The main aim of this paper is to analyse the recent financial crisis and to make recommendations how to handle it in the best possible way. Financial bubbles, since the great depression, have been analysed and some recommendations have been made taking into account the internationalization of the world economy which behaves like a domino. The recent financial crisis in the sub-prime mortgage market creates new problems in the world market with unforeseen continuances. Deflation has been referred to as a possible continuance after a financial bubble because often but not always deflation follows. Deflation often results in financial and economic crises. Financial and economic crises affect the architecture of the monetary system, while a change in the system may affect the role of the dollar, the euro and the yen

Thalassinos E.

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Bulletin of the Transilvania University of Braşov • Vol. 2 (51) - 2009  Series V: Economic Sciences  THE RECENT FINANCIAL BUBBLE:  AN OVERVIEW  El THALASSINOS 1  Abstract: The main aim of this paper is to analyse the recent financial crisis and  to  make  recommendations  how  to  handle  it  in  the  best  possible  way. Financial bubbles, since the great depression, have been analysed and some recommendations have been made taking into account the internationalization of the world economy which behaves like a domino. The recent financial crisis in the sub-prime mortgage market creates new problems in the world market with unforeseen continuances. Deflation has been referred to as a possible continuance after a financial bubble because often but not always deflation follows. Deflation often results in financial and economic crises. Financial and economic crises affect the architecture of the monetary system, while a change in the system may affect the role of the dollar, the euro and the yen.  Key words: Financial crisis, world economy, monetary system.                                                   1 Director of Graduate Studies in Maritime Studies www.maritime-unipi.gr, University of Piraeus, Greece, European Chair Jean Monnet, General Editor, European Research Studies Journal www.ersj.eu, Chairman ICABE www.icabe.gr. 1. Introduction Although, there is a tough debate between university  professors,  professionals  and market analysts regarding the characteristics and the reasons behind the current financial bubble, the present paper considers that the crucial characteristics of this credit crisis is a combination  of  less  available  and  more expensive  credit  in  addition  to  a  declining demand  which  eventually  will  hurt  even healthy companies.  It  is  known  that  corporate  financial decisions are driven by demand and supply factors.  In  that  respect  from  the  demand side  the  expected  decline  in  demand and the  likely  fall  in  capacity  utilization  will cause  companies  to  cut  back  on  new investments  in  capacity  and  expansion, stalling growth further and reducing their need for external capital. From the supply side, the available credit is now scarce and more  expensive  than  ever.  Selective financing  is  possible  with  significantly higher spreads.  2. The Current Financial Crisis The current financial crisis has affected almost all economic sectors hardly.  Auto industry,  shipping  industry,  construction industry,  banking/insurance  services  and agriculture are in great danger. Thousands of cars of all types are parked in free-zone lots, ships are anchored and empty around the  world,  construction  is  low,  letters  of credit have  disappeared  from  the  market, while  the  market  prices  for  most agricultural products are not fair.  We are facing a very tough environment and  certainly  a  recession  in  many countries. The question is: How severe will it be? Some observers have argued that it will be relatively short and shallow. They point to the relative  flexibility  of the  US economy  and  the  rapid  intervention  of Obama’s government. In  this  scenario,  the  main  issue  that companies will have to content with is the increased risk aversion and tighter lending standards  of  banks.  It  might  also  take  a while for confidence to return to the capital markets. This scenario favours companies with stronger credit profiles because they will  still  be  able  to  raise  funds,  not  just from  banks  in  home  markets  but  from Bulletin of the Transilvania University of Braşov • Vol. 2 (51) - 2009 • Series V  178global financial sources. The IMF has studied more than 100 past recessions around the world and arrived at a clear conclusion. Recessions induced by a  financial  crisis  are  deeper  and  worse. Such recessions tend to be  “two to three times  as  deep  and  two  to  four  times  as long” and to lead to “negative  growth  of 4.5%  of  GDP”.    In the  current  situation, the  overall  high  level  of  credit,  the financial bubbles, and the highly leveraged consumers in the US, are the main reasons to  be  worried  about.  Therefore,  real economies  around  the  world  need  to  be prepared  for  a  serious  recession  in  2009 and 2010. They have to plan for a situation in which banks continue to fail, consumer demand  continues  to  decline,  and  the unemployment rate goes up.  All  developed  economies  will  fall  into recession.  