Economic Crisis, or Political Crisis

With an initial drop of around 500 points Friday, I have begun to reflect back on the real causes of this economic crisis.  Don’t miss understand me, I am well aware of the bad mortgages which several banks wrote, as well as the collapse of the derivative market.  However, let’s look closely at the reasons for the perpetuation of this sharp slump.

First off, let’s be sure to understand that the direct impact of the mortgage crisis hit home with banks.  Banks wrote mortgages and loans with variable interest rates, as well as used these loans to underwrite and leverage other interests.  When the rate went up, as it inevitably would, many of these loans went into default.  This unsecured any other options which were hedged with these loans, tossing their balance sheets into a meat grinder along the way.  Many banks were left seriously in danger of failing.  Next came the credit crunch.

The term credit crunch refers to banks inability to trade freely at the overnight rate.  The Federal Funds Rate is the rate at which banks actively trade overnight.  Each bank is required to keep 20% of their actual deposits on hand.  For example, if two banks have 100$ in deposits each, they are required to keep 20$ on hand.  If one day, one bank’s customers withdraw 5$, and the other banks customers deposit 5$, then each bank now has 15$ and 25$ at closing.  This is where the overnight rate comes into play.  One bank will lend the 5$ to the other bank, so that both are back at the 20% mark.  This process happens every day and relatively fluidly.  When markets become turbulent, banks are hesitant to lend to each other.  This causes a credit lockup, because banks hold on to what they have, causing other banks to have a lack of capital.  Although banks can borrow directly from the Federal Reserve at the discount rate, this is viewed as an indicator of impending failure, so, for stock reasons, banks in general avoid this.

It seems obvious then, that many banks stocks would become troubled and probably sink due to this situation.  However, the crunch spread to almost all stocks, with literally no stock being undamaged by the end of the weeks decline.  Was this a full force market crash?  Maybe so, but I think that the media is heavily to blame as well.

There is no real reason which explains the full market slump except for investor confidence.  With the impending election, it seems as though the media is trying desperately to play up, so to speak, the impending doom of our current economic situation.

Which leads to my conclusion: The media intensified the economic crisis by misreporting the caliber of the “disaster”.  By convincing everyone that the next great depression was imminent, they came close to creating exactly that.  Even after the Federal Reserve and the treasury released statements assuring the public of the sound design of the financial system, the media twist of the situation counteracted the positive effects on investor confidence.  Stocks continued to plummet as well when President Bush (the media scapegoat) also spoke. 

It took a weekend summit of every major industrialized nation’s leaders to revive confidence in investors.  With media spin almost impossible,(there are just too many implications associated with downplaying a world effort) the media was forced to write of hope for the (world) economy.  What happened?  A huge, almost 1000 point rally in the markets today. 

Much of the market performance depends on investor confidence, and when the media plays into negative performance, it only perpetuates the problem.  Lets keep politics out of financial media, and actually try to avoid economic disaster.  

Tags: banks, credit crunch, economy, federal reserve, finance, investment, media, Money, Politics, rates