How the financial crisis affects you and me

After reading the comments on my previous post, I realized that many readers don’t seem to fully understand the broader implications of the crisis on Wall Street, and how it can affect Main Street, or the average person. We cannot afford to gloat on the collapse of the i-banks, because their loss is our loss too. We are all focusing on the arrogance of investment bankers and their lifestyles, but we don’t realize what investment bank layoffs mean for us. My previous post also did not go into any detail to explain this point. Some commenters have tried to point out this aspect, but I thought it needed to be explained in detail as a blog post.

So I asked one of the commenters, Mango Juice, to write a guest post on the subject – going by MJ’s comment on the previous post, it was obvious MJ had a lot more to say and was quite knowledgeable on the topic. So take it away, MJ !

***

MJ’s take :

I have read with interest the various comments posted on Lekhni’s piece on the turmoil at Lehman. Most writers have expressed their own perception and their own values and judgements and reflected them in the post. However, what I found glaringly missing from any of the comments was introspection and how the situation can affect your life. Maybe because they were just focusing on one aspect, i.e. the the role of the investment banker, or they don’t have a clear understanding of the implications of the last one week.

So I have a question for all the readers here – have you thought about how the situation is going to affect you, whether you are a worker in the US or a farmer in Russia ?

Here is my view on how this situation could have unraveled and affected everyone in the globe, and it might still happen. Did you realize we were staring at the abyss of a giant Depression? As the events unfolded over the week, there was a small, but very real probability that things can get out of hand, and we were staring at a calamity. Think 50% reduction in home prices, as a starter.

Think about the financial aspect of your life. We drive a car to take our kids to school, go to the shopping mall and swipe our credit cards without thinking twice about happens in the background. The loans on the card you swipe and the car you drive is securitized by the very same investment banks everybody seems to hate, and parceled as securities around the globe. These guys play an effective role of finding where excess money is, and selling these securities to people with the cash, thereby lowering the cost of financing for your credit card company or auto loan company. If such markets don’t exist, you will have to depend on your local bank who is much smaller, and whose ability to raise money is costlier, and this additional burden is passed on to who else but you. So is the case with mortgages and student loans. Every aspect of your life is touched. As the events of last week told us, even what you thought as cash in your money market account was not safe.

One of my friends was feeling very happy about having shifted all his investments to cash – or rather, money market accounts, until I asked him which money market account it was, and then alarm bells started ringing in his mind.

The implications for the average person is wide ranging –

(i) higher interest rates and reduced availability on loans;

(ii) lower rates of return on your personal investments;

(iii) reduced level of government spending as governments and municipalities are affected.

(iv) Higher unemployment as companies tighten their belt.

However, it seems to me that it is fashionable to bash the symptoms (investment banks, hedge funds making money, short selling) rather than the cause. Read this Guardian article about why hedge funds or short sellers are not the cause of the problem.

The cause is imprudent borrowing and gullible lending.

Can you imagine a world where you are a pristine borrower with a 730 or a 740 FICO with no revolving creditcard debt but yet have to pay 8% for your mortgage, 10% for your car loan, where your return on your 401-K is going to 4-5% and your bank account will give you 0% interest. You can translate the same thing to other countries by doubling your current interest rate on loans, and all this with no increase in your current pay. The cost increase to you will be due to lack of availability of funds as folks with money don’t want to lend out for the fear of non-return of Principal.

A Bloomberg story couple of days back said that the 3 month Treasury bill interest went negative. Can you imagine that people are saying to the government – take my money, don’t pay me any interest, give me back 99.99% Principal after 3 months… Investors with cash were running scared.

For you to get a sense of how bad the situation was – read this New York Times article. Strangely, the rest of the world seems to be blissfully unaware as we carry on our normal life of going to a ballgame or visiting the Mall, or our favorite pastime.

My own feelings on this are mixed. While I am not going to shed a tear for the shareholders of Lehman or Fannie Mae, I think this affects us more than the stakeholders of those companies. The life which you and I have been used to, and taken for granted, is going to change dramatically over the next 6 months. The integrity of our financial system was severely tested, and the confidence in the system completely shattered, and it requires the mother of all bailouts to bring some semblance of order. Inspite of this massive government intervention, I personally think that folks in this blog and elsewhere, should start tightening their belts, as we are sure headed for a very rough landing.

