When the stock market and state of the economy are headlines in newspapers and the main story when tuning into the nightly news on television, everyone pays attention. The problem is that as news gets worse, the predictions get even gloomier. Gloomy predictions promote fear and panic, which is what we have seen the past few weeks.
No doubt, there have been extraordinary circumstances that have shaken the worldwide financial system. Governments have had to step up and provide whatever is necessary to ensure the banking system functions as it should. The problem has been that the banks were not extending credit to other banks, companies or individuals. Credit was not made available. After the problems of a few financial institutions, the worry was who was to be next and subsequently credit dried up.
The cause of the worry stemmed from “toxic investment products” on the balance sheets of virtually every financial institution. They all owned them; the question was to what extent. These assets (structured products backed by loans and guarantees of others) had to be marked to their current value in a market where nobody was buying. The rules of “mark to market” stipulate that an asset on a balance sheet is to be priced at its best selling price. These products that were always priced at $0.95 - $1.00 per dollar worth of value, had to be re-priced at $0.15 - $0.25 per dollar. Capital ratios are then compromised, which then creates rumours concerning the viability of the institution, causing clients to pull their assets, loans to be called and their stock values get pummeled. The irony of the situation is that a lot of the products have a maturity and provide a monthly cash flow which should value the investments higher than the values that are forced upon them by “mark to market” rules.
Various governments and central banks are dealing with the financial crisis in different ways. Their goal is to solve this “liquidity” problem, which is to get financial institutions to begin lending and borrowing as they always have with each other and their clients. The US Treasury has arranged for $700 billion to buy up these toxic products and to buy stakes in financial institutions. Similar plans are underway in other countries, including Canada.
What this shows, is that governments and central banks will do whatever it takes to instill confidence in the financial system and encourage commerce to keep the economy rolling. The housing problem, which began in the U.S. last year, was the beginning of an economic slowdown. This recent financial turmoil is causing central banks to reduce interest rates and provide liquidity to the system. Lower rates eventually have the desired effect of bolstering economic activity, but it will still take a while. The effects of these measures are not immediate. Confidence building takes a while.
Markets will move before a recovery in the economy has taken place (as it always does). The doom and gloom predictors come out when markets are low and create panic and fear. Conversely, the greed factor sets in when markets are at record highs and newspapers are predicting lofty returns to continue. We have to learn to be sellers during the greed phase and buyers during the fear and panic stage. Unfortunately this is not advice that you’ll read on the front pages
Research Capital Corporation
The economy and financial markets