Under  this  development  what, specifically, are most companies in the real economy likely to face? According to what most  observers  believe,  we  are  going  to face:  • Difficult  access  to  funds  accompanied with significantly higher cost of capital • Weak  stock  markets  with  continued volatility • Credit losses • Significant  balance-sheet  risks,  reduced cash flows and low profit margins • More  government  intervention  along with protectionism and re-regulation • Shifts in consumer behaviour • Every  industry  will  be  affected  from  a consolidation wave. In such an environment, what will be the actions  to  be  taken  by  financial institutions?  A  proper  rescue-plan  is certainly  an  immediate  issue  for  the financial industry to make which must be consistent  with  the  conditions  of  every economy in the world.    3. Reality and Prospects  Due  to  internationalization  the  world economy behaves like a domino.  The recent financial bubble in the sub-prime mortgage market  creates  new problems in  the  world market with unforeseen continuances. For  example  deflation  is  a  possible continuance  after  financial  bubbles because  when  financial  bubbles  collapse, often  but  not  always  deflation  follows. Deflation  often  results  in  financial  and economic  crises  while  financial  and economic  crises affect the architecture of the monetary system. In this case, a change in  the  system  may  affect  the  role  of  the dollar, the euro and the yen. If  the  resources  of  the  US  economy  are sufficient to redefine financial markets, there will be a way to manage the outcome of this crisis. If the crisis becomes so large that even the  resources  of  a  $14  trillion  economy mobilized by the state cannot do the job, then the world economy is in great trouble. If the latter is true, then  all other discussions are irrelevant. Events will take their course, and nothing can be done. The world economy is going in a deep depression. If it is not true, that means that politics defines the crisis as it has other crisis. In that case, the US federal government  can  marshal  the  resources needed to redefine the markets. The federal government must act in due course, and an institutional resolution taking power from the Treasury will emerge as soon as possible. The  next  question  is  how  much  time remains before massive damage is done to the  world  economy.  If  there  is  no  time, events will take their course, and nothing can  be  done.  We  are  going  in  a  deep depression  again.  If  there  is  still  time events  will  take  their  course,  and something can be done. We are going in a deep recession. Therefore, in any case be prepared  for  either  a  deep recession  or a deep depression.  4.  The  How’s  and  the  Why’s  of  the Financial Crisis  There are actually two possible ways to deal  with the crisis. Allow the  market to solve  the  problem  over  time  or  have the state organize the resources of the society to  speed  up  the  resolution.  The  market solution  is  more  efficient  over  time, producing better outcomes and disciplining financial decision-making in the long run.  However,  it  is  known  that  the  market solution  can  create  massive  collateral damage such as high unemployment on the Thalassinos, E.: The Recent Financial Bubble: an Overview  179 way  to  the superior  resolution.  The state solution,  on  the  other  hand,  creates inequities  by  not  sufficiently  punishing poor economic decisions because it creates long-term inefficiencies that are costly and it  has  the  virtue  of  being  quicker  and mitigating collateral damage. Based  on  the  explanations  given  by distinguished  researchers,  the  current financial crisis can be attributed to at least 5 misleadings in the global economy.     • Lack  of  effective  regulation  in Investment Banking • Market makers • Risky  innovative  products  (toxic products) • Economy decline • Globalization. Some concerns about the crisis are still open  for  discussion.    Beyond  the uncertainties  which  the  real  banks  face, there is mounting concern around the rest of  the  shadow  banking  system  regarding Hedge  Funds,  Private  Equity  Funds,  and other alternative investors. What has begun as a leverage crisis and a credit crunch has turned  into  a  full-blown  insolvency problem as well. The globalization on US Treasuries with a  rate  close  to  60%  in 2008  may  be  the next weak point of the world economy. A huge  amount  of  money  in  the  US Treasuries  depends  on  the  kindness  of strangers.  The  globalization  on investments with a tremendous amount of capacity built up, a rate close to 23.5% of the global GDP in 2008  is another concern on how the crisis will be developing. The  huge  growth  in  derivatives  with  the outstanding  amount  of  open  positions  in OTC* (over the counter) derivatives markets reaching  35  times  the  US  GDP  in  2007 (about  $525  trillions  with  $13,8  trillions GDP) while in 2004 it was 14 times ($162 trillions  with  $11,6  trillions  GDP)  and  in 2001 it was only 6 times ($67 trillions with $10,1  trillions  GDP)  is  also  an  important issue  to  watch  for  since  the  current outstanding amount of open positions in OTC derivatives markets is 35 times the US GDP. Besides all the above, the changing face of the  US  economy  with  the  consumer spending close to 73% of the total GDP may be  the  next  weak  point  in  the  global economy.  5. Financial Pillars Looking  back  to  the  crisis  we  have realised that the  modern  financial system has been affected mainly on its pillars. It is known that the MFS rests on three pillars: • Capital • Liquidity • Confidence Regarding the first pillar, capital, in the 12  months  to  August  2008  the  reported losses have reached $250 billion in the US, $200 billion in Europe and $100 billion in Asia. These losses have depleted financial institutions’  capital  faster  than  they  can raise new capital.  