reasons for global recession explained in simple english.doc

7/31/2019 Reasons for Global Recession explained in Simple English.doc

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Reasons for Global Recession Explained in Simple English: Part One

These days the most talked about news is the current financial crisis that has engulfed theworld economy. Every day the main headline of all newspapers is about our falling sharemarkets, decreasing industrial growth and the overall negative mood of the economy. Formany 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 itseffect on India.

So what has caused this major economic upheavalin the world? What is the cause of falling sharemarkets the world over and bankruptcy of majorbanks? In this article, I shall try to explain thereasons for recent economic depression for allthose who find it difficult to understand thecomplex economics lingo and are looking for asimple explanation.

It all started in US

In order to understand what is now happening inthe world economy, we need to go a little back inpast and understand what was happening in thehousing sector of America for past many years. In

US, a boom in the housing sector was driving the economy to a new level. A combinationof 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 morepeople 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 agenciesstarted 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 andincentives. Since it was a good time and property prices were soaring, the only aim ofmost lending institutions and mortgage firms was to give loans to as many potentialcustomers as possible. Since almost everybody was driving by the greed factor during thathousing boom period, the common sense practice of checking the customers repayingcapacity was also ignored in many cases. As a result, many people with low income & badcredit history or those who come under the NINJA (No Income, No Job, and 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 primeloan market (as the repaying capacity of the borrowers was doubtful).

Since the demands for homes were at an all time high, many homeowners used theincreased property value to refinance their homes with lower interest rates and take outsecond mortgages against the added value (of home) to use the funds for consumerspending. The lending companies also lured the borrowers with attractive loan conditionswhere for an initial period the interest rates were low (known as adjustable ratemortgage (ARM). However, despite knowing that the interest rates would increase after


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an initial period, many sub-prime borrowers opted for them in the hope that as a result ofsoaring 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 bursteventually. Overbuilding of houses during the boom period finally led to a surplusinventory 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 becamemore difficult. Home owners, who were expecting to get a refinance on the basis ofincreased home prices, found they were unable to re-finance and began to default onloans 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 hadzero 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 themortgage.

Foreclosures (i.e. the legal proceedings initiated by a creditor to repossess the property forloan that is in default) accelerated in the United States in late 2006. During 2007, nearly1.3 million U.S. housing properties were subject to foreclosure activity. Increasing

foreclosure rates and unwillingness of manyhomeowners to sell their homes at reducedmarket prices significantly increased the supply ofhousing inventory available. Sales volumes i.e.units of new homes dropped by 26.4% in 2007 ascompare to 2006. Further, a record nearly fourmillion unsold existing homes were for saleincluding nearly 2.9 million that were vacant. Thisexcess supply of home inventory placedsignificant downward pressure on prices. As pricesdeclined, more homeowners were at risk ofdefault and foreclosure.

Now you must be wondering how this housing boom and its subsequent decline is relatedto 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 amatter between the lenders (who disbursed risky loans) and unreliable borrowers (whotook loans and then got defaulted) then probably it would remain a local problem ofAmerica. However, this was not the case. Let us understand what complicated theproblem.


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For original lenders these subprime loans were very lucrative part of their investmentportfolio as they were expected to yield a very high return in view of the increasing homeprices. Since, the interest rate charged on subprime loans was about 2% higher than theinterest on prime loans (owing to their risky nature); lenders were confident that theywould get a handsome return on their investment. In case a sub-prime borrower continuedto pay his loans installment, the lender would get higher interest on the loans. And in casea sub-prime borrower could not pay his loan and defaulted, the lender would have theoption 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 thehousing market was booming. Just at this point, the things started complicating.

