Global Recession

“A significant decline in activity across the economy, lasting longer than a few months (6 to 18 months). It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP)”

1. THE MOST TALKED NEWS THESE DAYS.
2. FALLING SHARE MARKET  &  IND. GROWTH.
3. NEGATIVE MOOD OF ECONOMY.
4. MANY COUNTRIES  RESCESSION HAS ARRIVED.
5. SOME COUNTRIES IT IS IN THE CORNER.

Introduction

Causes of recessions

1. Currency crises
2. Inflation
3. National Debt
4. Speculation and economic bubbles
5. War
6. Excessive interest rates
7. Under consumption
8. Overproduction

Effects of recessions

1. Bankruptcies
2. Bank lending less money
3. National Debt
4. Deflation/disinflation
5. Foreclosures
6. Reduced sales
7. Stock market crash
8. Unemployment

Beginning of 2008 recession

Economic bubble busted in “Wall Street” New York ,USA

The Wall Street and History

Head Quartered NYSE, Worlds prominent Commercial Banks, Investment Banks and Universal Banks.
Commercial banks

Accepted customer deposits, made loans to businesses and consumers.
Low profit margins.
Considered a safe and stable business with relatively low profit margins.
E.g.:-Bank of America, Bank of commerce, etc

Investment banks

Helped raise money for companies and governments through stock and bond sales, advised companies on mergers and acquisitions and traded securities for customers on their own accounts.
High profit margins.
Considered riskier business.
E.g.:-Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanly, Bear Sterns etc.

Universal banks

Doing the business of commercial and investment banks business together.
E.g.:- Citigroup, JP Morgan, Barclays, RBS, Forties, etc

The Ascent of Risk of Investment banks which lead to collapse.

Competition from Universal banks.
Principle trading and investing.
Trading in complicated derivatives and securitized products.

Conclusion
Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman  Brothers and Bear Stearns were the five largest stand-alone investment banks in the world. The companies had existed for a combined total of 549 years, but within the span of six months, they would all be gone. Which is resulted to the credit crisis and recession in the Whole world.

Firm
Goldman Sachs             1869  Converted to bank holding company September 21, 2008

Morgan Stanley             1935  Converted to bank holding company September 21, 2008

Merrill Lynch                 1914  Acquired by Bank of America September 15, 2008

Lehman Brothers           1850  Filed for bankruptcy September 15, 2008

Bear Stearns                  1923  Acquired by JPMorgan March 16, 2008

Financial crisis and its fundamentals

A financial crisis often preceded by a “bubble”

What is bubble?

1.  When many investors are attracted to a market sector, usually due to attractive fundamentals.
2.  Speculators then rush to this newest hot market, searching for quick profits and driving prices even higher.
3. At some point, the amount of money flowing to the market increases to the point that valuations are no longer supported by attractive fundamentals.
4. Many market participants may realize that valuations are stretched, greed drives them to bid prices ever higher.
5. This is signaling the end of a bull market and the beginning of a bubble.

Crisis

1.  When market participants eventually realize that valuations are not supported by the fundamentals, the market begins to decline.
2.  As prices fall, more and more investors rush to sell.
3. This wave of selling quickly escalates, driving prices even lower. As this downward spiral continues.
4. Fear replaces greed, and market participants stop making rational decisions and instead rush to sell their holdings at whatever price they can get.
5. Profits made over the course of many years can turn into losses in a frighteningly short time.
6. A sufficiently bad downward spiral is commonly referred to as a crisis

Foundations

1. Asset /Liability mismatch.
2. Excessive leverage.
3. Excessive Risk.
4. Housing Loans

Asset /Liability mismatch:-

When a financial institution has a wide differential between the duration of its assets (loans or investments) and its liabilities (depositors or creditors), it is experiencing an asset/liability mismatch.

This is the main reason why the business model of the standalone investment bank came into question during the 2008 credit crisis. Investment banks are extremely dependent on short term financing to conduct their operations. However, the assets (investments) of the firms are longer term in nature, particularly during periods of market illiquidity when selling is difficult.

Housing Loans
As housing prices soared in many areas ,mortgage providers offered a variety of creative products designed to help buyers to afford more expensive homes. At the same  time ,lenders relaxed underwriting standards, allowing more marginal buyers to receive the mortgages.

Terms widely used along with Housing loans and “financial crisis” is

1. Mortgage-Backed Security - MBS...
2. Subprime Credit…

Mortgage-Backed Security - MBS...

When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.

Subprime Credit...

Subprime credit has highly debated pros and cons; on the plus side it allows people who wouldn't otherwise have access to credit to obtain loans for things like automobiles, homes and credit cards. On the negative side, subprime credit can come with very unfavorable terms based on high interest rates, excessive fees and short grace periods.

What caused crisis?

