during the last decade, financial innovation, in combination with lax and ill-guided regulation and "cheap money" has created a liquidity bubble
instruments vital for creating this bubble were e.g. structured investment vehicles (SIV's) or conduits, which enabled banks, to shift assets, that were supposedly high quality (as confirmed by the infamous rating agencies) off balance sheet. if the quality of the assets was itself not good enough, so-called monoline insurance companies guaranteed the assets to achieve the desired rating. huge volumes of credit were thus made indirectly available to mortgage lenders, credit card holders, car lessees, emerging market banks, aircraft financiers, railwaggon operators, etc.
regulatory regimes, which were based on ratings and designed to reduce capital and ensure comptetitiveness of banks located in the negotiating countries enabled banks to achieve unrealistic leverage ratios.
availability of too much liquidity created asset price bubbles.
as long as asset prices went up. everyone happily participated in the party. everyone was better off - the consumer in the US, the producers and their employees in the emerging markets, the exporting industries in Europe, investors who could leverage up their investments to achieve higher yields, the family which easily got money to buy a nice house or car or both etc.
obviously, prices at some point reach a level wher even the greediest start to get worried and hold off.
in a moderately leveraged world this would have meant prices going down, banks writing off quite some assets, but en gros they would have been able to withstand the downturn.
given the degree of leverage in the system, aided by newly implemented accounting standards that merciless laid open the weak spots in banks' balance sheets, the write-down amounts were simply too big, to be compensated by banks' equity.
the nature of many of the products created, namely tranched products, also meant that write downs did not lead to recovery rates like in normal losses of loans, but to definitive full write-off of assets. the multy-layer products increased the power of this phenomenon
banks writing off assets and thereby reducing their remaining equity made them sell assets, in order to reduce so-called "risk weighted assets" - assets that bear credit risks and hence have equity allocated to them in order to enable the bank to withstand an eventual loss on these assets.
decreasing asset prices meant that the safety of Commercial Paper (CPs - notes with short maturities and a high rating, usually AAA (i.e. the best rating)) Investors was reduced, as the over-collateralization of their CPs effectivelymelted away.
this made the CP market dry up. Investors were not prepared any more to take on these risks.
banks in turn were sponsoring most of the Conduits out there with liquidity lines. with CP investors rejecting to give money to the SIVs and Conduits, the liquidity lines were drawn and banks hence suddenly bore the full risk of the assets, which they never intended to hold themselves, and obviously hadn't put equity aside for.
as banks had to reduce assets in order to get back to the required equity ratios, asset prices fell further, which lead to more liquidation of funds, hedgefunds, etc.
writedowns increased more and more (hence equity became less and less) and obviously people got concerned about the safety of banks and investment banks. banks also got concerned and started to be more careful or reduce credit to other banks - nobody really knows, what the other banks exactly hold on their balance sheet.
at first, some US banks managed to convince sovereign wealth funds (SWF) to provide them with additional equity. however, as write-downs on teh bank balance-sheets continued and the value of the SWF's investments more and more turned out to be not very successful, they became less and less convinced that it would be a good idea to buy more of such equity.
then Bear Stearns was saved in the last minute by JP Morgan and the Fed, despite having assured the public until teh last minute, that all was fine.
it took surprisingly long for Lehman Brothers to run out of breath (despite as well assuring that everything was fine), but here, no buyer could be found, and the US treasury and the Fed decided to "let this one go". the effect was disastrous - risk aversion has risen dramatically, liquidity in many mrkets has all but dried up, and even foremost strongholds of liquidity, like German Jumbo Pfandbriefe (Covered Bonds) are since suffering in value and liquidity.
the day after Lehman, the US treasury had to bail out the countries biggest insurance company - American International Group (AIG). the "loan facility" extended to them has been steadily increased and is now amounting to $150bn.
this spiral of write-downs is still spinning. however, its reach has widened. Economic indicators show that most of the western world is in recession.
as the financial system is at the heart of the modern economy, providing companies and individual with credit they need to invest, build and create, governments decided that it would not be a good idea, to let the system collapse. hence, more and more government designed "bail-out programmes", usually providing equity as well as guarantees to support bank funding. the sizes of most of these programmes are huge, and will have a measurable impact on sovereign budgets.
the most dramatic example currently is Iceland, which entertained a financial system that was far too big to be saved by the state. Dramatically increased risk premia payable for credit insurance on various other sovereigns indicate that more trouble might lie ahead.
reports on the IMF which has effectively already spent half his budget on Hungary, Ukraine, etc indicate the seriousness of the problem.
auto companies feature a special fate - overcapacity and a strategy that relied on consumers asking for SUVs and big limousines (another effect of "the party") neglected preparations for the time, when consumers would start thinking differently.
the oil price spike up to USD 146 led to an astonishingly abrupt change of mind of buyers. the fact the exhaust fumes were responsible for destroying the planet we are living on (which was discussed since the 80s) obviously was not as persuasive as wallet-ache induced by rising gas prices. Astonishingly, this phenomenon still holds true, although oil prices have collapsed since then.