Regarding  the  second  pillar  Illiquid capital markets have made it hard for them to  finance  their  own  debt.  For  the  third pillar,  falling  confidence  has  damaged inter-bank  lending  and  made  depositors jittery. As a result, it is not since the crash of  1929  that  the  global  financial  system has been subjected to such a severe shock.   The reasons behind the crisis are based on three widely held misconceptions: That the creditworthiness of borrowers was strong, that investors were sophisticated, that credit  risk  was  widely  distributed. Unfortunately none of them was valid. i.  The  creditworthiness  of  borrowers was strong That  was  however,  a  dangerous circularity to the logic. Lender and investor perception  of  healthy  homeowner  credit drove  spreads  lower,  causing  marginal borrowers to appear to be more financially attractive  than  they  were,  in  fact,  and making it easier to justify providing them financing.  ii. Investors were sophisticated  Lenders and investors were assumed to be exceptionally  sophisticated.  Advanced financial technology meant that the risk could be  finely  tailored  to  their  specific  needs. Strengthened by credit insurance and blessed by rating agencies, this risk was assumed to be  nearly  bullet-proof.  Consequently,  the capital applied against it was minimized. Bulletin of the Transilvania University of Braşov • Vol. 2 (51) - 2009 • Series V  180iii. Credit risk was widely distributed Market participants believed that the risk was  widely  distributed  among  global investors.  Even  if  credit  worsened  and analytics failed, the absence of concentrated risk would prevent systemic problems. This belief, more than any other factor, explains why people - instead of being worried of a market bubble - were under the impression that this time, it was different. Financial  markets  worldwide  are  still unstable,  harming  the  world  economy hardly.  They  reflect  ongoing  deleveraging pressures  amidst  a  deepening  economic downturn. In spite of extensive policies, the global  financial  system  remains  under intense  stress.  The  worsening  economic conditions  worldwide  are  producing  new, large write downs for financial institutions. According  to  some  analysts  the  new  bank write-downs  during  2010-2011,  after offsetting  the  anticipated  revenues,  would result in a capital shortfall of another half a trillion  dollars.  In response,  balance  sheets are being cut back through asset sales and the retiring  of  maturing  credits.  These  actions have increased downward pressure on asset prices and reduced credit availability.  6. Conclusions Restoring  the  financial  sector functionality and confidence are necessary elements of economic recovery. However, more  aggressive  actions  by  both  policy makers and market participants are needed to  ensure that the necessary  deleveraging process is less disorderly.   A  broad  three-pronged  approach including  liquidity  provision,  capital injections and  disposal  of problem  assets should  be  implemented  to  encourage balance sheet cleansing. At the same time, international  cooperation  will be  required to  ensure  the  policy  coherence  and consistency needed to re-establish financial stability. Are the main players in the world economy ready to cooperate?   Today, with the global financial system shaking what are the necessary steps to be taken, what are the new initiatives from the managerial and the financial point of view?  The Proposed Initiatives to be taken and/or to be adjusted are: From the managerial point of view: • Introduce  a  crisis-monitoring  team, which  will  monitor  the  key  early-warning  indicators  and  stress-test scenario  planning,  develop  scenarios, evaluate the competitive landscape and implement measures   • Cost  and  organizational  efficiency  - implement  new  measures  for  cost  and organizational  efficiency  that  can  be executed  without  risking  major opportunities • Plan  for  the  upturn  -  investments  that strong companies make in R&D, IT or new  infrastructure  will  only  come  on stream once the recession is over. From the financial point of view: • Watch your trade credits • Start  working  capital  initiatives  - improve processes  to  monitor  working capital • Look  for  opportunities  and  engage  in selective  M&As  -  recession  changes some of the long-standing “rules of the game”.  Take  advantage  of  the weaknesses  of  competition  in order  to redefine the industry.  References  1.  Thalassinos,  E.,  2008,  “Financial Bubbles: What is Next?” International Conference  on  Applied  Business  and Economics, 2-4 October, University of Thessaloniki. 2.  Thalassinos, E., 2009, “The How’s and the  Why’s  of  the  Financial  Crisis” International  Conference  on  Applied Business and Economics, 1-3 October, Technological Educational Institute of Kavala. 3.  Thalassinos,  E.,  2008,  “Trends  and Developments  in  the  European Financial  Sector”,  European  Financial and Accounting Journal, vol. 3, no. 3, pp. 51-68. 4.  Thalassinos,  E.,  2007,  “Trade Regionalization,  Exchange  Rate Policies  and  EU-US  Economic Cooperation”,  European  Research Studies  Vol. X, Issue 1-2.  

The Recent Financial Bubble: an Overview

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