1.  Introduction of new type of financial instruments and its trading.
2.  Housing bubble
3.  Globalization of financial markets
4.  Capital imbalances
5.  Asset/ Liability mismatch
6.  Excessive leverage and risk
7.  Greed and fear

New financial instruments

1. MBS and CDO (mortgage backed securities and Collateralized debt obligations).
2. CDS (Credit default swaps).
3. Structured investment Vehicles.
4. And wide trend of securitization of financial assets

Major American and European investment banks and institutions heavily bought MBS through CDO’s. CDO’s are just like mutual funds.

Global financial imbalances

1. U.S. current account deficit recently as high as 6% of U.S. GDP! Financing provided mostly by capital inflows from Asian countires and oil exporters.

Housing Loans

1. Boom in the housing sector due to Low interest rates and large flow of foreign funds.
2. 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.
3. The loan agents were asked to find more potential home buyers in lieu of huge bonus and incentives.
4. 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.
5. 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.
6. As a result, many people with low income & bad credit 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.
7. 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.
8. 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).
9. 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.
10. 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.
11. Once housing prices started depreciating in many parts of the U.S., refinancing became more difficult.
12. 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.
13. 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.
14. 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.
15. Increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices significantly increased the supply of housing inventory available.
16. 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.
17. This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure.

What Complicated the Matter….

1. Unfortunately, this problem was not as straightforward as it appears.
2. 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.
3. 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.
4. 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 confident that they would get a handsome return on their investment.
5. In case of a sub-prime the lender would get higher interest on the loans. And in case 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.
6. 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.
7. 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.
8. This in turn meant the lenders had fresh funds to lend. The subprime loan market thus became a fast growing segment.
9. 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).
10. 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. CDOs usually buy securities that are backed by loans (just like the MBS of subprime loans.)
11. 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 world’s financial markets.
12. When the home prices started declining, the attractive investments in Subprime loans become risky and unprofitable.
13. 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.
14. 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.
15. 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.
16. 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.
17. 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

Financial fiascos:

1. 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.
2. 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.
3. Merrill Lynch has been bought out by Bank of America.
4. Freddie Mac and Fannie Mae, two giant mortgage companies of US, have effectively been nationalized to prevent them from going under.
5. AIG (American Insurance Group) is also under severe pressure and has so far taken over USD. 82.9 Billion so far to tide over the crisis.
6. 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.
7. 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.
8. 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.

What is Money Market?

1. Money Market is actually an inter-bank market where banks borrow and lend money among them to meet short-term need for funds.
2. Banks usually never hold the exact amount of cash that they need to disburse as credit.
3. 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).
4. As the housing loan crisis intensified, banks grew increasingly suspicious about each other’s solvency and ability to honor commitments. The inter-bank market shrank as a result and this began to hurt the flow of funds to the ‘real’ economy.
5. 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.
6. A sense of disbelief and extreme precaution is prevailing in the banking sectors
7. 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).
8. 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.
9. Let us hope that proper monitoring and controlling of the money market will eventually control the situation.

The results

1. The collapse of big investment banks in USA and around the world.
   E.g.:-In the span of 72 Hours, “Bear Stearns” went from a profitable entity to the verge of bankruptcy.(Liquidity crisis)
2. The financial crisis and bankruptcies of insurance companies in USA .
   E.g.:- Bailout of $85 million by US government to AIG
3. Closure of credit rating agencies due to the Sub prime loan crisis in US.
4. Due to US sub prime crisis ,caused European and Asian Banks to write down   billions of dollars in holdings.
5. Less spending by U.S. Consumers and companies reduce demand for imports. (21%  of the global economy is represented by U.S.A)
6. Dropping U.S. Stock prices drag down other stock exchanges in the world by   30%.
7. Retrenchment, lay off, termination, unemployment.(In November 2008 Employers eliminated 533,000 jobs , the largest single month loss in 34    years). As per ILO at least 20 million jobs in the world will have been lost by the end of 2009 .

Results(continued..)

1. Dramatic drop in the demand and price of commodities.
2. Nationalization of banks and financial institutions
   E.g.: Landsbanki by Ice land,  Washington Mutual, Fannie Mae and Freddie      Mac by USA.
3. Car sales in all over the world is dropped by 31%
4. Bailout plan of $ 700 billion to money market by US govt.
5. Home appliances trading were dropped around 20% for the first time in last       20 years in Japan and South Korea.
6. Sri Lank is facing 35 % drop in the export of commodities.
7. Sovereign funds in the Middle East is resulted a loss of $451 billions.
   E.g.:- Abu Dhabi Investment Authority.

Lesson learned.

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 ideological front, it is high time to have a rethink on the very idea of free markets and capitalism.

We can hope this condition (where greed of some people can affect the lives of billions) will face a rectification properly in the coming future.

Greed vs. Trust

Greed is the pursuit of self-interest that infringes on the rights of others.

Economic transactions involving unethical or greedy behavior impose higher transactions costs for monitoring and enforcing contracts.

Adam Smith notes that “virtue and trust lubricate the wheels of society”.

Trust and shared moral values play a crucial role in facilitating the work of the Market’s Invisible Hand.