of the pie like no other. It escalates to such an extent that requirements for a loan aren’t even considered and everyone is handed over their free stimulus. When free money comes, people look for areas to put it in to make more, the greedy mindset. Real estate has proven to be a time tested asset so people flock towards it in large number thereby slowly inflating a bubble.
A financial instrument sees its popularity soar
When the loan business starts booming everyone was in it like crazy. People with a low credit score and no serious proof of income are loading in on debt called subprime borrowers. Banks are also keen to facilitate these people by providing a wide variety of instruments. In addition, the SEC has eased its oversight on large banks including Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley, the institutions whom everyone trusts. The investment product Collateralized Debt Obligation (CDOs) gains popularity because of their ability to bundle up all the debt that has been rampant in the economy, in the form of securities able to traded in the market.
It turns out that a black box within a black box such the Mortgage backed securities(MBS) into a Collateralized debt Obligation(CDO) which is supposedly secured by a Credit Default Swap (CDS) displaying such interconnectedness that large banks owe each other large amounts of money and if something bad happens, all of them point fingers at each other. The housing market just has to keep rising to sustain the large amount of debt piled up and what’s worse that this has extended globally.
The final pop
Money made easily is, obviously, lost easily as well. The market has a unique way of refreshing itself. No one is expecting something and boom, the market flushes out all the fallacies. It is the regression to mean value that every asset must face when trading in free markets. It can be manipulated multiple times by some centralizing force as is in the case of 2008 financial crises but in the end, it doesn’t even matter.
There are shrewd investors in the economy and when they see signs of distress, no matter how trustworthy the asset class is, they withdraw at high time. The CDSs have also been proven to fail in the long run. Banks know that and they play accordingly. It is the lower class players and the institutions having short sightedness who suffer the most. This has been seen quite clearly in the crises.
When there are many buyers in the market and finally everyone has had his piece of the pie, the market becomes saturated, the same we see in Q4 of 2004 reaching to 69.2%. That is heck of a number and with fewer sellers, the tide abruptly shifts. In addition, the increased inflation that the low interest rates have been causing leads the FED into turning the dial to the other side. The result of such an equation, falling home prices and panic to sell your home. Well, what about all the loans that are in people’s hands. The lenders must be coming for them. The subprime borrowers were in the most bleak positions as they take debt that has not been worth taking in the first place, something they cannot afford.
Finally, lenders start filing for bankruptcy, people are unable to pay back loans to them and the government injects money to save large corporations from failing. The contagion spreads beyond borders with the Swiss Bank the first to announce a hefty loss of $3.4 billion primarily because of its subprime lending practices.
This is a gigantic bill for the FED and Wall Street as the market is unable to handle all these bankruptcy. First it is Bear Stearns filing for bankruptcy in March 2008 then to be acquired by JPMorgan Chase for a huge discount. Then it is the one and only Lehman Brothers filing for bankruptcy in September 2008 thereby marking the largest collapse in US history. Obviously it has been owning toxic assets and confidence has been completely eroded. The government has to step in. A total of $1.48 trillion is arranged to buy up these toxic assets and plug the hole of an ever increasing bloodshed of redemptions.
Now that our lens in rectified, let’s look at 2022-23
So, when has the first seed been sown for this seemingly recessionary period. Well, come to think of it the 2008 crises has been like a grip reaper finding the best opportunity to capture the souls of bad banks who dare to even step into the abyss of irresponsibility. The inflow of liquidity by the government has made the dollar prone to dominance risk and confidence has eroded to some extent from the global lens. And then there’s another thorn in the hand, inflation: the stringent bug not leaving.
It starts with a crises i.e. COVID 19 which everyone knows nothing about and starts panicking. A flu with such a less morality rate can shake the world from the ground up, who knows? But all the conspiracies aside, it has been a medical emergency and the people suffering have been hit hard. But stimulating the economy is such an unprepared way is where all the incompetence lies. Stimulus checks have been distributed, the national debt climbs greatly and everyone is in a false sense of optimism that their financial life is secured. Interest rates have been lowered and the economy is stimulated.
In such a free money era, people again look for investments to double their money and seek greater returns. This is when the “get-rich-quick” ideology gains popularity. Influencers boasting how meme stocks can make them rich and how the pandemic can be your way to earn billions. Stocks like Gamestop and Robinhood get undeserved attention spiking their valuations up the roof. The crypto sector also gets its wings installed and aims for the moon only to realize a devastating downhill after bitcoin hits $69,000. Ill investments have been on the rise and any company claiming to develop some revolutionary tech is found on the headlines. To reiterate, look at Cathie Wood’s ARK Innovation ETF, the losses it has faced the previous year. All promise and hype but much less action. Now I am not saying the companies are not working but valuing them at what they were valued during the pandemic is just completely illogical. So, to some a buying bonanza has started in such an increased liquidity environment.
A parasitic economy is defined as the one bubbling upward without replenishing the source. It defies all ecological principles. This happens in a society where money does not represent the natural standard. Monetary base is increased keeping an arbitrary, man-made metric in mind without considering all the possible consequences. The measure looks good but it does nothing to increase productivity or the well-being of a society.
