Reasons for Global Recession: In plain simple English

These days the most talked about news is the current financial crisis that has engulfed the
world economy. 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 an economic depression has already arrived whereas for some it is just round
the corner. In my opinion 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 falling
share markets the world over and bankruptcy of major banks? In this article, I shall try to
explain the reasons for recent economic depression for all those who find it difficult to
understand the complex 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
back in past and understand what was happening in the housing sector of America for past
many years. In US, a boom in the housing sector was driving the economy to a new level.  A
combination of low interest rates and large inflows of foreign funds helped to create easy
credit conditions where it became quite easy for people to take home loans. As more and
more people took home loans, the demands for property increased and fueled the home prices
further. As there was enough money to lend to potential borrowers, the loan agencies started
to widen their loan disbursement reach and relaxed the loan conditions.

The loan agents were asked to find more potential home buyers in lieu of huge bonus and
incentives. Since it was a good time and property prices were soaring, the only aim of most
lending institutions and mortgage firms was to give loans to as many potential customers as
possible. Since almost everybody was driving by the greed factor during that housing boom
period, the common sense practice of checking the customer’s repaying capacity was also
ignored in many cases. As a result, many people with low income & bad credit history or
those who come under the NINJA (No Income, No Job, No Assets) category were given
housing loans in 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 the borrowers was doubtful).

Since the demands for homes were at an all time high, many homeowners used the increased
property value to refinance their homes with lower interest rates and take out second
mortgages against the added value (of home) to use the funds for consumer spending. The
lending companies also lured the borrowers with attractive loan conditions where for an
initial period the interest rates were low (known as adjustable rate mortgage (ARM).
However, despite knowing that the interest rates would increase after an initial period, many
sub-prime borrowers opted for them in the hope that as a result of soaring housing prices they
would be able to quickly refinance at more favorable terms.

Bubble that burst…

However, as the saying goes, “No boom lasts forever”, the housing bubble was to burst
eventually. Overbuilding of houses during the boom period finally led to a surplus inventory
of homes, causing home prices to decline beginning from the summer of 2006. Once housing
prices started 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 themselves unable to re-finance and began to default on loans as their loans reset to
higher interest rates and payment amounts.

In the US, an estimated 8.8 million homeowners - nearly 10.8% of total homeowners - had
zero or 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
loan that is in default ) accelerated in the United States in late 2006. During 2007, nearly 1.3
million U.S. housing properties were subject to foreclosure activity.  Increasing foreclosure
rates and unwillingness of many homeowners to sell their homes at reduced market prices
significantly increased the supply of housing inventory available. Sales volume (units) of new
homes dropped by 26.4% in 2007 as compare to 2006. Further, a record nearly four million
unsold existing homes were for sale including nearly 2.9 million that were vacant. This
excess supply of home inventory placed significant downward pressure on prices. As prices
declined, more homeowners were at risk of default and foreclosure.

Now you must be wondering how this housing boom and its subsequent decline is related to
current 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

For original lenders these subprime loans were very lucrative part of their investment
portfolio as they were expected to yield a very high return in view of the increasing home
prices. Since, the interest 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 on their investment. In case a sub-prime borrower continued to pay his
loans installment, the lender would get higher interest on the loans. And in case a sub-prime
borrower could not pay his loan and defaulted, the lender would have the option to sell his
home (on a high market price) and recovered his loan amount. In both the situations the Sub-
prime loans were excellent investment options as long as the housing market was booming.
Just at this point, the things started complicating.

With stock markets booming and the system flush with liquidity, many big fund investors
like hedge funds and mutual funds saw subprime loan portfolios as attractive investment
opportunities. Hence, they bought such portfolios from the original lenders. This in turn
meant the lenders had fresh funds to lend. The subprime loan market thus became a fast
growing segment.  Major (American and European) investment banks and institutions heavily
bought these loans (known as Mortgage Backed Securities, MBS) to diversify their
investment portfolios. 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, in CDOs all investors do not assume the risk equally and each
participatory group has different risk profiles. Secondly, in contrast to mutual funds which
normally buy shares and bonds, CDOs usually 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 major
American and European Banks, the problem, which was to remain within the confines of US
propagated into the word’s financial markets. Ideally, the MBS were a very attractive option
as long as home prices were soaring in US. However, when the home prices started declining,
the attractive investments in Subprime loans become risky and unprofitable.

