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One firm defaults, all their investors lose a bit of money. Now that they've lost a bit of money, they will have less money to lend to other firms. Now those fi

One firm defaults, all their investors lose a bit of money. Now that they've lost a bit of money, they will have less money to lend to other firms. Now those firms find it harder to service their debts (eg they were planning to roll over their loans with other loans), so some of them default. A firm in the real estate business defaults. That makes people think other firms in that business will also default. So then all real estate businesses find it a a bit harder to borrow. Add leverage. I buy a loan from a number RE businesses, but I don't just use the money in my pocket. I borrow it from the bank at a lower rate than what I receive from Evergrande. They go bust, bank asks me for money, I need to sell my other loans in the RE firms. Those loans will go down in value, reflecting higher rates and making it harder for the firms. This credit cycle is described by Soros in his books. Works both ways actually, when things are good it's the reverse.

technofiend 5y ago
That's the gentle dominoes falling version. Then there is the version where lending institutions completely rethink the risk in that sector. In that version they call loans and stop extending credit to same or similar businesses overnight. When Enron collapsed every other energy trading firm lost access to trading capital, taking out the entire sector. Whether or not energy companies should have been speculating in the futures market with borrowed money is a separate conversation.
- vlovich123 5y ago
  Maybe it’s not a separate conversation? Maybe you shouldn’t be allowed to speculate on the futures in your company’s sector?
DebtDeflation 5y ago
> One firm defaults, all their investors lose a bit of money. Now that they've lost a bit of money, they will have less money to lend to other firms. There's a lot more to it than that. You have to take into account 1) We have a fractional reserve banking system. When banks start individually calling in loans, there isn't enough "money" in the system for everyone to repay them. 2) Asset market prices (e.g., equities) reflect the present discounted values of expected future earnings. When everyone suddenly expects those future earnings to be less, the prices of those assets fall precipitously. That's not an issue in and of itself, except that those assets may have been purchased on margin (a loan) which depends on the value of those assets and may suddenly be called in for payment, forcing a liquidation of the underlying assets and further price falls. 3) As businesses scramble to pay loans that have been called and to adjust to a market where credit is difficult to come by (and businesses run on credit not cash) they reduce costs and often do so by laying off workers. This causes a reduction in aggregate demand (worker income) across the economy which further exacerbates the problem. There is inherent instability in the system and all sorts of positive feedback loops that can amplify an initial shock. Suggest reading Irving Fisher and Hyman Minsky to understand more.
- mohanmcgeek 5y ago
  I agree with (2) but on (1), isn't that about the liquidity _of the bank_. And when banks are illiquid like they were in 2008, the central bank creates liquidity through QE which isn't a bad thing unless you are questioning these banks' ability to repay the money they "borrowed" from the central bank.

technofiend 5y ago

That's the gentle dominoes falling version. Then there is the version where lending institutions completely rethink the risk in that sector. In that version they call loans and stop extending credit to same or similar businesses overnight. When Enron collapsed every other energy trading firm lost access to trading capital, taking out the entire sector. Whether or not energy companies should have been speculating in the futures market with borrowed money is a separate conversation.

vlovich123 5y ago
Maybe it’s not a separate conversation? Maybe you shouldn’t be allowed to speculate on the futures in your company’s sector?

DebtDeflation 5y ago

> One firm defaults, all their investors lose a bit of money. Now that they've lost a bit of money, they will have less money to lend to other firms. There's a lot more to it than that. You have to take into account 1) We have a fractional reserve banking system. When banks start individually calling in loans, there isn't enough "money" in the system for everyone to repay them. 2) Asset market prices (e.g., equities) reflect the present discounted values of expected future earnings. When everyone suddenly expects those future earnings to be less, the prices of those assets fall precipitously. That's not an issue in and of itself, except that those assets may have been purchased on margin (a loan) which depends on the value of those assets and may suddenly be called in for payment, forcing a liquidation of the underlying assets and further price falls. 3) As businesses scramble to pay loans that have been called and to adjust to a market where credit is difficult to come by (and businesses run on credit not cash) they reduce costs and often do so by laying off workers. This causes a reduction in aggregate demand (worker income) across the economy which further exacerbates the problem. There is inherent instability in the system and all sorts of positive feedback loops that can amplify an initial shock. Suggest reading Irving Fisher and Hyman Minsky to understand more.

mohanmcgeek 5y ago
I agree with (2) but on (1), isn't that about the liquidity _of the bank_. And when banks are illiquid like they were in 2008, the central bank creates liquidity through QE which isn't a bad thing unless you are questioning these banks' ability to repay the money they "borrowed" from the central bank.