Learning from the six phases of economic crisis

There’s a lot of confusion about the state of the economy and where we are moving.To understand where we are heading economically, it’s necessary to understand the nature of financial crises. Crises aren’t single events that have measurable, easily understood beginnings and endings, but are, in fact, complex situations comprised of a number of phases. In the case of financial crises, they tend to be made up of six distinct phases.Many believe the current crisis began in September and October of 2008 with the meltdown of the financial industry. In fact, the first phase actually began in 2005.The first phase of a financial crisis typically occurs when banks loosen lending rules resulting in businesses and individuals over-leveraging themselves.This trend continued right through 2007. Money was readily available, even to those who didn’t have good credit, and this started the slide as individuals and businesses alike became overextended.The next phase of a typical financial crisis is characterized by a slow recognition that many of these loans are not going to be paid back. We saw this in 2008 and early 2009.During this phase, while financial institutions are in danger of going bankrupt, central banks and governments typically step in and try to save the banking system. There is considerable danger of runs on banks, as we saw in both America and overseas, as there is never more than a fraction of depositors’ money available at any one time for withdrawal.This is exactly what began to happen. Banks tightened credit and businesses couldn’t get money to pay workers or invest in improvements. The resulting layoffs caused an economic chain reaction as there were fewer people working and buying goods. Even those who kept their jobs tightened their belts for fear they could be next. This is a moment of maximum danger, when the economy can slide into depression with unemployment of 20 percent or more. We actually saw the beginnings of that slide in early 2009.Failing mortgagesPhase two typically comes to a close when the government pumps money into the banks, attempting to instill confidence and give banks the opportunity to raise capital themselves.When they do, this signals the third phase of the financial crisis. Amazingly, the banks thrived last year during this phase.The economy starts to recover because banks start to lend money to businesses again, ushering phase four. However, you still have large numbers of unemployed people and lenders start to see more people falling behind on their mortgage payments.Banks get stuck with more and more properties while the value of those properties is often less than the amount of the loan. Tack on legal, real estate and fees to get the house in shape to sell, and you have a substantial loss. As a result, banks that appeared to be strong suddenly look very weak again.This begins the fifth stage of the crisis, which is where we are now. Governments discover that they aren’t able to collect as much in taxes, so they become faced with layoffs themselves or raising taxes – or both.In rare cases, governments have to file for bankruptcy, as Orange County, Calif., and Bridgeport, Conn., did during the last financial crisis.Real recoveryAs the crisis continues, the stock market is typically “talked up” and can make the economy as a whole look stronger than it may actually be. That’s one reason why there is such a disconnect right now between the general economy and the stock market which experienced significant gains from March 2009 through April 2010.Eventually investors figure out that the situation isn’t as rosy as it appears and they pull back. That explains the volatility that the markets have experienced since April.The good news is that relief finally comes in the sixth phase of economic crisis.Despite the economy bottoming and unemployment remaining high, banks finally begin to loan to viable companies and individuals. Phase six, however, comes with a dark flourish: stock markets can be expected to drop significantly as investors realize that the crisis isn’t really over just yet.Once the markets have settled, we typically see an amazing bull market which lasts many years and makes patient investors very wealthy.Nicholas Rowe, CFP, is a senior partner at Focus Capital Wealth Management Inc. in Bedford. The firm can be found online at focus-capital.com.