After reading the article "Economics 101" in today's papers, I think I want to share what I have learned in my own words. This will help to crystallize my thoughts as well as help others to be more informed about the financial crisis on Wall Street. This crisis is resonating to the rest of the world. First, let's understand a couple of terminologies.
SUBPRIME LOAN: This is simply a loan given to borrowers who are at high risks of defaulting on repayment. In the U.S. it is reported that up to 25% of all mortgages are subprime.
CDO: Stands for collateralised debt obligation.In order to get money to loan out, the finance companies sell bonds ("IOU's", in simple terms) that yield high interest rates. Who buys? Pension Funds, local councils all over the world, trust funds, private investors, etc... all looking for high interest rates on their fixed deposits. These bonds were even given AAA rating by the ratings agencies.
Chief executives of big financial institutions are paid millions each year, yet they seem to have been sleeping on the job. They participated in the financial feeding frenzy that has allowed their pay and bonuses to balloon, while at the same time encouraging practices that border on the scandalous. The most outstanding of all must be Henry Paulson, the U.S. Treasury Secretary himself. As chief executive of Goldman Sachs he paid himself US$37mil in 2005. Goldman Sachs is one of the financial institutions that has to be rescued; so how could Henry Paulson have done such a brilliant job to earn him US$37mil in one year? Now, Paulson, as Treasury Secretary, is asking Congress for money to bail out all the companies that have participated in decades of financial madness. The very same person who seemed oblivious to what eventually brought Goldman Sachs down, is now trying to steer the U.S. economy out of financial ruins.
As for the U.S. bailout plan, here are some interesting points:
The US$700bil requested for bailout was an arbitrary figure. It was reported that a U.S. Treasury spokeswoman told Forbes magazine that "we just wanted to choose a really large number". Is that enough? I doubt it. The outstanding mortgage debt in the U.S. is US$14 trillion. As a quarter of that is subprime, that means US$3.5 trillion is at risk. Is US$700bil enough?