Making sense of the Financial Crisis

I’m sure you all know by now about the Financial Crisis that’s been going on lately. But why did it happen? What does it mean to us as a country? Before anything, lets have a quick summary of what’s going on (I keep it updated as the days go by):

In a very short amount of time JP Morgan took over Bear Stearns, Fannie Mae/Freddie Mac were nationalized, Lehman Brothers filed Chapter 11 bankruptcy, Bank of America bought Merrill Lynch, and both AIG and WaMu are in serious trouble. The Government is now putting in $85 Billion to own 79.9% of AIG, in hopes to make an eventual liquidation event less dramatic. JP Morgan is looking to buy out WaMu too. Out of the big 5 investment broker-dealers, only Morgan Stanley and Goldman Sachs are relatively out of the mess, but still have reported huge losses this year.

Lehman’s bankruptcy would be the largest failure of an investment bank since Drexel Burnham Lambert collapsed amid fraud allegations 18 years earlier. AIG has $1.1 trillion in assets and 74 million clients in 130 countries. If it falls apart, the world will definitely fall into some financial chaos (come Fight Club?).

So why is this happening? It’s primarily because of the nature of our economy. The United States economy is run on two things: Credit and Confidence. People lend money, live above their means, and look to pay it all back with their next 30 years of steady income. That’s why credit card companies are making big bucks here in the US, but less so in other nations. Also, the value of certain entities is not based on how much value it can PRODUCE, but more on how much value it is TO OTHERS. That instantly creates a “virtual economy” : something that works because everyone imagines it to work. In essence, money is a virtual good too. It is only worth something because everyone agrees that it does. A farm is a real good, and it produces real value that keeps people alive. However, people start to agree that a virtual good is worth many times that farm, and as long as you can convince the next person that this virtual good is EVEN more times that farm, you are fine. That’s why when people lose confidence in their currency, hyperinflation like what happened to Germany takes over, and the virtual goods on peoples’ hands become 1/10 of what they were worth yesterday, and everyone comes back to recognize the value of the farm. Unfortunately, it is not the farm owners who become millionaires, but the virtual goods people who go broke.

So how does this Credit – Confidence model lead to what is happening today? Early on, during the real estate inflation, Confidence was high, and a lot of bad loans (Credit) were thrown out there. Later on, people couldn’t pay up with their mortgage loans, and the Subprime Mortgage happened. This is the part where Credit goes bad. The economy tanked, and mortgage companies like Countrywide lost a lot of money. Confidence at this point is not looking stellar.

During this time of Credit gone bad, the 30x leverage that Bear Stearns and Lehman Brothers had (for every $1 of asset, they had $30 of debt) wasn’t helping either. Bear Stearns fell apart when Confidence broke and all the entities were trying to withdraw money from it, causing it to be bought by JP Morgan. Lehman continued to suffer from heavy losses based on the bad Credit with the “Subprimates.” It was only holding on by Confidence too. Late August (and this is of course 2008), state-controlled Korea Development Bank engaged in talks about buying 25% of Lehman for $6B. However, it was reported that the Korean bank was “facing difficulties pleasing regulators and attracting partners for the deal,” and they withdrew from it. At this point, Lehman lost its last currency of Confidence, and while debtors wanted to pull money out, Lehman became insolvent and had to finally declare bankruptcy.

Now the Confidence factor is very tricky. It is like the prisoners dilemma in game theory. If everyone felt confident about the situation and kept their money where it is, then things will go fine. However, whoever withdraws their money will be safe themselves and screw over the rest of the people. In order not to get screwed over, everyone becomes the first to withdraw their money, and the system falls apart. This then becomes a situation where fear of a disaster is also the cause of that disaster, quite a self-fulfilling tragedy.

