Thursday, September 18, 2008

Will this Financial Crisis become a Panic?

There have been fourteen banking panics in the U.S., but none since the Great Depression, with the last one being in 1933. Historically, it seems that many of panics are caused by bubbles, a crisis of confidence, or a credit tightening. In addition, many panics occurred during or close to an economic recession.

In 2008, we experienced all three causes with the housing bubble, subprime mortgage defaults and a liquidity crisis. The housing bubble was created by low interest rates and loose lending standards, driving up prices and creating a building boom. Loans were facilitated by CDOs which were perceived to be high yield, and low risk debt instruments. However, as subprime mortgage defaults were increasing, the value of CDOs decreased significantly, reducing the access to money by companies owning CDOs. This caused the failure or merger of several companies that had invested heavily in CDOs.

To me, the initial rounds of mergers happened to companies directly involved with the crisis. Countrywide, Bear Stearns, Fannie Mae, Freddie Mac and Indy Mac all actively participated in the creation and bursting of the housing bubble. One could also make the same argument about Merrill Lynch and Lehman Brothers. Although I believe the Fed should have acted more aggressively, they have done a relatively good job of maintaining order in financial markets by increasing liquidity. At this point, the Fed still appears to have control of the liquidity issues, therefore averting a panic.

However, the liquidity crisis seems to be affecting more companies that were not directly involved with the housing bubble, e.g. AIG and the Reserve Primary fund. Unfortunately if the issues spread rapidly beyond the core group of companies directly involved, the Fed’s resources may not be sufficient to stop a panic from happening.

Hopefully, the Fed has learned enough from history to prevent a panic from starting.

For more on Crossing Generations, check back every Thursday for a new segment.

This is not financial advice. Please consult a professional advisor.

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