The Changing Face of the Financial World, Fear is the Key, Wall Street Banks are History and so on and so forth.
These are just a few of the headlines running rampage over the daily newspapers, magazines, editorial columns, and of course the financial systems of the entire world. Everyone knows of the collapse of some big names like Lehman Brothers and Merrill Lynch, we all have read about the 2 trillion USD worldwide financial bailout; some of us read the Economic Times and nod wisely at all the financial jargon, but very few of us, including yours truly, have their heads wrapped around the ABC of the crisis. Yet, one must try to lay threadbare the situation and try to understand the goings on as plain logic.
To comprehend the trouble, one needs to understand the causes, the hanky-panky, the reactions and the effects of the crisis. To start off, the root cause of the crisis is the astounding progress that the US has made as a nation. Over the past 10 years, the US has been fuelling its economy through debt, be it easy debt to firms, consumers, in the foreign exchange market; everywhere. Add to that the social context, where children are not dependent on parents after the age of 18, and parents don’t save for marriages et al as in India, what you get is a mad rush towards bigger and better consumerism and a lower rate of saving. People dump their 2 month old washing machine for the latest model; take loans to buy that luxury car, and most of it as debt because it is available! As a responsible government taking care of its citizens, the US promulgated the concept of ‘financial inclusivity’. Under this, the government endeavours to enable lending to everyone, even those who do not have the means to be good borrowers. This is what is called sub-prime lending, where borrowers with no means of guarantee of repayment are given loans, what is popularly called a NINJA (No Income, No Job, No Assets) loan.
Moving specifically to the real estate market; after the bursting of the dot-com bubble in the early 2000s, people withdrew their money from these avenues in droves and chose real estate as the new crown prince of investment. As is true of any economic bubble, the possibility of a decrease in prices was completely blocked out, and the entire system functioned on this assumption. Prices of houses going up led to positive speculation about the market, and an expectancy of the prices going up further. A bad loan was all right because the property’s price had increased so non-payment or default leading to seizure of property would be profitable; an adjustable rate loan, where for the first few years a person pays a very low interest rate called a teaser rate and later a much higher interest rate, was taken because people weren’t told about the high rates in some cases and could refinance their loan in some cases against increasing property prices. For example, to buy a house worth 100,000 USD, one could take a loan of 80,000 USD. Now, if the price of the property goes up to 120,000 USD, the repayment of the loan is eased out, either by loan period or interest rate adjustment.
A spin-off of the assumption of ‘always increasing real estate prices’, that has, coupled with financial innovation on Wall Street wreaked havoc on the worlds financial systems is securitization of mortgages. A financial institution could either be a lender, or could buy these loans from property loans institutions. Such a loan would be an illiquid asset of the bank. But given the increasing real estate prices, and hence a guarantee of the loan being paid, there was an opportunity for banks to earn money from this. What they did is that they pooled together these mortgages/loans and created a security out of it. Hence a security is a financial asset, where people are given a certain rate of return. This way the mortgages and loans were sold again, raising more money for the bank, and diversifying the risk to other consumers as well. This became one of the major sources of funds for institutions, with the overall value running into trillions of dollars and was further exacerbated by rating agencies slacking on their due diligence reports. Ratings were given to the securities based on the reputations of the firms issuing them rather than the underlying asset backing them; once more, the assumption of the real estate market being stable leading to apathy of regulation. Yet another slip-up because of the ‘innovation’ was that the regulations, statutory capital requirements as backing for the securities were left ambiguous. These special purpose vehicles were allowed to be left off the balance sheets of firms, operated through a subsidiary. Hence, the mortgages being put together were often of bad quality, and this was kept hidden from the public at large, realization of a grave moral hazard.
Having established a background of the situation, the next step to be looked at is the trigger of the crisis. If there was a bubble, where did the pricking of the pin come from? The answer cannot be given in one line or one word, but is rather a combination of factors and a certain inevitability of the situation. Once the markets are being fuelled by speculative price rise, it is only a matter of time before one person selling property leads to 100 others doing the same. For them, it would simply be a realization of the returns they expected. In the market, seen from a simple demand-supply approach, it would mean a sudden jump of supply of housing leading to a fall in prices. Also, given the economic situation of the world, the rapid increase in the prices of oil, commodities and food, daily household spending received a pinch. To control this inflation, the Federal Reserve increased its interest rates leading to loans and other form of borrowing becoming more expensive. Add to that the fact that Americans did not save up their money (the saving rate for the economy was 1.7% compared to India’s 20-30%) for tough times and that a lot of the loans taken were adjustable rate loans whereby payments required to be made jumped up after a certain period of time; these factors together led to a severe payment shock for the borrowers and led to a large number of defaults or non-payments of the loans.
The danger to the economy here started from the micro level, with people at risk of being shunted out of their homes, not being able to pay for them anymore. Then the toxic effects started spreading. Because of the sudden rush to sell homes, the supply outstripped demand and led to the price crash everyone was afraid of. The number of bad loans given out were humungous, so the lending institutions got the rap from there. The banking system and this needs attention to detail given the recent crashes, suffered due to the securitization process. As outlined, the cash flows to the securities dried up closing one major avenue of revenue for the banks. Also, institutions themselves were investors in these securities as much as individuals were, making that another loss which they had to bear. This led to the daily spending of banks being threatened because they rely on short term loans. These short term loans from other institutions disappeared since the institutions themselves required the money, and did not know which bank can be trusted with the money, since the records of the securities were off the balance sheets of the institutions. A breakdown of trust of position of the banks brought with it a credit crunch, where banks needing to make payments didn’t have reliable sources of money, and consequently, consumers wanted to withdraw their money from the bank- a run on the bank. It is this lack of transparency within the system that has led to the crashing of the financial giants on Wall Street. Banks have been desperately trying to raise capital by selling off assets, merging with performing firms, reducing the scope of their businesses. Yet, even these are not enough to overcome the twin blows of mortgage-backed losses and a fall in trust levels.
It is precisely for these reasons that governments all over the world are creating financial stimulus, bailout packages and the likes. The reason for them coming up is the simple ideological differences of the micro and macro level. The world economy is judged by governments and people at a macro level, in terms of aggregate outputs, unemployment and other such indicators that include social welfare as one of the primary goals. However, at a micro level, individuals as well as firms operate on a principle of personal benefit, more popularly called profit. If avenues shut down, and output shrinks, it would be better for firms to stop production and minimize their personal losses, even though the macro economy would suffer because of it. This is the reason that a government intervention is taking place. It is being criticized as responsible tax-payers bailing out irresponsible spenders however a full-blown market correction would lead to a much larger loss to the entire economy, including the tax-payers, than if the government intervenes and saves some institutions from completely shutting down.
The effect is being felt globally because of the much touted globalization. Investors from foreign markets who had heavily invested in the mortgage backed securities suffered substantial losses. Further, with parent companies running into trouble, their arms in different parts of the world too suffered. Also, capital inflows to emerging economies like India, export-import dynamics, all have taken a hit because of reduced spending, the world over.
The question remains- Is the crisis over? Is the worst yet to come? I’m neither an expert economist (yet), nor a plagiarist of the numerous business journals that come out periodically, and can only put down a logical guess so to say. My verdict would be that the suffering is far from over. The cleaning up of toxic assets has only started yet. Even with government bailouts, the assets don’t evaporate. Regulatory mechanisms will undergo revamping, and the global economy will take some time to react to that. Availability of capital for businesses is and will continue to take a hit for a while. The world economy is like a gigantic beast tripped up. It will take a lot of effort and time to get it running again.
