The Basic reason behind recessionThese days the most talked about news is the current financial crisis that has engulfed the worldeconomy. Every day the main headline of all newspapers is about our falling share markets,decreasing industrial growth and the overall negative mood of the economy. For many people aneconomic depression has already arrived whereas for some it is just round the corner. In myopinion the depression has already arrived and it has started showing its effect on India.So what has caused this major economic upheaval in the world? What is the cause of fallingshare markets the world over and bankruptcy of major banks? In this article, I shall try to explainthe reasons for recent economic depression for all those who find it difficult to understand thecomplex economics lingo and are looking for a simple explanation.It all started in US…In order to understand what is now happening in the world economy, we need to go a little backin past and understand what was happening in the housing sector of America for past manyyears. In US, a boom in the housing sector was driving the economy to a new level. Acombination of low interest rates and large inflows of foreign funds helped to create easy creditconditions where it became quite easy for people to take home loans. As more and more peopletook home loans, the demands for property increased and fueled the home prices further. Asthere was enough money to lend to potential borrowers, the loan agencies started to widen theirloan disbursement reach and relaxed the loan conditions.The loan agents were asked to find more potential home buyers in lieu of huge bonus andincentives. Since it was a good time and property prices were soaring, the only aim of mostlending institutions and mortgage firms was to give loans to as many potential customers aspossible. Since almost everybody was driving by the greed factor during that housing boomperiod, the common sense practice of checking the customer‟s repaying capacity was alsoignored in many cases. As a result, many people with low income & bad credit history or thosewho come under the NINJA (No Income, No Job, No Assets) category were given housing loansin disregard to all principles of financial prudence. These types of loans were known as sub-prime loans as those were are not part of prime loan market (as the repaying capacity of theborrowers was doubtful).Since the demands for homes were at an all time high, many homeowners used the increasedproperty value to refinance their homes with lower interest rates and take out second mortgagesagainst the added value (of home) to use the funds for consumer spending. The lendingcompanies also lured the borrowers with attractive loan conditions where for an initial period theinterest rates were low (known as adjustable rate mortgage (ARM). However, despite knowingthat the interest rates would increase after an initial period, many sub-prime borrowers opted forthem in the hope that as a result of soaring housing prices they would be able to quicklyrefinance at more favorable terms.Bubble that burst…
However, as the saying goes, “No boom lasts forever”, the housing bubble was to bursteventually. Overbuilding of houses during the boom period finally led to a surplus inventory ofhomes, causing home prices to decline beginning from the summer of 2006. Once housing pricesstarted depreciating in many parts of the U.S., refinancing became more difficult. Home owners,who were expecting to get a refinance on the basis of increased home prices, found themselvesunable to re-finance and began to default on loans as their loans reset to higher interest rates andpayment amounts.In the US, an estimated 8.8 million homeowners - nearly 10.8% of total homeowners - had zeroor negative equity as of March 2008, meaning their homes are worth less than their mortgage.This provided an incentive to “walk away” from the home than to pay the mortgage.Foreclosures ( i.e. the legal proceedings initiated by a creditor to repossess the property for loanthat is in default ) accelerated in the United States in late 2006. During 2007, nearly 1.3 millionU.S. housing properties were subject to foreclosure activity. Increasing foreclosure rates andunwillingness of many homeowners to sell their homes at reduced market prices significantlyincreased the supply of housing inventory available. Sales volume (units) of new homes droppedby 26.4% in 2007 as compare to 2006. Further, a record nearly four million unsold existinghomes were for sale including nearly 2.9 million that were vacant. This excess supply of homeinventory placed significant downward pressure on prices. As prices declined, more homeownerswere at risk of default and foreclosure.Now you must be wondering how this housing boom and its subsequent decline is related tocurrent economic depression? After all it appears to be a local problem of America.What complicated the matter?…Unfortunately, this problem was not as straightforward as it appears. Had it remained a matterbetween the lenders (who disbursed risky loans) and unreliable borrowers (who took loans andthen got defaulted) then probably it would remain a local problem of America. However, thiswas not the case. Let us understand what complicated the problem.