There are other areas where I can talk about – the role of government, capital markets, regulation, asset bubbles, deflation and the Fed’s role, disintermediation, but I will leave that for a different post if you are interested in hearing my views.

Which comes back to the original question – should we feel sympathetic to the loss of employees at Lehman? We should not – if it is a stray layoff of a few people. But we should, if it is the loss of the entire firm.

Think of the impact on NYC’s tax revenue. The big fat cat investment banker sure earns a multi-million dollar pay package, but he also pays his taxes. His taxes are what runs the schools, the public service system, the hospitals, so who is going to plug in the missing tax revenue? Obviously, the city of New York only has to cut spending to handle the revenue shortfall, for they can’t issue any more bonds to meet the shortfall. So the vicious cycle continues.

If you say you don’t care about NYC, think about any other small town or city where you live. Whether you know or not, your small town/ city will be issuing muni bonds for their funding needs. You are going to see a reduced availability of such funding, which has a direct impact on the number of new projects – everything from road maintenance to upgrades for old facilities. If you are working in a company, your Treasury department is going to get lesser availability of loans at a higher cost – your company will be postponing new projects and hiring lesser people.

The bottom line – the capital markets are the lubricant which keeps the wheel spinning flawlessly. If some of the larger players fail, the speed of the spinning slows down dramatically, and it’s going to take you longer and harder to reach your destination, with more pain and more energy.

I want you guys to think about yourself – don’t think about Lehman or Bear Stearns or any other investment bank. But think about how this crisis will affect you and your family, or your friends or coworkers. This event is going to affect you, directly or indirectly. So be prepared for a rough landing.

It’s not about the investment bankers, it’s about you. Their loss, directly or indirectly, affects you.

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15 thoughts on “How the financial crisis affects you and me

  1. Well, I guess this is the first comment, however unqualified it might be. I do not live in US and do not know about treasury bills and other aspects of the financial districts such as economy. But, hopefully, it was written lucidly and temperately. Back home it created a major correction in both the indices [BSE, NIFTY], despite FM’s claim that our markets are immune [read disjoint] to foreign ones.

  2. You socialist, you!! šŸ˜€ šŸ˜‰

    While a bailout is on the cards, perhaps this crisis shows that unfettered capitalism is a failure, and we do need some regulations, and checks-and-balances to protect us from unsound decisions. Should sober up some John Galts of this world to stop drinking their kool-aid.
    As Tuttle said, “We’re all in this together.”

  3. I came here via DP. I’d like to respond to MJ’s take.

    >Here is my view on how this situation could have unraveled and affected >everyone in the globe, and it might still happen. Did you realize we were >staring at the abyss of a giant Depression? As the events unfolded over >the week, there was a small, but very real probability that things can get >out of hand, and we were staring at a calamity. Think 50% reduction in >home prices, as a starter.

    In so far as inflated home prices is the proximate cause of this crisis, a correction is well overdue. People need to understand that herding is bad investing and has consequences.

    >Think about the financial aspect of your life. We drive a car to take our kids >to school, go to the shopping mall and swipe our credit cards without >thinking twice about happens in the background. The loans on the card you >swipe and the car you drive is securitized by the very same investment >banks everybody seems to hate, and parceled as securities around the >globe.

    Those who stand to lose from this collapse should have thought about the financial aspect of their lives before the collapse. In fact, most people who got in on the game misapprehended a basic principle of finance – taking high risk does not guarantee high realized returns, only high expected returns.

    >These guys play an effective role of finding where excess money is, and >selling these securities to people with the cash, thereby lowering the cost >of financing for your credit card company or auto loan company. If such >markets don?t exist, you will have to depend on your local bank who is much >smaller, and whose ability to raise money is costlier, and this additional >burden is passed on to who else but you. So is the case with mortgages >and student loans. Every aspect of your life is touched. As the events of >last week told us, even what you thought as cash in your money market >account was not safe.

