Saturday, October 11, 2008

A Basic Explanation of the Global Credit Crunch

At the outset, let me point out that I am not a financial expert, but one who has an active hobby in understanding finance and economics. My MBA degree also lends me certain credibility in this sphere. I will attempt to give a basic explanation of what happened during the past week in the financial crises that has wiped out people’s savings and fueled panic selling making markets lose 30% of their capitalization amounting to billions and billions of dollars.

The main reason (and there are many other reasons that have contributed to it) behind was a strategic planning mistake by the US banks. Instead of assessing the credit worthiness of the applicants and their ability to make the monthly payments when applying for loans, especially home purchases, they assessed the amount of credit based upon the current market valuation of the actual homes. Well, once the economy was healthy and booming with the prices of homes increasing on a regular basis, this was fine. However, it transferred the risk to the banks and this was the strategic mistake once the economy slowed down.

When they attempted to get rid of these home assets (once they reposed them), they could not at the price they had valued them in their balance sheets. Thus, a fire-sale ensued which led to huge write-offs.

The other strategic mistake is that they collateralized these mortgages to be able to take out more credit from other banks and become more aggressive. Thus, the domino effect happened and with one bank going down, the rest had to follow. That is why the bank bail-out was so important and the government having to guarantee people’s deposits. Otherwise, the ramifications would have been unthinkable.

However, I do not understand how this got translated towards the Arab world whereas the stock markets have shed about 20-30% of their market value over the past week. After all, accessing credit in the Middle East is a lot harder and restrictive than the Western world. In addition, there is only a small portion of mortgages as a percentage of banks’ portfolios relative to the Western world. Moreover, the high price of oil (which is our main produced component) shows no sign of easing or disappearing. In other words, our fundamentals are still strong. So, who can explain it to me?

One person who is a director for a reputed financial institution told me that if the market prices of real estate go down (and not maintain their prices within Dubai specifically and the Middle East in general), then we will see the effects over here. However, he also assured me that the sovereign wealth funds would be more than able to compensate by shifting their money from the Western world to the local country. With the stock markets collapsing as they are, let us all hope that we do not see this doomday scenario.

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