Financial Crisis- Simplified

So I was aked,in my english class, among other students, to give an outline of what is going on in the current financial crisis...while being clear and methodic in the explanation. This was my final presentation:

"When you deposit money in a Bank, you might think that this amount is held in a safe there until you wish to withdraw most of it. However, the banking system does not operate this way.

Your bank virtually takes a big amount of your money which is then lended to other borrowers.

What you should also keep in mind is that a bank has two main financial incomes:

- Your own deposits

- And the money it borrows from other investment banks

So if you ever want to borrow some money, in order for your bank to give it to you:

It must have the necessary capital (money); otherwise, it borrows the money from another investment bank

To sum it up, your debt is usually a consequence of your bank’s own debt

Now let us imagine a situation where most of the money is being injected into the economy without a reliable regulation. This means that all of the financial institutions have disbursed gigantic amounts of loans without even having enough fresh capital for any risk recovery. This is what happened to the investment banks Bear Stearns, Lehman Brothers, and Merrill Lynch who had all announced their bankruptcies. Goldman Sachs and Morgan Stanley are the only giants left standing. The media even reports that Morgan Stanley is actually fighting for survival and might consider a bail-out or a merger.

So what is really happening today?

What can usually happen on a micro level in a specific bank is actually happening today on a macro level on the stock market. Banks are contracting loan portfolios but there are no buyers for these loans anymore.

This failure in the banking system is the heritage of the mortgage lending crisis that has happened a couple of months ago on the American housing market. Loans were disbursed to people who in most cases failed to pay them back because of the increase in the interest rates and because of their rare assets (or sometimes, their lack of assets which are: Regular incomes, deposits in banks, valuable possessions etc)

In such a situation, banks can do two things:

- either raise some fresh capital

- or reduce their loan disbursments (stop giving loans for a while)

The second option is great if we are considering one bank. However, this is not what happened: The US financial institutions have all been sharply reducing their loan portfolios including loans to businesses and individuals. And as they all cut back on lending at the same time, the consequences on the economy as a whole have been drastic: a reduction in investment and spending, hence, a recession.

In such a systematic crisis, it is a raise of fresh capital that is needed which is why the Federal Reserve has injected billions of dollars into the stock market.

What are the consequences of this US financial crisis on the other economies?

As we all know, the US is very integrated in the financial market. Therefore, all of the developed economies have already launched major ways to overcome a potential recession. Most of the authorities are looking for means to comply with regulation without lowering the lending: Injecting billions of euros into the European stock market is one measure. Lowering the interest rate is another.

As for the growing economies (China mainly), the impact is relatively minor up to now but some spillovers can occur later on for such countries exporting to the US where the purchasing power and the investment are in trouble.

This expected recession is compared to that of the 1970's;
A recession is a contraction phase of the business cycle, defined broadly as: a significant decline in economic activity spread accross the economy, lasting more than a few months, normally visible in the real GDP, real income, employment, industrial production, and wholesale-retail sales."

Now, isn't it ironic that for the upcoming months, Africa will probably have the lightest decline in GDP? ... However, this continent might still strongly be affected by 3 factors:
- the reduction of its remittances (money sent home from expats)
- the exports and imports level (if the world demand of goods is lowered then the exporting countries will produce less and have less money to import later on)
- the private investment (discouragment of foreign firms to invest in other activities in other continents)

One student said something that really had an impact on us during his presentation about the lessons we could learn from this crisis: "The problem faced can also be the consequence of each of us thinking that our single decision or objection to something would never have a real impact on the system as a whole" He said that sentence while criticizing the bankers that were operating on the lowest level, and their chiefs who thought that they couldn't question the system: Why were they giving NINA loans? No Income No Asset loans??
He was a philosophy student. A good point was set out.