Quote : Credit buying is much like being drunk. The buzz happens immediately and gives you a lift.... The hangover comes the day after. ~Joyce Brothers
Recessions are a common occurrence in any economy, part of the pattern of expansion and contraction known as the business cycle. However, increasing economic insecurity on global sphere recalled the turmoil of the Great Depression. These days, everybody seemed to be talking about recession and describing it as “the worst decline since the Great Depression 1929.” Thank God, the difference between the “worst since” and “as worse as” the Great Depression is vast. Some events are similar: The failure of major investment banks and the largest commercial bank, as well as a sharp decline in consumer spending, decline in employment and production, have been the main points of comparison between these episodes. However, every event is unique in itself. Although there is a strong correlation between financial crises and severe economic downturns, not all financial crises result in a depression or even a recession.
Now, let us unveil the story of current recession, try and analyze it in a way it can be understood by a common man. 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? (No. of failed Banks – 94 ( Sept. 09)). It all started in US and then gradually dispersed across the globe.
- 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.
- This stimulated the demand for property 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. Systematic marketing campaign prevailed through out.
- The loan agents were offered huge bonuses and incentives to find more potential homes and buyers. 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.
- As a result, prior KYC (Know Your Customer) or say Due Diligence Norms and practices for measuring the customer’s repaying capacity were completely ignored or rather shelved in large number of cases. As a result, many people with low income and bad credit history were given housing loans in sheer 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.
- Because the demand for homes was extremely 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. As a result of burgeoning housing prices, they were fantasized enough to honestly believe that they would be able to quickly refinance at more favorable terms.
- Ultimately, nightmare occurred as it had to. Supply outstripped demand to a great deal. Over construction (production) of houses finally led to a surplus inventory of homes, causing home prices to decline. 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.
- Then, what followed was the destiny - Immensely large number of Foreclosures. Due to this and also unwillingness of many homeowners to sell their homes at declined prices further increased the housing inventory available for sale that reached a record of figure of nearly 4 million unsold existing homes for sale including nearly 2.9 million that were vacant. Process of seepage of prices did not stop and hence, more homeowners were at risk of default and foreclosure.
- A million dollar question aroused as to how this housing bubble and its burst which seem to be a domestic problem of USA, resulted in the world-wide current economic depression which is more often than not compared with the Great Depression 1929. It is interesting to see as to what happened next. It no more remained a problem between the lenders and unreliable borrowers. Sub-prime loans looked very attractive to the lenders in terms of handsome return because the interest rate charged on sub-prime loans was about 2% higher than the interest on prime loans obviously due to higher risk involved. However, it was an assumption in this belief that a sub-prime borrower would continue to pay his loans installments. And in case a sub-prime borrower could not pay his loan and defaulted, the lender shall have the option to sell his home at a prevailing high market price and recover his loan amount. In both the situations the Sub-prime loans were excellent investment options as long as the housing market was gearing up. Basking on a dream sky, possibility of Demand-Supply disequilibrium was not given necessary attention at all literally by anybody.
- Story does not end here simply leaving a wise moral behind. Stock markets were buzzing like beehives with immense liquidity. Major hedge funds and mutual funds saw sub-prime loans as attractive investment opportunity. They purchased the portfolio from the original lenders. This in turn meant the lenders had fresh funds to lend. The sub-prime 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, to diversify their investment portfolios. Here, they had their independent risks which cannot be shared equally among all investors like Mutual funds game. Mutual funds normally buy shares and bonds whereas banks usually buy securities that are backed by loans. In this sense, banks entangled into net risk.
- Due to heavy buying of Mortgage Backed Securities of sub-prime loans by major American and European Banks, risk factor (fall in market prices) did not remain confined to US but steamed into the world’s financial markets.
- With the home prices started declining in the US as discussed hereinbefore, sub-prime borrowers found themselves in a doldrums. House prices were decreasing and the loan interest on these houses was increasing. 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 which by that time had become significant part of investments of leading banks in US & Europe that immensely destroyed their capital.
- The effects of these losses were so huge that it caused a tornado like turmoil, which is evident from these estimations: Global banks and brokerages had write to off about $512 billion in sub-prime losses. Larger victims were Citigroup and Merrill Lynch, US-based firms, European firms and to a mediocre extent Asian firms. In spite of financial backup by US Federal Reserve, Bear Sterns could not be saved from going under. Lehman Brothers and insurance giant AIG faced a replica of crisis.
- Here onwards, a snow-ball effect or say chain reaction of panic started. Huge losses incurred by banks and other financial institutes adversely affected various businesses and industries in the form of serious cash crunch. The losses suffered by banks in the sub-prime mess directly affected their money market the world over. At this stage, it would be necessary to first understand what the Money Market is. It 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 to companies for working capital and to individual customers for spending on belongings. With growing sub-prime housing crisis, banks became risk-averse and tended to put a hold to inter-bank dealings which dried up 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. Confidence evaporated from everywhere. Common investors too are now finding safe-havens like Gold or Government Securities for investing their surplus funds further jeopardizing the liquidity of funds . They resist spending money liberally, inviting a decline in sales, production and therefore employments. Like a contagious disease, the infection spread over to important sectors like stock markets. Developing Countries whose economies thrived upon their export models in the recent era of globalization have been worst hit due to global meltdown. Governments and central banks (like Fed, RBI etc.) are deploying all possible measures to command situation. They are taking all possible measures, from policy actions, interest rate revisions, bail-out plans to printing additional money in order to reactivate inter-bank and credit markets. Large financial entities have been nationalized. The US government has set aside $700 billion to buy the ‘toxic’ assets that sparked off the crisis. Collective efforts of revival are being made on international forums like G20, G8, World Bank, IMF, and WTO at finance level and ILO, OECD etc. on socio-economic level. But, success is too far. Even if the GDP and macro-economic indicators show improvement on paper, apprehension of uncontrolled inflation is always there. If situation can be improved simply by printing currency out of worth less papers, why recession should arise. Things have to return to normalcy sooner or later, not because of mindless statistics and imaginary measures, but because of economic systems themselves have the tendency to self-correction. All and all, silver lining is always there at the end however, dark may be the cloud. History repeats history teaching valuable lesions to mankind. No matter anyone pays attention to it, life goes on relentlessly. But it should be precisely kept in mind that Growth for the sake of Growth is an ideology of the Cancer Cell. It is an unpleasant and unaccepted face of capitalism.
Unquote : "Owners of capital will stimulate the working class to buy more and more of their expensive goods, houses and technology, pushing them to take more and more expensive credit, until their debt becomes unbearable.
The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism" Karl Marx, Das Kapital, 1867