As the home prices started declining in the US, sub-prime borrowers found themselves in a
messy situation. Their house prices were decreasing and the loan interest on these houses was
soaring. As they could not manage a second mortgage on their home, it became very difficult
for them to pay the higher interest rate. As a result many of them opted to default on their
home loans and vacated the house. However, as the home prices were falling rapidly, the
lending companies, which were hoping to sell them and recover the loan amount, found them
in a situation where loan amount exceeded the total cost of the house. Eventually, there
remained no option but to write off losses on these loans.

The problem got worsened as the Mortgage Backed Securities (MBS), which by that time had
become parts of CDOs of giant investments banks of US & Europe, lost their value. Falling
prices 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 a situation where no one was too sure either about how big these losses were or
which banks had been hit the hardest.

Mayhem in the banks….

The effects of these losses were huge. Global banks and brokerages have had to write off an
estimated $512 billion in subprime losses so far, with the largest hits taken by Citigroup
($55.1 billion) and Merrill Lynch ($52.2 billion). A little over half of these losses, or $260
billion, have been suffered by US-based firms, $227 billion by European firms and a
relatively modest $24 billion by Asian ones.

Despite efforts by the US Federal Reserve to offer some financial assistance to the
beleaguered financial sector, it has led to the collapse of Bear Sterns, one of the world’s
largest investment banks and securities trading firm. Bear Sterns was bought out by JP
Morgan Chase with some help 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
the one which had survived every major upheaval for the past 158 years - file for bankruptcy.
Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae, two
giant mortgage companies of US, have effectively been nationalized to prevent them from
going under. Reports suggest that insurance major AIG (American Insurance Group) is also
under severe 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
are like backbone for other major industries and provide them with investment capital and
loans, a loss in the net capital of  banks meant a serious detriment in their capacity to disburse
loans for various businesses and industries.  This presented a serious cash crunch situation for
companies who needed cash for performing their business activities. Now it became
extremely difficult for them to raise money from banks.

What is worse is the fact that the losses suffered by banks in the subprime mess have directly
affected 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 among
themselves to meet short-term need for funds. Banks usually never hold the exact amount of
cash that they need to disburse as credit. The ‘inter-bank’ market performs this critical role of
bringing cash-surplus and cash-deficit banks together and lubricates the process of credit
delivery to companies (for working capital and capacity creation) and consumers (for buying
cars, white goods etc). As the housing loan crisis intensified, banks grew increasingly
suspicious about each other’s solvency and ability to honour commitments. The inter-bank
market shrank as a result and this began to hurt the flow of funds to the ‘real’ economy. Panic
begets panic and as the 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
extremely difficult even for top companies to take loans for their needs. A sense of disbelief
and extreme precaution is prevailing in the banking sectors. The global investment
community has become extremely risk-averse. They are pulling out of assets that are even
remotely considered risky and buying things traditionally considered safe-gold, government
bonds and bank deposits (in banks that are still considered solvent).

As such this financial crisis is the culmination of the above mentioned problems in the global
banking system. Inter-bank markets across the world have frozen over. The meltdown in
stock markets 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
the markets. They have pumped hundreds of billions of dollars into their money markets to
try and unfreeze their inter-bank and credit markets. Large financial entities have been
nationalized. The US government has set aside $700 billion to buy the ‘toxic’ assets like
CDOs that sparked off the crisis. Central banks have got together to co-ordinate cuts in
interest rates. None of this has stabilized the global markets so far. However, it is hoped that
proper monitoring and controlling of 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 world
economy. Heavy losses suffered by major International Banks is going to affect all countries
of the 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 in shortage 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
investments by 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 Indian Stock Markets to meet liabilities at home. FIIs were the main buyers of
Indian Stocks and their exit from the market is certain to wreak havoc in the market.   FIIs
who were on a buying spree last year, are now in the mood of selling their stocks in India. As
a result our Share Markets are touching new lows everyday.

