The Economic Downturn

Yesterday afternoon I had an interesting but briefly conversation with two persons from one of the two main banks in Spain. Suddenly, and without "anestesya" (something I would have needed of right after coming from an exhausting "Quant" exam), they asked me the causes of the economic crisis.

As you may imagine, my brain was burning, and I started with what I think were the "causes": the story is that to stimulate the economy back in 2001 (or 2002?), Alan The Great and his "corte" at the FED decided to slash interest rates several times up to 1% in the US. The reduction of interest rates has a lag in its effects though but it enhance expectations on people to go and get a loan either to buy a house or to pay the credit card debt (which at the end, allow them to finance new acquisitions). The "stimulus" cut the vicious circle of pessimism making private consumption to react and, therefore, companies go buy new machines to satisfy customers' needs.

From what I see, the reduction in interest rates along with a precarious risk analysis of loan-takers created a bubble in consumption and real state investments that burst about eight months ago and that now we are "enjoying" so much! As mentioned earlier, the cut in interest rates has a lag period (usually around 9 months): as soon as the expansive effect starts it is difficult to stop and that is why it is so important to calibrate monetary policy. Well, when consumption increases too much guess who comes: inflation! (yeap, we argentines know about it...sadly!)

Once again, when the FED reacted to the increases in expected inflation it was too late: the world was consuming...and growing...but too much. Interest rates were increased with the goal of moderating growth and, hence, inflation. And when the adjustment in interest rates came into effect consumers, mainly in the US, find out difficult to afford their debts (mortgages, credit cards, etc) and have to reduce consumption in other stuff (a new car, a cinema ticket) to pay them. As a consequence, the economy starts to cool off, business are affected due to lower sales and have to fired employees, many of them that got a loan and suddenly lost their jobs...and left their houses to the bank.

Why the crisis spread out in the financial system? Well, nowadays the financial system is so developed and there are so many financial instruments to "play" with...Let's suppose that 1 million consumers with bad credit ratings got a mortgage loan with Bank 1. After that, Bank 1 takes 2/3 of those loans, divide them in four and sell them in the market. Banks 2, 3, 4,...,n do the same. Since financial markets are so integrated investment banks, that do not give mortgages, and other commercial banks from other countries buy those trenches expecting a good return. Then, the "domino" effect comes into the picture: as soon as mortgages owners stop paying their loans they affect not only Bank 1, who lent them the money, but also the "real" and new creditors. That is what is called "toxic assets". And that is one of the main initiators of the crisis.