Obviously, the economy has to regress to the mean and that is quite imminent when the FED has decided to jack up interest rate in the hope to curb inflation and has maintained that stance still. The first rate hike has been in March of 2021 where people start to realize that borrowing will be expensive now. The economic activity starts to decline and people realize that the assets they invest in when cheap capital is present are not worth it. Some of the shrewd sell, some pump. Eventually, the price declines. People see that, more selling, price declines more. Hence a downward spiral comes into play. The people who suffer most are the ones who have loans piling on them with the collateral diminishing in value and time to service that debt in near.
Then the banks come in. This time we have seen the collapse of Silicon Valley Bank, Signature Bank and Silvergate. These banks were providing financial services to companies and projects that have been budding i.e. their potential is not yet recognized and they are slowly developing onto a dream. Okay, that is fair but why pump their valuations to the roof. Well, that is where the market is irrational. This is obviously fueled by the policies that have been enacted by the government most notably Glass-Steagall Act in 1999 loosening lending practices and the Dodd-Frank Act in 2008 which has been broken free from its tighter provisions after its “modernization” in 2018. So a stage is set to do the unthinkable, and banks do it first!
The collapse of SVB has been marked as the largest collapse after Seattle’s Washington Mutual in 2008 which technically has been a savings and loan institution, not the holder of depositor’s funds. But, anything breaks in the financial system, it boils down to these institutions. Companies that have been trusting the bank are mostly startups and have more than the FDIC insured limit and thus face a tight situation where company finances come to halt. What SVB has done seriously wrong is not manage its risk and insure deposits. It sees large inflow of capital in the easy money environment and decides to buy longer term treasury bonds. The FED raises rates, the bonds fall in price. The depositors see the asset declining in the bank and rush to get their money. So much money is withdrawn at the same tie that the bank has to sell the bonds at a loss. More panic, more selling and a spiral, voila!
The FED has introduced three packages to inject liquidity in the system. The first it the tradition Discount Window (DW) which is $148 billion in liquidity. The second is BTF providing $12 billion in liquidity and the third is $143 billion given to SVB and Signature bank as part of their acquisition by the FDIC. All of these loans differ in the borrowers, collateral content, terms of the loan, valuation of collateral, interest rates and disclosure details.
Most people perceive this as QE ignition by the FED. Let’s dissect that thought
For Central Banks, their top priority is monetary policy and financial stability. The former is done through interest rate and balance sheet control while the latter includes temporary liquidity tools. The BoE has done the latter to save the local pension funds under the Truss era. When the FED does QE, it actively buys assets from the market and increases the reserves. In this case, however, the FED is passively injecting the reserves in a situation where commercial banks are borrowing from the Central Bank, loans that are collateral backed. The Discount Window has also been used in the 2008 crises but it is important to remember that it has been just a small chunk of the $1.7 Trln injected in the economy then. It has not been the main tool then but it is now and obviously it has to be large to curb the losses.
So, will the FED start lowering interest rates seeing the banks collapse and retort to QE? Then a recession will follow like 2008. Well, there are some logical explanations to why that is unlikely.
Not 2008…?
First of all, it is important to note that liquidity has not dried up in the financial system. There’s tons of that present. It has only dried up in the sectors that are advertised so highly that every common man knows about them. In 2008, the saturation is 69.2% leading to wide collapse. Investments in startups, crypto and tech don’t even come close to that. This is a sector-limited disaster marked by faults of management by a single entity for which it is rightfully punished. In additions allegation for them being involved in money laundering and crime have also been surfaced. I will recommend listening to Marc Cohodes, a straightforward and staunch person, on his Blockworks interview. The large organizations and politicians have also affirmed many times that crypto does not pose a large systemic risk, yet. That is believable, right?
The events that this time period have shown do rhyme with 2008 with the series by which the events are taking place. From a disaster, to injecting liquidity, to then tightening, collapse of institutions and then a recession. Well, the FED is not loosening, yet. The liquidity problems faced are limited to banks and do not include primary dealers like money market funds, corporate financing departments, asset-backed securities and non-US financial institutions like they have been in 2008. This time only the institutions that are regulated or supposed o be regulated by the FED get caught. The FED has a tighter hand.
What now?
One thing is for certain, inflation is still a menace and must be eradicated at all costs. The financial stability tools will show effect and will prevent the FED sing interest rates to to maintain financial stability. That is difficult path. For the short term, things will improve. But the atrocities of the current financial system and its underlying principles are coming forth in the public’s notice.
The present financial system is based on greed. Not a tradition banking model where the banks are responsible for safeguarding your deposits. That concept is long gone. Now banks chase profits, the CEO makes billions and the shareholders are happy by the ticker. The rich quick narrative is upheld whereas inflation which is the real problem is often overlooked.
Genuine money extends the natural standard in an ecologically valid manner It has a check and balance, the natural forces that act as the arbiter and every person is health accountable to the real wealth being produced, not printing new bills with the press of a button.
A good game is bound by rules where principles enable activity. Those rules are natural and must be respected.
Hope you enjoyed reading this long one. Good things take time.