With stock markets booming and the system flush with liquidity, many big fund investorslike hedge funds and mutual funds saw subprime loan portfolios as attractive investmentopportunities. Hence, they bought such portfolios from the original lenders. This in turnmeant the lenders had fresh funds to lend. The subprime loan market thus became a fastgrowing segment. Major (American and European) investment banks and institutionsheavily bought these loans (known as Mortgage Backed Securities, MBS) to diversify theirinvestment portfolios. Most of these loans were brought as parts of CDOs (CollateralizedDebt 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 eachparticipatory group has different risk profiles. Secondly, in contrast to mutual funds whichnormally buy shares and bonds, CDOs usually buy securities that are backed by loans (justlike 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 ofUS propagated into the worlds financial markets. Ideally, the MBS were a very attractiveoption as long as home prices were soaring in US. However, when the home prices starteddeclining, 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 amessy situation. Their house prices were decreasing and the loan interest on these houseswas soaring. As they could not manage a second mortgage on their home, it became verydifficult for them to pay the higher interest rate. As a result many of them opted to defaulton their home loans and vacated the house. However, as the home prices were fallingrapidly, the lending companies, which were hoping to sell them and recover the loanamount, found them in a situation where loan amount exceeded the total cost of thehouse. 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 timehad 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 destroyedbanks capital. The complexity of these instruments and their wide spread to majorInternational banks created a situation where no one was too sure either about how bigthese 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 offan 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


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billion, have been suffered by US-based firms, $227 billion by European firms and arelatively modest $24 billion by Asian ones.

Despite efforts by the US Federal Reserve to offer some financial assistance to thebeleaguered financial sector, it has led to the collapse of Bear Sterns, one of the worldslargest investment banks and securities trading firm. Bear Sterns was bought out by JPMorgan Chase with some help from the US Federal Bank (The central Bank of America justlike RBI in India)

The crisis has also seen Lehman Brothers the fourth largest investment bank in the USand the one which had survived every major upheaval for the past 158 years file forbankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac andFannie Mae, two giant mortgage companies of US, have effectively been nationalized toprevent them from going under. Reports suggest that insurance major AIG (AmericanInsurance Group) is also under severe pressure and has so far taken over $82.9 billion sofar to tide over the crisis.

From this point, a chain reaction of panic started. Since banks and other financial institutesare 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 todisburse loans for various businesses and industries. This presented a serious cash crunchsituation for companies who needed cash for performing their business activities. Now itbecame 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 havedirectly 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 moneyamong them to meet short-term need for funds. Banks usually never hold the exactamount of cash that they need to disburse as credit. The inter-bank market performs thiscritical role of bringing cash-surplus and cash-deficit banks together and lubricates theprocess of credit delivery to companies (for working capital and capacity creation) andconsumers (for buying cars, white goods etc). As the housing loan crisis intensified, banksgrew increasingly suspicious about each others solvency and ability to honorcommitments. The inter-bank market shrank as a result and this began to hurt the flow offunds to the real economy. Panic begets panic and as the loan market went into atailspin, it sucked other markets into its centrifuge.

The liquidity crunch in the banks has resulted in a tight situation where it has becomeextremely difficult even for top companies to take loans for their needs. A sense ofdisbelief and extreme precaution is prevailing in the banking sectors. The globalinvestment community has become extremely risk-averse. They are pulling out of assetsthat 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 theglobal banking system. Inter-bank markets across the world have frozen over. Themeltdown in stock markets across the world is a victim of this contagion.
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Governments and central banks (like Fed in US) are trying every trick in the book tostabilize the markets. They have pumped hundreds of billions of dollars into their moneymarkets to try and unfreeze their inter-bank and credit markets. Large financial entitieshave been nationalized. The US government has set aside $700 billion to buy the toxicassets like CDOs that sparked off the crisis. Central banks have got together to co-ordinatecuts in interest rates. None of this has stabilized the global markets so far. However, it ishoped that proper monitoring and controlling of the money market will eventually controlthe 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 allcountries of the world as these financial institutes have their investment interest in almostall countries.

As of now India is facing heat on three grounds: 1. Our Share Markets are falling every day,2. Rupee is weakening against dollars and 3. Our banks are facing severe cash crunchresulting in shortage of liquidity in the market.

Actually all the above three problems are interconnected and have their roots in theabove-mentioned global crisis.

For the last two years, our stock market was touching new heights thanks to heavyinvestments by Foreign Institutional Investors (FIIs). However, when the parent companiesof these investors (based mainly in US and Europe) found themselves in a severe creditcrunch as a result of sub-prime mess, the only option left with these investors was towithdraw their money from Indian Stock Markets to meet liabilities at home. FIIs were themain buyers of Indian Stocks and their exit from the market is certain to wreak havoc inthe market. FIIs who were on a buying spree last year, are now in the mood of selling theirstocks in India. As a result our Share Markets are touching new lows every day.

