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 matter between the lenders (who disbursed risky loans) and unreliable borrowers (who took loans and then got defaulted) then probably it would remain a local problem of America. However, this was not the case.  Let us understand what complicated the problem.

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.

Update : Owing to the overhelming questions/suggestions of the readers, I have written a second article in this series : Reasons for Global Recession – Part Two. This article tries to explain the reason for easy credit situation in US that leads to the emergence of sub-prime mess. It also offers comments on why curbing the recession is taking longer than expected. Read it here.