My opinion of the financial crisis
Posted by Don on March 20, 2009
If anyone has been watching the news lately you have heard a lot about what is happening with the economy. Well here is my two cents worth of a very high level of what is happening and my opinion of where I believe we are headed.
First we know that banks and investment banks borrowed a lot of money to purchase financial derivatives and securities. These financial derivatives were secured by mortgages in the United States. House prices began going down and the collateral backing these securities were worth less. This meant that in the event of default the owner of the security would not get full value back which made the security worth less.
As a result banks were required by accounting regulations to mark down their assets and by government regulation to get more capital to continue to operate. To attain more capital you have to do either issue more stock or reduce your liabilities. So banks stopped lending so that they could try and put their balance sheet back in order to meet the government capital requirements.
When banks stopped loaning money several businesses were unable to refinance their short term debt and had to sell assets to pay off debt. This began a horrible cycle of reduced demand which has led to reduced prices or the dreaded deflation. According to Investopedia deflation is a decline in prices caused by a reduction in money or credit. Now home values fell because a reduction in demand by consumers caused prices to go down, but the reduction in credit has been caused by the banks. Now consumers and businesses are not spending unless it is necessary which is causing further demand reductions and additional price decreases.
So the government and Federal Reserve start printing and borrowing money to inject capital hoping to stop the deflation and inflate the economy, with the understanding that once economic growth returns they will pull the funds out. Unfortunately as history has taught us no government can efficiently manage anything.
We have two options going forward continued deflation or inflation. The correct answer depends on what day you look at data coming out.
First you have had price deflation over the last year in housing. As businesses and consumers have stopped buying, prices of certain items like cars, TV’s, and gasoline have gone down. The savings rate in America has jumped from 0% in the beginning of 2008 to 4% in December 2008 and 5% in January 2009. This money being saved (which is a good idea) comes out of the GDP and causes an immediate reduction in demand. Remember though this money is being saved so it will be available for use at a later date. At the same time we have the government putting money in the system to replace this reduction in demand and lack of credit.
The only problem is the government stimulus, TARP, and every other method has injected almost double the amount of money from what was in the system which is reducing the value of dollars. Supply and demand states that when supply goes up, prices go down. So since there are twice as many dollars available now as there was six months ago, your dollar will be worth less in the future. This will cause prices to rise sometime in the future. When that happens if the government doesn’t begin taking money out of the system (which it can’t take money out as fast as it put it in) we will have inflation. Our worst nightmare is to have global inflation and no economic growth aka 1977.
If you read my last S&P post we hit 795 on Wednesday and the 50 day moving average was at 803. I hope you used this 20% rally from the lows to sell some of your 401K and increase your cash position. The 50 day moving average has flattened out, but we are due for a pullback to about 740 or 750 on the S&P. The Treasury Department is going to come out with their toxic asset plan next week. Watch the market action from that. If the street likes it we could have a rally back up to the 200 day moving average at around 1000 by Memorial Day.
Remember the disclaimer. I am not a licensed financial adviser and this is my opinion only. Please consult your financial adviser before making any trade.
