Economic Recession

PREFACE IN THE FORMATION OF THIS REPORT EFFORTS HAD BEEN MADE TO COVER EVERY ASPECT OF THE RECESSION BUT DUE TO THE TIME CONSTRAINT SOME OF THE TOPICS HAD NOT BEEN COVERED IN ITS FULL EXTENT SUCH AS HOW RECESSION SPREAD FROM U.S. TO ACROSS THE WORLD, AND WHAT ARE THE IMMEDIATE MEASURES TAKEN BY THE INDIAN GOVT TO PROTECT INDIAN MARKET, AND WHAT ARE THE CAUSES OF GREAT DEPRESSION OF 1926 AND HOW U.S. CAME OUT OF IT. HOWEVER EVERY EFFORT HAS BEEN MADE TO EXPLAIN THE PRESENT ECONOMIC CRISIS AND FAILURE OF LEADING BANKS OF THE WORLD AND THE BAILOUT PLAN ADOPTED BY THE WEST TO KEEP RECESSION UNDER ARREST SO AS TO PREVENT IT FROM BECOMING A DEPRESSION AND AT LAST BUT NOT THE LEAST THE IMPACT OF RECESSION ON INDIA.

INDEX 1.Why banks prefer low rates. 2.How low rates lead to recession. 3.Spread of Crisis 4.Measures taken by U.S. 5.Measures taken by other economies. 6.Impact on India 7.Conclusion

ABSTRACT -

Prior to crisis the financial market in U.S. and other major economies of the world had been growing at a rapid rate. Investors of all types that is both the small savings of household and large corporate savings have been able to mobilize their savings and earned a lot investing through capital market. Various type of sectoral funding agencies had been operating to facilitate those movements and help the borrowers in getting their requirement financed. However, with the advent of subprime crisis that generally refers to situation that resulted from the borrowing defaults on subprime lenders. This type of lending was advanced mostly by the mortgage funding agencies. However as long as situation in both the market i.e. capital market and property market remained tacit the things were okay. With time the house prices initially rising and than falling these agencies started making huge losses on account of defaulting loans and decreasing prices and decreasing prices of mortgaged houses. This led to credit crunch for other sector thus the whole financial market came under this grip. Also recently some of the America’s top investment banks like Lehman Brothers, Merill Lynch, Wachovia also started falling as the assets valuation began to

decrease and liabilities rose for these institutions. This economic imbalance first hit the financial sector, then the credit sector, then the whole of capital sector. 1.Why prefer low rate 1.1 “Lend and hold model” Before 1970s U.S. financial sector was an example of a highly regulated and stable financial system in which bank dominated deposits rate were controlled, small and medium deposits were guaranteed, bank profits were determined by the difference between deposits and lending rates, and banks were restrained from staying into areas such as securities, trading and insurance. To quote one apt description, that was a time when banks that lent to a business or provide a mortgage would take the asset and put it on their books much the way a museum “would place a piece of art on the wall or under glass to be admired and valued for its security and constant return”. This was the “lend and hold model”. `

1.2 “Originate and sell model”

1.Banks extended their activity beyond conventional commercial banking into merchant banking and insurance.

2.Within banking there was a gradual shift in focus from generating income from net interest margins to obtaining them in the form of fees and commissions charged for various financial services. 3. Banks adopted changes in the focus of banking activity. While banks did provide credit and create assets that provide a stream of income in the future, they did not hold these assets any more. Rather, they structured them into pools securitised those pools, and sold these securities for a fee to institutional investors and portfolio management. Banks transferred the risk for a fee, and those who bought into the risk looked to the returns, they would earn in the long run. This was the “Originate and sell” model. This “Originate and sell” model of banking meant, in the words of Secretariat of the Organization for Economic Cooperation and Development, the banks were no longer museum, but parking lots that served as temporary holding spaces to bundle up assets and sell them to investor looking for long term investments. 1.3 Loop Holes Financial liberalization increased the number of layers in an increasingly universalized financial system, with the extent of regulation varying

across the layers. In areas where regulation was light ( investment banks, hedge funds and private equity firms, for instance), financial companies could borrow a huge amounts based on a small amount of their own capital and undertake leveraged investment to create complex products that were often traded over the counter rather than through exchanges. Finally, while the many layers of the financial structure were seen as independent and were differentially regulated depending upon how and from whom they obtained their capital ( such as small depositors, pension funds or high net worth individual ), they were in the final analysis integrated in ways that were not always transparent. 1.4 Only way to survive The household debt crisis erupted in the 1990s, largely because of the stagnation in real wages (more than a quarter of U.S. workers labour for wages below the poverty line). As ordinary people struggled to hold on to jobs, they turns to the generous credit markets to pay off their overpriced homes, their cars, their college tuitions and their everyday expenses. The Federal govt. kept interest rates very low to enable the expansion of the debt, which was one easy way to maintain the illusion of the