Since, the money, which FIIs get after selling their stocks, needs to be converted into dollars
before they can sent it home, the demands for dollars has suddenly increased. As more and
more FIIs are buying dollars, the rupee is loosing its strength against dollar. As long as
demands for dollars 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
few years, the two most preferred method of raising money by the companies were Stock
Markets and external borrowings on low interest rates. Stock Markets are bleeding everyday
and it is not possible to raise money there. Regarding external borrowing from world markets,
this option has also become difficult.

In the last fiscal year alone, India borrowed $29 billion from foreign lenders and got $34
billion of foreign direct investment. A global recession has hurt external demand.
International lenders who have become extremely risk aversive can limit access to
international capital. If that happens, 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 to clock 7% this fiscal year and the next.

However, one positive point in favor of India is the fact that Indian Banks are more or less
secured from the ill-effects of sub-prime mess. A glance at Indian banks’ balance sheets
would show that their exposure to complex instruments like CDOs is almost nil. In India, still
the major banking operations are in the hands of Public Sector Banks who exercise extreme
cautions in disbursing 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 and even some Indian banks (like ICICI) have some foreign subsidiary with
stake in the sub-prime losses, there presence is miniscule as compare to the overall size of
Indian banking industry. So at 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 consumer
goods. In 2007-08, India sold 13.5% of its goods to foreign buyers. A fall in demand is likely
to affect the growth rate this year. Our export may get affected badly.

A negative atmosphere, shortage of cash, fall in demands, reducing growth rate and
uncertainties in the market are some of the most visible aspects of an economic depression.
What started as a small matter of sub-prime loan defaulters has now become a subject of
global discussion and has engulfed the global economy scenario.

Greed of some…woes of billions

If you think about this with a cool mind, you will find that the underlying cause of this
depression is the greed of those who failed to anticipate the consequence of their actions. On
a more ideological front, it is high time to have a rethink on the very idea of free markets and
capitalism. I think the time has come to evolve a capitalism where everything works under a
broad regulatory framework and we do not see a repeat of this condition where greed of some
people can affect the lives of billions.

So here concludes my attempt to explain the current economic crisis which has started to
affect the lives of all of us. The above explanation is very simple and by no means it presents
an accurate picture (i.e the one that includes all the micro/macro factors)  of the crisis.
However, I hope 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.

Reasons for Global Recession - Part Two

In one of my earlier posts, I wrote about the causes of global recession. This post become
quite popular and hundreds of people thanked me for the simple explanation of this
phenomenon. This is 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 eventually
sparked a world wide recession is at best an immediate cause of the recession. In this post, I
will throw some light on the reason behind the very emergence of a sub-prime situation and
why despite pumping of billions of dollars into the world economy, it is still not showing any
sign of recovery.

In my first post on recession, I told you about how availability of an easy credit situation
prompted the US lending institution to lend money to sub-prime borrowers and how these
risky deals turned into a nightmare for big financial institution. In this post, we will be
discussing three main issues :

(1) How American economy became so full of cash that made availability of loans for almost
everything 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
of dollars?

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
by a decade. In 1997-98, the tiger economies of Asia (a term used to refer the countries of
South East Asia like Thailand, Malaysia, Indonesia etc) suffered a major economic crisis.
Though it is not necessary to know the details of this crisis, a brief overview of that crisis will
help us understand the current mess in world as it is all linked.

During those years, several countries of South East Asia had developed worrying financial
weaknesses 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 under regulated domestic financial institutions.

The crisis began with wrong banking practices.  In those countries crony capitalism (where
borrower had the connections with government) became too dominant.  The minister’s
nephew or the president’s son could open a bank and raise money both from the domestic
populace and from foreign lenders, with everyone believing that their money was safe
because official connections stood behind the institution. Government guarantees on bank
deposits are standard practice throughout the world, but normally these guarantees come with
strings attached. The owners 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 many people were granted privilege without responsibility, allowing
them to play a game of “heads I win, tails somebody else loses.” And the loans financed
highly speculative real estate ventures and wildly overambitious corporate expansions.

This bubble was inflated still further by credulous foreign investors, who were all too eager to
put money into faraway countries about which they knew nothing (except that they were
thriving). 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 look much healthier than they were.