For original lenders these subprime loans were very lucrative part of their investment portfolio asthey were expected to yield a very high return in view of the increasing home prices. Since, theinterest rate charged on subprime loans was about 2% higher than the interest on prime loans(owing to their risky nature); lenders were confidant that they would get a handsome return ontheir investment. In case a sub-prime borrower continued to pay his loans installment, the lenderwould get higher interest on the loans. And in case a sub-prime borrower could not pay his loanand defaulted, the lender would have the option to sell his home (on a high market price) andrecovered his loan amount. In both the situations the Sub-prime loans were excellent investmentoptions as long as the housing market was booming. Just at this point, the things startedcomplicating.With stock markets booming and the system flush with liquidity, many big fund investors likehedge funds and mutual funds saw subprime loan portfolios as attractive investmentopportunities. Hence, they bought such portfolios from the original lenders. This in turn meantthe lenders had fresh funds to lend. The subprime loan market thus became a fast growingsegment. Major (American and European) investment banks and institutions heavily boughtthese loans (known as Mortgage Backed Securities, MBS) to diversify their investmentportfolios. Most of these loans were brought as parts of CDOs (Collateralized Debt Obligations).CDOs are just like mutual funds with two significant differences. First unlike mutual funds, inCDOs all investors do not assume the risk equally and each participatory group has different riskprofiles. Secondly, in contrast to mutual funds which normally buy shares and bonds, CDOsusually buy securities that are backed by loans (just like the MBS of subprime loans.)Owing to heavy buying of Mortgage Backed Securities (MBS) of subprime loans by majorAmerican and European Banks, the problem, which was to remain within the confines of USpropagated into the word‟s financial markets. Ideally, the MBS were a very attractive option aslong as home prices were soaring in US. However, when the home prices started declining, theattractive investments in Subprime loans become risky and unprofitable.As the home prices started declining in the US, sub-prime borrowers found themselves in amessy situation. Their house prices were decreasing and the loan interest on these houses wassoaring. As they could not manage a second mortgage on their home, it became very difficult forthem to pay the higher interest rate. As a result many of them opted to default on their homeloans and vacated the house. However, as the home prices were falling rapidly, the lendingcompanies, which were hoping to sell them and recover the loan amount, found them in asituation where loan amount exceeded the total cost of the house. Eventually, there remained nooption but to write off losses on these loans.The problem got worsened as the Mortgage Backed Securities (MBS), which by that time hadbecome parts of CDOs of giant investments banks of US & Europe, lost their value. Fallingprices of CDOs dented banks‟ investment portfolios and these losses destroyed banks‟ capital.The complexity of these instruments and their wide spread to major International banks created asituation where no one was too sure either about how big these losses were or which banks hadbeen hit the hardest.Mayhem in the banks….
The effects of these losses were huge. Global banks and brokerages have had to write off anestimated $512 billion in subprime losses so far, with the largest hits taken by Citigroup ($55.1billion) and Merrill Lynch ($52.2 billion). A little over half of these losses, or $260 billion, havebeen suffered by US-based firms, $227 billion by European firms and a relatively modest $24billion by Asian ones.Despite efforts by the US Federal Reserve to offer some financial assistance to the beleagueredfinancial sector, it has led to the collapse of Bear Sterns, one of the world‟s largest investmentbanks and securities trading firm. Bear Sterns was bought out by JP Morgan Chase with somehelp from the US Federal Bank (The central Bank of America just like RBI in India)The crisis has also seen Lehman Brothers - the fourth largest investment bank in the US and theone which had survived every major upheaval for the past 158 years - file for bankruptcy. MerrillLynch has been bought out by Bank of America. Freddie Mac and Fannie Mae, two giantmortgage companies of US, have effectively been nationalized to prevent them from goingunder. Reports suggest that insurance major AIG (American Insurance Group) is also undersevere pressure and has so far taken over $82.9 billion so far to tide over the crisis.From this point, a chain reaction of panic started. Since banks and other financial institutes arelike backbone for other major industries and provide them with investment capital and loans, aloss in the net capital of banks meant a serious detriment in their capacity to disburse loans forvarious businesses and industries. This presented a serious cash crunch situation for companieswho needed cash for performing their business activities. Now it became extremely difficult forthem to raise money from banks.What is worse is the fact that the losses suffered by banks in the subprime mess have directlyaffected their money market the world over.Now what is a money market?Money Market is actually an inter-bank market where banks borrow and lend money amongthemselves to meet short-term need for funds. Banks usually never hold the exact amount of cashthat they need to disburse as credit. The „inter-bank‟ market performs this critical role ofbringing cash-surplus and cash-deficit banks together and lubricates the process of creditdelivery to companies (for working capital and capacity creation) and consumers (for buyingcars, white goods etc). As the housing loan crisis intensified, banks grew increasingly suspiciousabout each other‟s solvency and ability to honour commitments. The inter-bank market shrank asa result and this began to hurt the flow of funds to the „real‟ economy. Panic begets panic and asthe loan market went into a tailspin, it sucked other markets into its centrifuge.The liquidity crunch in the banks has resulted in a tight situation where it has become extremelydifficult even for top companies to take loans for their needs. A sense of disbelief and extremeprecaution is prevailing in the banking sectors. The global investment community has becomeextremely risk-averse. They are pulling out of assets that are even remotely considered risky andbuying things traditionally considered safe-gold, government bonds and bank deposits (in banksthat are still considered solvent).