    Yes, financial markets increase the ability to borrow and lend, and move income around intertemporally, but what nobody is willing to admit is that :

    In markets where pricing is forward-looking and psychological biases are pervasive, there is a systemic tendency towards crises.

    This is a law. It is more robust than the law of demand. And as stated, the conditions for existence of a systemic tendency towards crises, are only sufficient, not necessary. Not a pretty picture, but hopefully, people who understand this law will think twice next time before herding.

    >The implications for the average person is wide ranging –

    >(i) higher interest rates and reduced availability on loans;

    >(ii) lower rates of return on your personal investments;

    >(iii) reduced level of government spending as governments and >municipalities are affected.

    >(iv) Higher unemployment as companies tighten their belt.

    All required corrections.

    >The cause is imprudent borrowing and gullible lending.

    No, see the law above. Our society to date has not solved the problem of how to trade off the socially valuable function of innovation, against the social costs of highly skewed remunerative mechanisms. Some would say it is a mechanism-design problem, but mechanism design theory has been around for a long time, and the state of the art is quite impressive on paper, but crises cannot be averted.

    As for the rest of MJ’s comment, in the last 10 years, we have witnessed crises in first currency markets, then stock markets, then currency markets again, then real estate, and now credit-insurance. Bailouts DO NOT HELP. It is shocking to see Ben Bernanke stand shoulder to shoulder with GWB and make a case for hundreds of billions of dollars worth of bailout money. This is the person who introduced balance sheet analysis into macroeconomics and should be well acquainted with the words “moral hazard.” Now this same person is rolling out a scheme to make not just the current generation of US taxpayers, but future generations as well, pay for the mistakes of wealthy bank bosses.

    Meanwhile Obama says – We cannot just have a plan for Wall Street. We need one for Main Street as well.

    When I was a child, I had to *go* somewhere to see the circus.

  4. I see this has really hacked you off, hasn’t it? šŸ™‚ Well, we only have to read what you write.

    You wrote a lengthy, technical explanation and here is what I said on Neha’s blog:

    When a shopgirl loses her job, she loses her job. When an i-banker loses his job, his cook, au pair, trainer, gardener and a whole bunch of other sundry service providers suffer directly too. Pretty straight forward. No?

    And as if by magic, in today’s papers, we are already discussing au pairs unable to find jobs, trainers being fired, spa appointments being cancelled, large plastic surgeries being cancelled (though botox top-ups continue), people not buying cars but signing up to Zipcar etc in their neighbourhoods (where available). I would imagine even a fool can do the maths!

  5. come on, lekhni, you write a post explicitly titled “in defense of those on the street”, and some of us objected to that, so now it’s become “we don’t understand the ramifications of what happened”?

    let me clarify that i do understand the ramifications of what happened. the financial markets got screwed. i may wake up tomorrow and find that my very comfortable bank balance is not worth the paper it’s printed on. the thought has crossed my mind. my wife and i have talked about moving our money out of american banks. we’re not dumb. we recognize a crisis when we see it — just as we recognize hubris, which was the point of my comment on the previous post.

    let me say it again. i am not happy that wall street has collapsed. i am not gloating that i-bankers are out of jobs. i am – instead – furious at them, because their greed, stupidity, and arrogance has brought all of us to this turn.

  6. Anyone who loses their job for no fault of their own deserves sympathy. Especially for immigrants, this can be life-changing.

    That said, i think some of the arguments used in this post is, with respect, pure hyperbole. The collapse of Lehman or Bear does not spell the end for capital markets. People got loans for college and housing, local governments collected taxes and interest was paid on deposits long before Lehman and the others turned into what they have become in recent years, and these will continue to happen when the dust has settled. America and the world will survive.