Since, the money, which FIIs get after selling their stocks, needs to be converted intodollars before they can sent it home, the demands for dollars has suddenly increased. Asmore and more FIIs are buying dollars, the rupee is losing its strength against dollar. Aslong as demands for dollars remain high, the rupee will keep losing its strength againstdollar.

The current financial crisis has also started directly affecting Indian Industries. For the pastfew years, the two most preferred method of raising money by the companies were StockMarkets and external borrowings on low interest rates. Stock Markets are bleedingeveryday and it is not possible to raise money there. Regarding external borrowing fromworld markets, this option has also become difficult.

In the last fiscal year alone, India borrowed $29 billion from foreign lenders and got $34billion of foreign direct investment. A global recession has hurt external demand.International lenders who have become extremely risk aversive can limit access tointernational capital. If that happens, both Indias financial markets and the real economywill be hurt in the process. Suddenly, the 9% growth target does not seem that doableanymore; we should be happy to clock 7% this fiscal year and the next.


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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 sheetswould 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 exerciseextreme cautions in disbursing loans to needy people/companies. As a result, we are notlikely to see a repeat of sub-prime crisis in India. Though there have been a presence ofbig US/European Banks in India and even some Indian banks (like ICICI) have some foreignsubsidiary with stake in the sub-prime losses, their presence is miniscule as compare to

the overall size of Indian banking industry. So at least on this major front we need notworry 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 likelyto affect the growth rate this year. Our export may get affected badly.

A negative atmosphere, shortage of cash, fall in demands, reducing growth rate anduncertainties in the market are some of the most visible aspects of an economicdepression. What started as a small matter of sub-prime loan defaulters has now becomea 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 thisdepression 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 freemarkets and capitalism. I think the time has come to evolve a capitalism where everythingworks under a broad regulatory framework and we do not see a repeat of this conditionwhere greed of some people can affect the lives of billions.

So here concludes my attempt to explain the current economic crisis which has started toaffect the lives of all of us. The above explanation is very simple and by no means itpresents an accurate picture (i.e. the one that includes all the micro/macro factors) of thecrisis. However, I hope that it must have given you a broad idea of the reasons behindcurrent economic depression. Feel free to post your comments on this issue.


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Reasons for Global Recession: Part TwoIn 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 postand the prime reason that eventually sparked aworldwide recession is at best an immediate cause of therecession. In this post, I will throw some light on thereason behind the very emergence of a sub-primesituation and why despite pumping of billions of dollarsinto 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 situation prompted the USlending institution to lend money to sub-prime borrowersand 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 foralmost 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

billions of dollars?

From where did the cash came in US?

In order to understand how US economy got flooded with dollars, we need to go back intime by a decade. In 1997-98, the tiger economies of Asia (a term used to refer thecountries of South East Asia like Thailand, Malaysia, and Indonesia etc) suffered a majoreconomic crisis. Though it is not necessary to know the details of this crisis, a briefoverview 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 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 creditfrom under regulated 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 ministersnephew or the presidents son could open a bank and raise money both from the domesticpopulace and from foreign lenders, with everyone believing that their money was safebecause official connections stood behind the institution. Government guarantees on bankdeposits are standard practice throughout the world, but normally these guarantees comewith strings attached. The owners of banks have to meet capital requirements (that is, put
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a lot of their own money at risk), restrict themselves to prudent investments, and so on. InAsian 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 loansfinanced highly speculative real estate ventures and wildly overambitious corporateexpansions.

This bubble was inflated still further by credulous foreign investors, who were all too eagerto 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 createda boom in real estate and stock markets, which made the balance sheets of banks andtheir clients, look much healthier than they were.

However, this bubble had to burst sooner or later. At some point it was going to becomeclear that the high values Asian markets had placed on their assets werent realistic.Speculative bubbles are vulnerable to self-fulfilling pessimism. As soon as a significantnumber of investors begin to wonder whether the bubble would burst, it did.

