Written By: Vivek Sharma

There is no hidden fact that market has been going down for past few weeks and investors have and are facing a tough time. Firstly, it was bankruptcy filed by Lehman Brothers and then Fed rescued AIG from sinking. It was a tough last week with bad news pouring from all over. And we also know, you’ll be in a heap of trouble when the lender of last resort suddenly runs out of money.

The Federal Reserve pumped in $100 billion into the banking system and lent $115 billion more to rescue Bear Stearns and AIG. With this act they were forced to borrow some extra money to replenish its coffers from the Treasury. The only good news flashed by online business magazine was that investors here and abroad were eager to help out; having decided that the only safe place to put their money is in U.S. government securities.

Undoubtedly, demand was very brisk at one point for an investor. The effective yield on a three-month Treasury bill was driven below zero, once the broker's fee was figured in. This is known as a Category 4 financial crisis. During this phase, giant blue-chip financial institutions sweep away in a matter of days and banks refuse to lend money to other banks. To stop the panicked selling, Russia was forced to close its stock market. The only good point was that the gold soared $70 in a single trading session and there was a fall in the developing countries’ currencies.

If we keep a close eye on the market, we’ll witness the greatest destruction of financial wealth that the world has ever seen. On paper the loss measured is the trillions of dollars in terms of corporate wealth, oil wealth, real estate wealth, bank wealth, private equity wealth, pension wealth, and even hedge fund wealth. For past few weeks, business week magazines have been giving painful reminders of a situation where you strip away all the complexity and trappings from the magnificent new global infrastructure, finance are still a confidence game.

But more of psychology is involved here and we have to know what is really going on and that too at the most fundamental level. To sum up the long story we should say that these are cheap money days. However, this wasn’t the case earlier. On the contrary, for most of the past decade, foreigners seemed too willing to provide U.S. households, corporations and governments all the cheap money they wanted.

That pumped in cheap money was extensively used by households to buy houses, cars and college educations, along with more health care, extra vacations and all manner of consumer goods. In fact governments too used the cheap money to pay for services and benefits that citizens were not willing to pay for with higher taxes. Same went for the corporations and investment vehicles such as hedge funds, private-equity funds and real estate investment trusts. They all used the cheap financing to buy real estate and other companies.

Being in this situation, two important things happened as a result of the availability of all this cheap credit. The first was the price of residential and commercial real estate, corporate takeover targets, and the stock of technology companies were on rise.

It won’t be wrong to say that the faster they raised, the more investors were interested in buying. This drove the prices even higher and created even stronger demand. On the same token, many companies expanded operations to accommodate the increased demand from households and decided they could save less and spend more.

In this respect, airlines added planes and pilots, retail chains expanded into new malls and markets, auto companies increased production, and developers built more homes and shopping centers. In short, overall development. But everything came stand to still in early 2007, when foreigners began to lose their appetite for financing much of this activity, that too in the non-government bonds used to finance sub-prime mortgages, auto loans, college loans and loans used to finance big corporate takeovers.

To curb this panicking situation, the interest rate on those loans should have increased, demand for that kind of borrowing should have decreased, and the price of real estate and corporate stocks should have leveled off. These steps along with the takeover activity should have certainly slowed and companies should have begun to cut back on expansion.

Above all there was nobody willing to finance those lifestyles, and to overcome these issues, there are two choices available. Firstly, turn to Uncle Sam and keep the economy and the financial system afloat. Unlike businesses, households and Wall Street firms, the Treasury can still borrow from foreign banks and investors at incredibly attractive rates and by acting as an intermediary, the Treasury and the Federal Reserve have shown a newfound willingness to use those funds to keep the housing market and the financial system from totally collapsing.

Nevertheless, the only other choice is for Americans to finally put their spending in line with their incomes and their need for long-term savings. That's a bitter pill involving lost jobs, lower incomes and a big hit to government tax revenues. Think of that, as the inevitable second round of this financial crisis that, alas, still lies ahead.

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• Posted: 01 Oct 2008
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  The only question is whether this crisis will be of the same magnitude as the great depression of the late 1920s