American dream as U.S. manufacturing disappeared and pay packets in service jobs shrank. The total consumer debt in the U.S. is now about $2.6 trillion (22 % more than in 2000). Mortgage debt is around $10.5 trillion (in 2000 it was $4.8 trillion) 1.5. Steps that gradually lead to failure Banks that sold credit assets to investment banks, and claimed to have transferred the risk, lent to or invested in these investment banks in order to earn higher returns from the less regulated activities. Investment banks that sold derivative to hedge fund served as prime brokers for these funds and therefore provided them credit . Credit risk transfer neither meant that the risk disappeared nor that some segments were absolved of exposure to such risk. T his complex structure, which delivered extremely high profit to the financial sector, was prone to failure and has been proved by the number of bank failure in the U.S. after the 1980s. The Saving and Loan (S & L) crisis was precipitated by the financial behavior induced by liberalization; and the collapse of long term capital management pointed to the dangers of leveraged speculation.

Each time a mini-crisis occurs, there are calls for a reversal of liberalization and return to regulation. But financial interest that had become extremely powerful and had come to control the U.S. treasury managed to stave, off criticism, stall any reversal and even ensure further liberalization. The financial sector had become to complex to be regulated from outside; what was needed was self regulation. In the event, a less regulated more complex financial structure then existed at the time of S & L crisis was in place by the late 1990s. 2.How low banking rates leads to economic collapse. From late 2002 to mid 2005, the U.S. Federal Reserves federal funds rate stood at levels, which implied that, when adjusted for inflation, the “real” interest rate was negative. Further, by the middle of 2003, the federal fund ate has been reduced to 1%, where it remained for more than a year. Easy access to credit at low interest rates triggered a housing boom, which in turn triggered inflation in housing prices that encouraged more housing investment. From 2001 to end 2007, the real estate value of household and the corporate sector is estimated to have increased by $14.5 trillion. Many believe that thw process would go on.

Sensing an opportunity based on that belief & the interest rate environment, the financial system worked to expand the circle of borrowers by including sub prime ones, or borrowing with low credit ratings and high probability of default. Mortgage brokers attracted these clients by relaxing these income documentation requirements or offering sweeteners like lower interest rates for an initial period. The share of such sub-prime loans in all mortgage rose sharply, from 5% in 2001 to more than 20% by 2007. In the process, demand rose stressing the prices, as a result house prices began to rise. The interest cost in general started rising making the borrowing costly. As a result many borrowers started defaulting. 3.Spread of Crisis However, the crisis began in June 2007 with the advent of subprime market crisis hitting the US market. This crisis became prominent in June 2007 when the two subprime mortgage hedge funds managed by Bear Stearns collapsed followed by three other funds managed by BNP Paribas. The financial dam burst on Sep 13, 2008. A flood of capital swept out of the stock

markets and went into govt backed bank accounts, where they remain pooled up and inert. For the month after Sep 13, the topography of the wall street changed radically. Bear Stearns (founded in 1923) had already collapsed in March and was acquired by J.P.Morgan (Which later bought the ailing bank Washington Mutual).Lehman Brothers (founded in 1850) declared bankruptcy, and was swepy up for a song by Babclay’s Bank . Merlill Lynch (founded in 1914) folded alongside Lehman, to be picked up by the Bank ofAmerica. American International Group (AIG) (founded in 1919), the world’s largest insurance company went down the slope towards bankruptcy but was saved at the eleventh hour by an emergency infusion of $85 billion by the U.S.Govt, few weeks later, the Federal Reserves provided an additional loans of almost $38 billion just as reports emerged that executives of the firm went off on a corporate retreat that included golf and spa treatment and cost $440,000. Again later in july and august, govt sponsored mortgage agencies Freddie Mac and Fannie Mae (created in 1970 and 1968 respectively) faltered. Federal reserves pumped in $200 billion to ease the credit situation. Finally, in mid October, Wells Fargo

Bank absorbed Wachovia Bank (founded in 1879). Meanwhile, J.P.Morgan (founded in 1824) and Goldman Sachs (founded in 1869) went from being investment bank holding companies (with Mitsubhi taking a stake in J.P.Morgan) Turbulence on the stock market now resulted in a downward slide for the Dow Jones and, as a consequence, for the world’s stock market. By Sep 18, sellers flocked to the pits, asking for their money back, and put whatever could be made liquid into the cash backed by the governmental assurance. Credit markets seized up, which threatened economic activity outside stock exchanges, investment firms and their computer networks. The pulse of electricity now began to make inroads into the confidence of those who hire and fire, who makes and break. 4.Measures taken by U.S. Treasury Secretary = Henry Paulson Federal Reserve Chairman = Ben Bernanke Chairperson of the Federal deposit insurance carp = Sheila Bair J.P.Morgan chase was paid off to take over Bear Stearns at a cheap price.  Lehman was allowed to go. 

