Gaining a better understanding of the financial crisis

Kate Warne, Ph.D, CFA, Edward Jones Market Strategist: The recent events in the financial services industry and the market in general have left many feeling a little unsteady and confused. Here we try to answer some of the biggest questions surrounding this crisis.

Q: Is there a simple way to explain what is happening?

A: In the current financial downturn banks and other financial institutions (e.g., building societies and investment banks) made increasingly risky loans, especially subprime mortgage loans in the US, and some won't be repaid. As a result, they've cut back on making new loans and want to reduce the risks on any loans they do make. In addition, many banks depend on short-term loans from other banks, and those short-term loans also have become scarce and costly.

Over the past few weeks, the problems worsened as we saw several major institutions fail, nationalised or acquired, including Bradford & Bingley, Lehman and HBOS. This made the financial network more fragile and tenuous. The financial crisis makes this situation much worse than average, but the overall financial downturn is still taking a path similar to many others. Eventually conditions will improve, and a smaller number of less risky financial institutions will emerge as the survivors.

Q: How did the financial situation get so bad?

A: To boost their earnings over the past few years, banks increased their leverage (debt). Borrowing large sums boosted the gains in good times, but it also increased the risks. Therefore, those with too much leverage now have to raise more capital in difficult circumstances. In addition, many loans were packaged (securitised) in ways that make it difficult to determine what they are worth, and in this environment, there are few buyers. Most financial downturns don't include a financial crisis, but financial crises seem to happen about every 20 years or so.

Q: Is the worst of the financial crisis over?

A: No one knows for sure. The economy has weakened and there is almost certainly more bad news about some banks. Usually when feelings become as pessimistic about the outlook as they are now, times begin to improve. We know consumer confidence is extremely low, many headlines are negative and many investors are worried. Instead of guessing about the short-term news, stay focused on your long-term goals and your strategy. The worst mistake is to react out of fear and miss the rebound when it occurs.

Q: What about the US bailout plan?

A: The US government has approved a plan to buy up to $700 billion of the worst loans and related securities. The UK and some European governments are considering similar plans. The main goal is to get the financial system working again quickly, which would be positive. The specific details will matter more in the future because the programme makes the US government a large participant in the financial system.

Q: Why does the financial system matter so much?

A: Lending and borrowing are everyday actions that businesses and consumers take for granted. The financial system is a low-cost way for savers to finance borrowers. Without a well-functioning financial system, economic growth would slow sharply and incomes would generally be lower. Whilst no one likes the idea of using taxpayer money to support those who created this mess, fixing the financial system is important to everyone. The nationalisation of Northern Rock and Bradford & Bingley's mortgages as well as proposed changes in regulations are necessary steps to end the current crisis.

Q: Why is this affecting the global economy?

A: The global financial system is tightly connected to the global economy and anything that disrupts one part has an impact throughout. Investments that included US subprime mortgages were sold around the world, exposing most banks and investors. The turmoil in the financial system is now reducing the financing available to companies and individuals, causing economic growth to slow, and many countries are likely to experience at least a mild recession. The knock-on effects of the slowdowns in the UK, Europe and the US are being seen in China, South America and other faster growing areas as well.

Q: How bad will the economy get?

A: No one knows yet. The longer the financial crisis lasts, the larger the potential impact on the global economy. That's why the US and potentially other countries are trying to bring about an end to this crisis soon, with help from the Bank of England, the European Central Bank and other central banks. Predictions of another Great Depression are unlikely to be correct because:

The depression was a cyclical slowdown that turned into a global depression due to a sequence of policy mistakes. In the 1930s central banks kept money tight. Governments cut spending and raised tariffs. These policy mistakes are unlikely to be repeated.
Today central banks are trying to avoid the mistakes made in the past by providing cash to financial companies that need it, arranging bailouts and potentially lowering short-term interest rates.

Trade restrictions contributed to the depression, particularly the Smoot-Hawley Tariff Act imposed by the US in 1930, which reduced world trade by more than 50% over the following two years.

Growing world trade remains a source of strength today.

Governments are running deficits and are generally inclined to provide stimulus packages to boost economic growth during slowdowns.

Instead of inflation, the 1930s were characterized by deflation, or falling prices. Today's concern remains inflation, which is likely to be dampened by the global slowdown.

The world economy is less cyclical today because its structure and government policies have changed considerably since the 1930s.

Q: What happens next?

A: Watch for indications the financial crisis is easing.

Unfortunately it won't be a headline because the headlines rarely include good news.

Generally, we see a relief bounce in the stock market. Whilst no one ever knows exactly what will happen with shares from day to day, we should begin to see stronger financial institutions take advantage of the lending voids left by weaker banks. Financial regulations will increase to prevent banks and other financial institutions from taking so much risk.

The magnitude of the economic slowdown will become the next major concern, as consumer spending and housing will almost certainly decline further. Shares are already anticipating some slowdown and historically rebound whilst the economic news is poor.

Q: What should investors do?

A: Don't believe all of the crisis headlines. Whilst the news is not good, and we don't typically experience financial crises, most companies and individuals are continuing their lives as usual. This still has many of the characteristics of a typical cyclical downturn. In the past, those who stayed properly invested in a diversified portfolio of quality investments and looked for opportunities were rewarded.

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