As such this financial crisis is the culmination of the above mentioned problems in the globalbanking system. Inter-bank markets across the world have frozen over. The meltdown in stockmarkets across the world is a victim of this contagion.Governments and central banks (like Fed in US) are trying every trick in the book to stabilize themarkets. They have pumped hundreds of billions of dollars into their money markets to try andunfreeze their inter-bank and credit markets. Large financial entities have been nationalized. TheUS government has set aside $700 billion to buy the „toxic‟ assets like CDOs that sparked off thecrisis. Central banks have got together to co-ordinate cuts in interest rates. None of this hasstabilized the global markets so far. However, it is hoped that proper monitoring and controllingof the money market will eventually control the situation.How it has affected India?In the age of globalization, no country can remains isolated from the fluctuations of worldeconomy. Heavy losses suffered by major International Banks is going to affect all countries ofthe world as these financial institutes have their investment interest in almost all countries.As of now India is facing heat on three grounds: (1) Our Share Markets are falling everyday, (2)Rupee is weakening against dollars and (3) Our banks are facing severe crash crunch resulting inshortage of liquidity in the market.Actually all the above three problems are interconnected and have their roots in the above-mentioned global crisis.For the last two years, our stock market was touching new heights thanks to heavy investmentsby Foreign Institutional Investors (FIIs). However, when the parent companies of these investors(based mainly in US and Europe) found themselves in a severe credit crunch as a result of sub-prime mess, the only option left with these investors was to withdraw their money from IndianStock Markets to meet liabilities at home. FIIs were the main buyers of Indian Stocks and theirexit from the market is certain to wreak havoc in the market. FIIs who were on a buying spreelast year, are now in the mood of selling their stocks in India. As a result our Share Markets aretouching new lows everyday.Since, the money, which FIIs get after selling their stocks, needs to be converted into dollarsbefore they can sent it home, the demands for dollars has suddenly increased. As more and moreFIIs are buying dollars, the rupee is loosing its strength against dollar. As long as demands fordollars remain high, the rupee will keep loosing its strength against dollar.The current financial crisis has also started directly affecting Indian Industries. For the past fewyears, the two most preferred method of raising money by the companies were Stock Marketsand external borrowings on low interest rates. Stock Markets are bleeding everyday and it is notpossible to raise money there. Regarding external borrowing from world markets, this option hasalso become difficult.
In the last fiscal year alone, India borrowed $29 billion from foreign lenders and got $34 billionof foreign direct investment. A global recession has hurt external demand. International lenderswho have become extremely risk aversive can limit access to international capital. If thathappens, both India‟s financial markets and the real economy will be hurt in the process.Suddenly, the 9% growth target does not seem that „doable‟ any more; we should be happy toclock 7% this fiscal year and the next.However, one positive point in favor of India is the fact that Indian Banks are more or lesssecured from the ill-effects of sub-prime mess. A glance at Indian banks‟ balance sheets wouldshow that their exposure to complex instruments like CDOs is almost nil. In India, still the majorbanking operations are in the hands of Public Sector Banks who exercise extreme cautions indisbursing loans to needy people/companies. As a result, we are not likely to see a repeat of sub-prime crisis in India. Though there have been a presence of big US/European Banks in India andeven some Indian banks (like ICICI) have some foreign subsidiary with stake in the sub-primelosses, there presence is miniscule as compare to the overall size of Indian banking industry. Soat least on this major front we need not worry much.However, a global depression is likely to result in a fall in demand of all types of consumergoods. In 2007-08, India sold 13.5% of its goods to foreign buyers. A fall in demand is likely toaffect the growth rate this year. Our export may get affected badly.A negative atmosphere, shortage of cash, fall in demands, reducing growth rate and uncertaintiesin the market are some of the most visible aspects of an economic depression. What started as asmall matter of sub-prime loan defaulters has now become a subject of global discussion and hasengulfed the global economy scenario.Greed of some…woes of billionsIf you think about this with a cool mind, you will find that the underlying cause of thisdepression is the greed of those who failed to anticipate the consequence of their actions. On amore ideological front, it is high time to have a rethink on the very idea of free markets andcapitalism. I think the time has come to evolve a capitalism where everything works under abroad regulatory framework and we do not see a repeat of this condition where greed of somepeople can affect the lives of billions.So here concludes my attempt to explain the current economic crisis which has started to affectthe lives of all of us. The above explanation is very simple and by no means it presents anaccurate picture (i.e the one that includes all the micro/macro factors) of the crisis. However, Ihope that it must have given you a broad idea of the reasons behind current economic depression.Feel free to post your comments on this issue.In one of my earlier posts, I wrote about the causes of global recession. This post become quitepopular and hundreds of people thanked me for the simple explanation of this phenomenon. Thisis article is in continuation of what I wrote in that post.