    Granted, in the present climate of fear and uncertainty (partly caused by these very doomsayers) retail banks are very careful about whom to and how much they lend. That is not necessarily a bad thing as irresponsible lending was one of the causes for this crisis in the first place. But competition between banks will improve things over time. Sure they perform a useful role in the economy, but so do the telecoms industry, the hotel industry and even the au pair industry. When a hotel goes bust in a downturn, their staff lose their jobs, but no one talks of a bailout! Banks do pay heavy taxes during the boom years, but when things go bad they also get enormous bailouts paid for from payroll taxes collected from everyone, including waiters, cleaners and au pairs. One must be blind not to see the enormous irony in all of this.

    Let us be very clear about this, no industry should be above the fundamental rules of the free market. Risk brings great rewards, mistakes and profligacy bring losses. Over the past few years, the auto industry, the print media, the dotcom and the airline industries have learnt this the hard way. They have changed their business models, cut costs and become profitable once more, all without tax dollars. Customers have benefitted immensely from the better and cheaper products that are now offered.

    It is a shame that many employees had to lose their jobs before some financial industry CEOs and shareholders decide to do the same.

  7. Have you ever heard of the words
    – Moral Hazard
    – Social Stigma
    ???

    If you have, then awesome! Let’s see – taken your logic to the extreme, every bad news in the world affects me. You know, there have been 100 accidents today in the US – and hence maybe, I should stop going on the road – or something to that effect.

    When these financial service companies (service? or disservice?) were raking in huge profits, I could not do a damn thing to stop them or earn any shared prosperity. On the other hand, when these financial service companies are in turmoil, I can’t do a damn thing other than to pay up extra taxes down the road due to the bailouts. When the shit hit the fan, all the walls in my house got colored.

    We all understand that we are getting/going to get screwed going forward, simply due to the inevitable raise in taxes if not anything else. However, unless we attach a goddamn social stigma to such an action, unless we call out moral hazards with respect to such actions, unless there is widespread anger, frustration and schadenfreude at such a situation, we won’t be correcting ourselves in the future – rather, the financial service companies would be encouraged to continue on similar lines – and that my dear friend is the whole issue.

    Privatizing wealth and socializing debt…this is precisely what the past few months have indicated to the normal public. Left to me – sympathy, emotions and taxes – ah, well, I might as well have none of it due to this turmoil.

  8. Well, it is all over my head, but what I ask, is a simple question. As a student, soon to be graduating, in America, ok, I must be worried. But I see no point in doing that. Really, what is in my hands? What can I do, to mitigate anything here? When nothing is in my hands, why should I be worried?

    And because I don’t understand the technicalities of it (am a Computer Science graduate), I don’t get the sympathy wave, either. I don’t choose to be ignorant. I am just not sure.

  9. Lekhni/MJ:
    The comments in the previous post were not about “not understanding the implications”. They were strictly about whether we should sympathise with the people at LB and MS who had lost their jobs. You said that people shouldn’t gloat about it, because it affects them. And that’s what several of us reacted to.

    The key word, and sticking point, is ‘sympathy’.

    As TR puts it, there’s no ‘sympathy’ here – there’s anger. Let me add a few to that – Chagrin. Disbelief. Outrage. At the bankers, the institutions for which they worked, and the whole system.

    None of those comments denied the ramifications of the collapse – or wished that it would happen. We don’t! But it’s difficult to sympathise.

    And nothing in the MJ piece addresses that.

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  11. That’s true, most people do not understand the situation. They think the 700 billion dollar bailout is wasting tax payer’s money. I dont know what will happen if the bailout doesnt take place. Right now it seems to be the only choice. As I said in my previous comment, the common people who were carried away are the ones who are affected. They spent and borrowed so much beyond what they can afford, the system has collapsed. Also, that means that the govt. and the organization allowed such borrowing which means the blame and impact of it falls on everyone of us. It is a ripple effect and it is going to affect everyone in someway.
    But does this mean we have to stay at home and cry over spilt milk? Should we stop going to ballgames and malls because of this? The answer is in solving the crisis not crying over what happened. If we make it a point to save atleast 30% of our income every month, no matter what, then it should be a good start, may not be the ultimate solution but a stepping stone. Unfortunately none of the media outlets are talking about solutions, they are only going gaa gaa about the problems and stating the facts over and over again!

  12. Pingback: Sane Voices on Financial Crisis | Financing Tips

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