However, this bubble had to burst sooner or later. At some point it was going to become clear
that the high values Asian markets had placed on their assets weren’t realistic. Speculative
bubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of
investors begin 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 of
banks, asset prices plunged. As asset prices fell, it became increasingly doubtful whether
governments would really stand behind the deposits and loans that remained, and investors
fled all the faster. Foreign investors stampeded for the exits, forcing currency devaluations,
which worsened the crisis still more as banks and companies found themselves with assets in
devalued baht 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 the
second half of 1997 it was flowing out at about the same rate. Inevitably, with that kind of
reversal, Asia’s asset markets plunged, its economies went into recession, and it only got
worse from there.

Eventually International Monetary Fund (IMF) had to step in to save these economies. How
these economies later recovered and at what cost is a different story.  However, this crisis
brought with it some major lessons for the Asian economies. One of the most important
lessons for them was to create a solid Foreign Exchange Reserve so as to withstand the most
volatile exit of the money from their markets. High reserves promise safety in a storm.
Therefore, most major economies of Asia (including the big China and India) adopted a
strategy of maintaining high forex reserve so as to ensure safety from any such crisis in
future.  This shift in priorities created a 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, in effect 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
huge foreign reserve, they also started buying US securities. This resulted in a huge inflow of
dollars into the US economy. As more and more dollars kept coming into the US economy
from world over, the American investors started devising very sophisticated and innovative
methods to convert the flood of money from Asia into a borrowing and spending spree for
American consumers.

Now instead of writing as to how and why this saving tendency of Asian Economies has
resulted into the current global mess, I would like to point you towards two excellent articles
on this issues written by two of my favorites economists. These articles are very well written
in a layman’s language and they will clarify all your doubts about the role Asian economies
in current global recession.

The first article is : High forex reserves can worsen recession

Written by Swaminathan S. Anklesaria Aiyar who is Consulting Editor, Economic Times, the
popular financial newspaper of India. He is my favorite columnist.

Second article is :  Revenge of the Glut

Written by noted economist, the Nobel winner Paul Krugman. In this article he has
concluded that 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
the recession. I did not feel the need to write on these topics as these two excellent articles are
sufficient 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 for
almost any thing so easy?

It was all because of the insistence of Asian economy to generate a huge Foreign Exchange
Reserve that ultimately created an imbalance of global money flow. If you read the above two
articles, 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
the country’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 by hiding risk and fooling investors.”

In America which has such a long history of free capital markets, financial institutions have
mastered the art of hiding risk and fooling investors. When a huge inflow of money is coming
your way, a sense of wealth and greed becomes dominant in our mind. After all capitalism is
all about profit and maximizing your return. Isn’t it?

(3) Why the situation is not improving as fast as expected despite stimulus package of
billions of dollars?

One of the top global economist of the world (I don’t know his name)  has declared that the
present crisis is a structural one , reflecting a serious global misallocation of money in recent
years, which had created many bubbles that had now burst. Pumping in more money could
not resolve the problem, since it amounted to an attempt to reflate the old bubbles. Instead
painful structural 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 the
front runners of global borrowing and spending spree have started savings seriously.  The
national savings rate of America has bumped up to 5% in January from 3.9% in December. A
year 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,
the saving will lose all its meaning. It is a well documented theory in economics known as the
Paradox of Thrift.  Suppose people decide to become more thrifty, that is, they decide to save
more at each level of income, one might expect that this would increase the total amount of
savings. But the simple Keynesian multiplier model predicts a paradox of thrift that total
savings will 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
world has ever seen and certainly this is not going to be the last. I think the need of the hour
for individuals 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 to find solution to this recession. Eventually, we’ll find a cure. And even if nothing
works, the greatest healer of all – the time – will subside this recession one day.

For every problem under the Sun,

We all have a limited time span on this earth. A Recession, not matter how lengthy or worse
it appears now, is a momentary phenomenon when compared on the global scale of our entire
life time. Don’t allow this momentary phenomenon to overshadow the wonderful days of
happiness and wealth which will definitely come in your life in the days to come.