Sub-prime mess which was the main theme of that post and the prime reason that eventuallysparked a world wide recession is at best an immediate cause of the recession. In this post, I willthrow some light on the reason behind the very emergence of a sub-prime situation and whydespite pumping of billions of dollars into the world economy, it is still not showing any sign ofrecovery.In my first post on recession, I told you about how availability of an easy credit situationprompted the US lending institution to lend money to sub-prime borrowers and how these riskydeals turned into a nightmare for big financial institution. In this post, we will be discussing threemain issues :(1) How American economy became so full of cash that made availability of loans for almosteverything so easy?(2) Why American banks could not foresee the risk involved in sub-prime loans?(3) Why the situation is not improving as fast as expected despite stimulus package of billons ofdollars?From where the Cash came in US ?In order to understand how US economy got flooded with dollars, we need to go back in time bya decade. In 1997-98, the tiger economies of Asia (a term used to refer the countries of SouthEast Asia like Thailand, Malaysia, Indonesia etc) suffered a major economic crisis. Though it isnot necessary to know the details of this crisis, a brief overview of that crisis will help usunderstand the current mess in world as it is all linked.During those years, several countries of South East Asia had developed worrying financialweaknesses which were the results of heavy investment in highly speculative real estate ventures,financed by borrowing either from poorly informed foreign sources or by credit from underregulated domestic financial institutions.The crisis began with wrong banking practices. In those countries crony capitalism (whereborrower had the connections with government) became too dominant. The minister‟s nephewor the president‟s son could open a bank and raise money both from the domestic populace andfrom foreign lenders, with everyone believing that their money was safe because officialconnections stood behind the institution. Government guarantees on bank deposits are standardpractice throughout the world, but normally these guarantees come with strings attached. Theowners of banks have to meet capital requirements (that is, put a lot of their own money at risk),restrict themselves to prudent investments, and so on. In Asian countries, however, too manypeople were granted privilege without responsibility, allowing them to play a game of “heads Iwin, tails somebody else loses.” And the loans financed highly speculative real estate venturesand wildly overambitious corporate expansions.This bubble was inflated still further by credulous foreign investors, who were all too eager toput money into faraway countries about which they knew nothing (except that they werethriving). It was also, for a while, self-sustaining: All those irresponsible loans created a boom in
real estate and stock markets, which made the balance sheets of banks and their clients lookmuch healthier than they were.However, this bubble had to burst sooner or later. At some point it was going to become clearthat the high values Asian markets had placed on their assets weren‟t realistic. Speculativebubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of investorsbegin to wonder whether the bubble would burst, it did.So Asia went into a downward spiral. As nervous investors began to pull their money out ofbanks, asset prices plunged. As asset prices fell, it became increasingly doubtful whethergovernments would really stand behind the deposits and loans that remained, and investors fledall the faster. Foreign investors stampeded for the exits, forcing currency devaluations, whichworsened the crisis still more as banks and companies found themselves with assets in devaluedbaht or rupiah, but with liabilities in lamentably solid dollars.In 1996 capital was flowing into emerging Asia at the rate of about $100 billion a year; by thesecond half of 1997 it was flowing out at about the same rate. Inevitably, with that kind ofreversal, Asia‟s asset markets plunged, its economies went into recession, and it only got worsefrom there.Eventually International Monetary Fund (IMF) had to step in to save these economies. Howthese economies later recovered and at what cost is a different story. However, this crisisbrought with it some major lessons for the Asian economies. One of the most important lessonsfor them was to create a solid Foreign Exchange Reserve so as to withstand the most volatile exitof the money from their markets. High reserves promise safety in a storm. Therefore, most majoreconomies of Asia (including the big China and India) adopted a strategy of maintaining highforex reserve so as to ensure safety from any such crisis in future. This shift in priorities createda very interesting situation.In the mid-1990s, the emerging economies of Asia had been major importers of capital,borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98
