The past month has been a trying time for the financial markets. The world watched in shock as giants such as Bear Stearns and Lehman Brothers collapsed. The US Government has been pumping in money by the billions as it struggled to bail out Fannie Mae, Freddie Mac and recently, AIG.
Investors have panicked by pulling out their funds which caused world markets to tumble drastically over these past few days.
However, one burning question remains…
What has caused this terrible financial crisis?
It seems hard and frightening to imagine that the entire financial collapse happened on the back of sub-prime mortgages. How can something as simple as loan mortgages cause such a wave of destruction?
The truth is, financial markets are only as good as the very foundations that support them. And in recent times, these foundations have started cracking at the seams and bringing down the markets they were supporting. A great article by CNN’s Richard Quest explains this in wonderfully simple terms in these excerpts below.
The world’s investment banks are basically houses built on pillars of money. Sometimes those pillars are cash, often bonds; these days pillars are made up of derivatives, swaps, options and other frighteningly complex instruments.
But these pillars are the strength that supports not only the bank itself, but also its debts and liabilities. Under technical rules the pillars have to be transparent and of a certain quality, so that investors know just how well propped up the bank is. In layman’s terms — everyone can tell “the bank is safe!” If the pillars remain strong — the bank stays standing.
What has happened is that the rot has got into the pillars and no-one noticed. If they were wooden it would be worms. The very financial instruments that make up the core of the banks are questionable.
No-one can say for certain how much these instruments are worth, if anything. No-one knows if counterparties to deals are financially secure and will be around tomorrow. The very structure upon which banks like Lehman depended became doubtful.
Often during a period of financial turmoil there are clearly definable events — oil crises, war, acts of terror — which cause a loss of confidence which leads to a slowdown and possibly a recession.But the infrastructure of the banks remains by-and-large solid. The pillars remain standing. Here the exact opposite is happening. Every event merely puts dodgy pillars under more strain and eventually they give way. (source)
Like a financial tsunami, the waves of destruction have just started. How long the financial markets will take to recover from this crisis remains anyone’s guess.