So Asia went into a downward spiral. Asnervous investors began to pull their money

out of banks, asset prices plunged. As assetprices fell, it became increasingly doubtfulwhether governments would really standbehind the deposits and loans that remained.And investors fled all the faster. Foreigninvestors stampeded for the exits, forcingcurrency devaluations, which worsened thecrisis still more as banks and companiesfound themselves with assets in devaluedbaht or rupiah, but with liabilities inlamentably solid dollars.

In 1996 capital was flowing into emerging Asia at the rate of about $100 billion a year; bythe second half of 1997 it was flowing out at about the same rate. Inevitably, with thatkind of reversal, Asias asset markets plunged, its economies went into recession, and itonly got worse from 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 importantlessons for them was to create a solid Foreign Exchange Reserve so as to withstand themost volatile exit of the money from their markets. High reserves promise safety in astorm. 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 suchcrisis 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 foreignassets, in effect exporting capital to the rest of the world.


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To say in other words, the Asian economy came in to a saving mode. In order to maintainhuge foreign reserve, they also started buying US securities. This resulted in a huge inflowof dollars into the US economy. As more and more dollars kept coming into the USeconomy from world over, the American investors started devising very sophisticated andinnovative methods to convert the flood of money from Asia into a borrowing and spendingspree 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 excellentarticles on these issues written by two of my favorite economists. These articles are verywell written in a laymans language and they will clarify all your doubts about the roleAsian economies in current global recession.

The first article is: High forex reserves can worsen recession

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

Second article is: Revenge of the Glut

Written by noted economist and Nobel Prize winner; Paul Krugman. In this article he hasconcluded 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 worseningthe recession. I did not feel the need to write on these topics as these two excellentarticles are sufficient in explaining the role of Asian economies in the present globalrecession.

So let us again reconsider the three issues we started with:

1. How American economy became so full of cash that made availability ofloans for almost anything so easy?

It was all because of the insistence of Asian economy to generate a huge ForeignExchange Reserve that ultimately created an imbalance of global money flow. If you readthe above two articles, you will understand this clearly.

2. Why American banks could not foresee the risk involved in sub-primeloans?

As Paul Krugman has pointed in his article, it is because of the depth and sophistication ofthe countrys financial markets. In his words, American bankers, empowered by a quarter-century of deregulatory zeal, led the world in finding sophisticated ways to enrichthemselves by hiding 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 iscoming your way, a sense of wealth and greed becomes dominant in our mind. After all,capitalism is all about profit and maximizing your return. Isnt it?
http://www.swaminomics.org/articles/20090208.htmhttp://www.nytimes.com/2009/03/02/opinion/02krugman.html?_r=2http://ingrimayne.com/econ/Keynes/Paradox.htmlhttp://www.swaminomics.org/articles/20090208.htmhttp://www.nytimes.com/2009/03/02/opinion/02krugman.html?_r=2http://ingrimayne.com/econ/Keynes/Paradox.html


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3. Why the situation is not improving as fast as expected despite stimuluspackage of billions of dollars?

One of the top global economist of the world (I dont know his name) has declared thatthe present crisis is a structural one , reflecting a serious global misallocation of money inrecent years, which had created many bubbles that had now burst. Pumping in moremoney could not resolve the problem, since it amounted to an attempt to reflate the oldbubbles. Instead painful structural change is 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 werethe 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% inDecember. 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 tospend, the saving will lose all its meaning. It is a well documented theory in economicsknown as the Paradox of Thrift. Suppose people decide to become thriftier, that is, theydecide 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 paradoxof thrift that total savings will remain the same and income will decline.

4. So when the situation will improve?

I believe in the spiritual mantra of This too will pass. This is not the first recession theworld has ever seen and certainly this is not going to be the last. I think the need of thehour for individuals is to not lose hope and prepare them for future. Keep learning newthings, improve your skills and above all dont lose heart. The best brains in the world areat work to find solution to this recession. Eventually, well find a cure. And even if nothingworks, the greatest 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 orworse it appears now, is a momentary phenomenon when compared on the global scale ofour entire life time. Dont allow this momentary phenomenon to overshadow the wonderfuldays of happiness and wealth which will definitely come in your life in the days to come.

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