Sunday, March 15, 2009

Banking crisis: What is the problem?

I just read Michael Mandel's article in business week about what caused the banking crisis and why it is difficult for people to comprehend the problem.

I have seen the broad facts and the arguments earlier. But Michael Mandel does an extremely good job of presenting them in a simple fashion as the title of the article claims. I remember reading economist and business week 4 years back when people were talking about the huge trade deficit of US. Many economists were arguing at the time that trade-deficit is not a big issue and the current situation can continue for next 15 years. The main threat that people were discussing at the time was the strength of the dollar. Certainly the problem of trade deficit has manifested in ways no one imagined at that time. And surprisingly dollar has strengthened.

A good explanation of why wall street is still under danger ( quoting from the article):

And when there wasn’t enough “safe assets” to sell to willing foreigners, the intrepid investment bankers created more. Consider, for example, credit default swaps, which pay off if a bond defaults—in effect, insurance on debt. Wall Street saw this as a ‘two-fer.’ They would sell corporate bonds to foreign investors, and at the same time collect fees on credit default swaps on the bonds in order to reassure those apparently too-nervous investors from another part of the world.

But the joke in the end was on Wall Street. The foreign investors bought the bonds, but they also bought the protection—which much to everyone’s surprise was needed. And the U.S. banks and investment banks were left with piles of ‘toxic assets’—the obligation to pay off all sorts of bonds and derivatives

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