these countries began protecting themselves by amassing huge war chests of foreign assets, ineffect exporting capital to the rest of the world.To say in other words, the Asian economy came in to a Saving mode. In order to maintain hugeforeign reserve, they also started buying US securities. This resulted in a huge inflow of dollarsinto the US economy. As more and more dollars kept coming into the US economy from worldover, the American investors started devising very sophisticated and innovative methods toconvert the flood of money from Asia into a borrowing and spending spree for Americanconsumers.Now instead of writing as to how and why this saving tendency of Asian Economies has resultedinto the current global mess, I would like to point you towards two excellent articles on thisissues written by two of my favorites economists. These articles are very well written in alayman‟s language and they will clarify all your doubts about the role Asian economies incurrent global recession.The first article is : High forex reserves can worsen recessionWritten by Swaminathan S. Anklesaria Aiyar who is Consulting Editor, Economic Times, thepopular financial newspaper of India. He is my favorite columnist.Second article is : Revenge of the GlutWritten by noted economist, the Nobel winner Paul Krugman. In this article he has concludedthat the world is suffering from a global paradox of thrift.The above two articles provide useful information on how a global saving glut is worsening therecession. I did not feel the need to write on these topics as these two excellent articles aresufficient in explaining the role of Asian economies in the present global recession.So let us again reconsider the three issues we started with:(1) How American economy became so full of cash that made availability of loans foralmost any thing so easy?It was all because of the insistence of Asian economy to generate a huge Foreign ExchangeReserve that ultimately created an imbalance of global money flow. If you read the above twoarticles, you will understand this clearly.(2) Why American banks could not foresee the risk involved in sub-prime loans?As Paul Krugman has pointed in his article, it is because of the depth and sophistication of thecountry‟s financial markets. In his own words, “American bankers, empowered by a quarter-century of deregulatory zeal, led the world in finding sophisticated ways to enrich themselves byhiding risk and fooling investors.”
In America which has such a long history of free capital markets, financial institutions havemastered the art of hiding risk and fooling investors. When a huge inflow of money is comingyour way, a sense of wealth and greed becomes dominant in our mind. After all capitalism is allabout profit and maximizing your return. Isn‟t it?(3) Why the situation is not improving as fast as expected despite stimulus package ofbillions of dollars?One of the top global economist of the world (I don‟t know his name) has declared that thepresent crisis is a structural one , reflecting a serious global misallocation of money in recentyears, which had created many bubbles that had now burst. Pumping in more money could notresolve the problem, since it amounted to an attempt to reflate the old bubbles. Instead painfulstructural change are the need of the hour, he said, and this could take years.What we are seeing the world today is a global saving phenomenon. American who were thefront runners of global borrowing and spending spree have started savings seriously. Thenational savings rate of America has bumped up to 5% in January from 3.9% in December. Ayear ago, it was at 0.1%.Saving is not a bad idea. But if everybody on earth starts saving and no one choose to spend, thesaving will lose all its meaning. It is a well documented theory in economics known as theParadox of Thrift. Suppose people decide to become more thrifty, that is, they decide to savemore at each level of income, one might expect that this would increase the total amount ofsavings. But the simple Keynesian multiplier model predicts a paradox of thrift that total savingswill remain the same and income will decline.So when the situation will improve?I believe in the spiritual mantra of “This too will pass”. This is not the first recession the worldhas ever seen and certainly this is not going to be the last. I think the need of the hour forindividuals is to not loose hope and prepare themselves for future. Keep learning new things,improve your skills and above all don‟t loose heart. The best brains in the world are at work tofind solution to this recession. Eventually, we‟ll find a cure. And even if nothing works, thegreatest healer of all – the time – will subside this recession one day.For every problem under the Sun,there is a solution or is noneif there is one, try to find it,If there is none, never mind it.We all have a limited time span on this earth. A Recession, not matter how lengthy or worse itappears now, is a momentary phenomenon when compared on the global scale of our entire lifetime. Don‟t allow this momentary phenomenon to overshadow the wonderful days of happinessand wealth which will definitely come in your life in the days to come.