Does a nation have to live by the Credit-Confidence Model and go through this? Not necessarily. However, basing your economy on credit and confidence does make it grow a lot faster during boom (high confidence) times, just like wealth can grow faster if you borrow money to buy a house, and the guy down the street thinks its worth more than what you bought it for. The other side of the flip coin is that it also falls a lot harder when everyone is chasing after the same virtual good with relatively little end value. It is more of a choice based on cultural values. In Asian countries, most people live on the cash they have at hand, save a lot, and mostly start businesses that can be run by retained earnings or profits from previous businesses. In the US, more people rely their standard of living on credit cards and mortgages. The US lives on a huge international deficit, claiming that all is fine as long as it is somewhat relative to the GDP of THAT time. The US is set in a model that is bound to rotate between explosion and depression.

What does this mean for us? In a plane economics model, we should cut down on credit and increase inconfidence? If we all felt safe and do business as usual, things might work out. However, that’s not going to happen. We are all doomed into the “citizens dilemma” of trying to protect our own rights before thinking about the common good, particularly when you are sure that the other guy would do the same thing. When everyone stands up in the stadium in hopes to have a better view of the game, no one can see again. It will only take awhile before the brave optimists start to regain that confidence, somewhat of an “early adapter,”¬† and have that confidence spread across the nation again. That’s when you see the explosion in economy and a new hand of billionaires again.

As for now, you should definitely think about saving (maybe not in US dollars), consume less, and go on sites that get you a job.

I have relocated to the Bay Area. Currently at Fremont.

So I have finally moved. It has been quite a rough one. 2 months ago I agreed to live with a friend in Oakland, and I left some of my stuff there. I told him I will go early September.

Then comes September 5th. Before that my friend was in Taiwan, so I couldn’t really get in touch with him. He told me September 5th he would come back. It all works out. I packed everything I own in the United States onto my car, and I called him to let him know that I will be there the next day. Oops, it turns out that he is shutting the place down, moving his operations elsewhere, and he forgot to tell me. At that point I have already moved out of my apartment, but had no where to move to. My friend is a cool guy, and is extremely apologetic. However, my life became complicated.

After living at various friends’ places in Socal, I started my drive up. I passed by my friend’s 600 acre ranch, and spent 2 days there. I met a lot of great friends from the California Student Sustainability Coalition and connected with some awesome old friends like Michael Cox, Crystal Durham and Nancy Brown. During this time, I still had no idea where would I move to.

Finally, when I got here, my Aunt’s friend knows someone who is looking for a person to occupy a room in her home. It looked nice, so I decided to move in.

It’s a fairly nice place. I have my own room. There are a pair of elder couples, a woman, and a college girl living in this house too, and they all seem extremely friendly. The place is 30 min away from Palo Altos (Silicon Valley and Stanford), an hour away from Oakland, and 90 min away from San Francisco. Not bad at all! Most of all, this is 10 minutes away from Eagle’s uncle’s house. Eagle is our developer from Canada, and he is moving to the Bay Area with me. Being so close to his Uncle, he could probably live with his Uncle and save a lot of costs. I pay $600 a month, which I seem to be able to afford for at least a few months. Everything seems to be working out. Now I just need to figure out what is around, and learn how to use the BART system.

Why did I move to the Bay Area? Because Silicon Valley is the High-Tech Startup Hub. If you want to do finance, you should go to New York. If you want to be a movie star, there is no reason to stay in Arizona. You should go to Hollywood. Similarly, if you are building a high-tech startup, you should go to Silicon Valley. All the infrastructure, support system, talents and money are here. You find others who moved away from their hometown to persue the same dream that you have. I can’t explain what it is, but the 3-4 times I came to Norcal, it really felt like home. The weather seems nice, the sky seems more blue, people are supportive and high quality at the same time…it just seemed like where I belonged. A well respected SEO guy Sean Percival told my CMO Jun that there is also a central startup hub emerging in the area between West Hollywood and Santa Monica, and even though it is second to Silicon Valley, if you start making a name there now, later you can be easily recognized as a big name due to low competiton. With that in mind, I would still like to be up here and seek more opportunities, meet great people, and hopefully create good value to everyone who I interface with in my life.

Anyone, if you are around or know good people I should meet. Let me know! I start afresh here, and would love to meet great people!