It is entirely possible that the world economic crisis and the US Sub-prime mortgage fiasco in 2008 may have been foreshadowed by what I’d like to call the June 13 incident in 2007, specifically, what happened after that day. On that day, the interest-rate spread (the difference between the interest rates of two different investments) between the main junk-bond index (a.k.a. the dross standard) and the ten-year US Treasury Bond (a.k.a. the Gold Standard) shrank to just 2.4 (2.4%) percentage points ( 7.7% (junk bond) – 5.3% (Treasury Bond) = 2.4%). What does this basically mean?
Well, junk-bonds are considered far riskier investments than treasury bonds, so logically, since we are assuming more risk, we should expect higher ROIs (return on investments). Such a low interest-rate spread between these two meant that investors were in fact overpaying for riskier investments.
After the June 13 incident, many investors around the world suddenly woke up to the reality of the financial situation after the many dream years of strong global economic growth since 2003. Since the June 13 incident, investors have demanded higher returns for riskier investments and some even retreated back to US treasury bonds even though the interest rate was dropped to 5.2% and other blue-chip corporate bonds.
Many commercial banks in the US, caught off guard by this sudden shift in investor behavior, saw their risky sub-prime mortgages bond values plummet into the abyss as investors did not want to buy them anymore, causing them to lose billions of dollars. In a desperate measure to remedy the situation, the banks were suddenly less keen to lend money to people at low interest rates as compared to before, in order to prevent their balance sheets from collapsing further. This means that it is now much harder for businesses and consumers in the US to get loans since the ‘cost’ of capital is now much higher than previously.
The interest-rate spread has been growing ever since the June 13 incident. As of April 2007, the spread was about seven percentage points (7%). Since the world’s economic engine for the past few years was largely fueled by the American consumer spending beyond their means on cheap credit; economic growth now could be presumed to be much slower as American consumers begin to spend within their means.
How exactly did we get ourselves into this mess? Well, ironically, one of the major factors is world economic growth. After the gloomy days of September 11, 2001, the world economy rebounded from 2003 onwards and entered a period of booming economic growth.
The economies of China, India and Asia, which are more savings-oriented than the West, provided a flush of cash to world financial systems, making capital cheap and plentiful.
Now, usually, economic growth is a good thing, but not when it is coupled with easy money. Investors figured that with capital so cheap and abundant, and asset prices ever increasing, they could not lose! A good example is the sub-prime mortgage fiasco in the US, where people were loaning money to buy homes that they really couldn’t afford, but thought that they could due to ever increasing property prices in the US, which actually turned out to be a bubble. Cheap money also gave consumers the illusion that they were richer, so they borrowed more to fund their more lavish lifestyles.
Of course, such a situation cannot last very long, so after the June 13 incident, many investors around the world came to their senses. The result is that we are now potentially in the midst of another global economic crisis. The important lesson that we can gather from here is to watch for interest-rate spreads in the future, as an indicator for the value of ‘capital’ and as a possible sign of a looming economic crisis.