 Fannie Mae and Freddie Mac were nationalized.  AIG was rescued with a huge infusion of public funds, triggering allegation of conflict of interest on the grounds that this was an effort at protecting Goldman Sachs that was substantially exposed to the insurer (AIG) But as a number of cases multiplied and lack of a clear strategy become obvious, the danger of the financial crisis intensified. This was when the the first signs recognition that there was a problem of potential generalized insolvency emerged. The first response was TARP (Troubled asset relief programme). Declaring that the system was faced with financial collapse of a kind that could drive the economy to recession, the Treasury Secretary, backed by the Chairman of the Federal Reserves, badgered congress into authorizing a $700 billion bailout package, which was primarily geared to buying into out the near worthless or “impaired” mortgage related assets rom financial institution, as also any other assets from any other party so as to “unclog” their balance sheets and get credit moving. However, no one knew

the exact size of this toxic pool, and even Paulson admitted that the figure he choose was largely a guess. Asked what he might do if this plan did not work, Paulson responded “We have nothing else”. Paulson assumed as the credit entered the system, normal economic vibrancy would pick up. In other words, the Bush team saw this as a solvency crisis created by the bad loans made by irresponsible bankers and not as a wider problem of debt in American society. This plan, too, did not clearly recognize that generalized insolvency was a potential problem. This was clear from the fact that the bailout plan sought to use market based methods to buy up troubled assets. Since, the prevailing market price of those assets was also close to zero, this would imply that the institutions selling those assets would have to take large write downs onto their balance sheets and reflect these losses. This would undermine their viability and result in failure unless they were recapitalized with an infusion of new funds. No one knows the exact size of the fictitious sector , but some estimate that

the credit default swap market alone is about $62 trillion. The danger this poses to the financial architecture is considerable. This is particularly the case as the major banks and investment houses now consolidate into four companies (J.P.Morgan, Citigroup, Bank of America, and Wachovia Wells Fargo). The toxic fictitious sector and equally unstable consumer debt bubble are within the balance sheet of these four entities. 5.Measure taken by other economies. The U.K., having experimented with liquidity infusion and limited nationalization, went beyond the Bush Administration. P.M. Gordon Brown announced that his govt would resort to “equity injection” to buy ordinary and preferences share worth £37 billion in three of the biggest bank of the Country : Royal Bank of Scotland (RBS), Lloyds TSB, and HBOS. 

Gordon Brown was the first Western Leader to announce virtual stake takeovers of major banks.

The Decision to nationalize banks was forced on the British government because facing the

banking system was not just one of inadequate liquidity resulting from fears generated from subprime crisis. Rather, credit market had frozen because the entities that needed liquidity most were those faced with a solvency problem created by the huge volumes of the bad assets they carried on their balance sheet. To lend to or buy into these entities with small doses of money was to risk losses and rendered these banks viable. So money was hard to come by, this is disastrous for a bank because rumors of its vulnerability trigger a run that devastate its already damaged images. What needs to be noted, however is that nationalization Is not the end of the matter. In addition British govt had chosen to guarantee all bank deposits, independent of their size to prevent a run. It has also decided to guarantee inter bank borrowing to keep credit flowing as and when needed. Once the U.K. decide to take this radical and comprehensive route, others were quick to read the writing on the wall. What followed was a deluge. Germany with an estimated bill of €470 billion, France with €340 billion, and others govt with large amounts, pitched in with plans to recapitalize banks with equity injection, besides guaranteeing deposits and inter bank lending. U.S. too has decided to use $250 billion of the bailout money to acquire a stake in a large number of banks. Half of that money is to go to the

nine largest banks, such as Bank of America, Citigroup, Wachovia and Morgan Stanley. The minimum investment will be the equivalent of 1.1% of risk weighted assets or $25 billion whichever is lower. 6.Impact on India Since Indian market is still in its nascent stage of growth with relatively less exposure to international credit market. Thus, the trade analysis and the policymakers believe that the financial crisis in the U.S. will have limited impact on Indian Market. The recent turnmoil in the financial markets weakened dollar in terms of major currencies. However, after the spread of the crisis in other major capital markets, the dollar value strengthened again. Some of the leading banks of India those invested abroad in debt and security markets will be hit by the crisis. ICICI, HDFC (Companies whose shares are listed in NASDAQ and NEW YORK Stock Exchange.) Some of the Indian companies that are listed in the New York Stock Exchange are Dr.Reddy’s Laboratories Limited, GenPact Ltd, HDFC, ICICI, MTNL, Satyam, Sterlite Industries Ltd,

Wipro, WNS, Tata Communication Ltd, Tata Motors Ltd. 7. Conclusion Even if the banks are safe (though there is no definite guarantee) there are many other institutions, varying from hedge and mutual funds to pension funds, that have suffered huge loses, both from the subprime fiasco and the stock market crash, eroding the wealth of many. Housing prices are still falling. The effect of that wealth erosion on investment and consumption demand are only now unraveling, indicating that there is much to be hold in this story. What may be necessary is one step more the refinancing of mortgages to stop the foreclosures that underline the financial crisis.