A video that recently appeared in YouTube describes in just a few minutes how the current financial crisis came about.

The producer, Jonathan Jarvis, uses model-like images to illustrate what happened on the US housing and financial markets which subsequently led to the crisis that saw major investment banks come crashing down. Terms like leverage, credit debt obligation and subprime mortgage are visualised in a way that makes them very understandable. The film itself is rather unusual in terms of its presentation and layout, and the speed at which the facts are presented requires your full attention!

On behalf of the iconomix team

Ronald Indergand

The current financial crisis is largely due to undesirable developments in the US housing market. Following a major rise in house prices within very few years, the trend turned suddenly in mid-2006. For two years, prices have been sinking fast and an end to the nosedive is not yet in sight.

When searching for reasons for these developments, people often speak of speculative bubbles. What do they mean?

For economists, real estate is comparable to other assets like bonds or shares. The market price of an investment of this kind reflects the expectations of investors with regard to future flows of assets (dividends, interest payments, increases in value, etc.). If the outlook for the real economy worsens, the price will generally fall, and vice versa.

Alongside the market price, economists use the concept of fundamental value. This reflects the ‘true, realistic value’ of an investment, the intrinsic value of the security from the current point of view. Unlike the market price, this cannot be measured anywhere and has to be estimated by analysts and investors.

If investors’ expectations are speculative and over-optimistic (or over-pessimistic), the market price of a security may diverge radically from its fundamental value over a long period of time. In a situation of this kind, economists speak of a bubble.

Although the divergence may be large and often depends on psychological factors, the market price cannot depart from the fundamental value for an infinite length of time or by an infinite amount, but must ultimately readjust to it. This correction is typically very abrupt.

The reason is that once market participants have realised that a given category of assets is overvalued, a lot of them try to sell their securities simultaneously. This results in a crash.

Sometimes demands are made for monetary policy to try and actively combat scenarios of this kind. Although this sounds good in theory, it is hard to put into practice. This is because it is not possible to be certain whether price rises in given assets are actually a speculative bubble until the bubble has burst because of the uncertainties with respect to the fundamental value, as outlined above.

And even if a speculative bubble can be recognised as such in advance, it is unclear how monetary policy should react. It would require a massive intervention by the central bank (by means of a substantial increase in its key rates) to burst the bubble. However, this would have a very negative impact on the real economy (an extremely sharp downturn). Consequently, there is a substantial danger that such a policy would do more damage than good.

Thus, monetary policy is not really in a position to combat speculative bubbles. However, it can help to increase the resilience of the financial system so that the results of burst speculative bubbles are less serious. More on this in one of the next blog articles.

On behalf of the iconomix team

Ronald Indergand

As the Swiss daily Neue Zürcher Zeitung reported on 9 January 2009, Swiss pension funds have posted the worst investment results since the introduction of occupational pension schemes in 1985. The pension funds, which manage the occupational pension funds (BVG/LPP) of the employed working population in Switzerland, were unable to escape the effects of the financial crisis.

Since pension funds are obliged to pay interest on credit balances, they have to invest the funds that have been paid in so that an adequate return can be earned. In addition to interest, administration costs as well as certain provisions have to be covered. Despite a relatively defensive investment strategy, many pension funds have been faced with major accounting losses since the beginning of this year – most of them on Swiss and foreign shares.

As a result, the coverage ratio at about half of the pension funds has fallen below 100 percent. Such insufficient coverage ratios mean that these pension funds would not be in a position to pay out all their credit balances if an unforeseen event such as a liquidation forced them to do so.

Does this mean that people’s savings for their old age are endangered? Swiss law allows pension funds to run insufficient coverage ratios for a temporary period, and this is no reason for concern. However, in the event of such insufficient coverage, the pension funds are obliged to undertake restructuring measures. Here are some ways in which they can go about the task:

• Many pension funds attempt to reduce administrative costs in order to increase their efficiency. However, this measure on its own seldom solves all the problems.
• Interest paid on old-age savings is reduced. In exceptional cases, the pension fund may pay a rate lower than the statutory minimum interest rate of 2% (as of 1 January 2009, as laid down by legislation on occupational pension funds (BVG/LPP)).
• Benefits are not inflation-adjusted.
• Pension funds can require insured employees to pay in contributions to cover losses. The scope for requiring contributions to cover losses from pensioners is extremely limited.

Pension funds generally refrain from short-term alterations in their investment strategy (e.g. selling shares) since they have a long-term investment horizon and the security prices are expected to recover after the financial crisis. In other words, they have to ‘sit out’ the crisis, as far as possible.

On behalf of the iconomix team

Boris Kaiser