World Recession And New Challenges Ahead

World Recession and Emerging Challenge_ SN

World Recession and New Challenges Ahead Sukumar Nandi Indian Institute of Management Lucknow Introduction The world is passing through a critical period. Every month thousands of persons are losing their jobs and the situation of the economy in individual countries is confounding the experts about the possible time of the upturn. The situation is complex in the sense that total uncertainty prevails regarding the movements of major economic parameters of the individual economies. The centre of world capitalism shifted to the United States of America after the World War II and last two decades saw an accelerated pace of globalization of the system. The strong interdependence among countries through international trade and capital flows has created a smooth process of transmission of economic effects across political borders. So any economic event in any country sends waves that do not remain limited within the political boundaries. This brief note will analyse the perspective of the recession that set in first in the United States of America. In Section 1 we will analyse the recession in USA. The spill over of recession in Europe and other countries will come in Section 2. Section 3 will explain the situation in Asia and the last section will be in the form of a conclusion. 1.

American Perspective

In the dawn of 21st century American economy started to show the sign of downturn and to address this situation Federal Reserve of the United States ( Fed) adopted a policy of expansionary monetary policy to stimulate economic growth. To this end Fed reduced the Federal reserve Fund rate and it came down to 1 per cent in 2003. Also the prime lending rate became as low as 4% in 2004. The sub-prime market had been lucrative to the lenders as the sub-prime borrowers would pay higher interest rate and fees for a mortgage loan than a customer with good and reliable track record. But since the Federal Reserve Fund rate had been too low that the real rate of interest was hardly 1 % , even a 2 to 3 per cent higher rate of interest for the sub-prime borrowers was lucrative enough to take loan from the banks. During the period 1996 to 2004 the financial market in the USA had witnessed the innovation of new products and the government had maintained a market driven approach. In their enthusiasm to go after the lucrative sub-prime market the lender banks introduced in the market a set of new products. Thus there were Alt-A loans ( loan based on alternate documents with little credibility), NINJA loans that were granted even when the situation was “ no income, no job, no asset” for the customer, and the piggyback loan in which case the home buyer could purchase a house with less than 20 per cent down payments. In fact, when prices of houses were rising, the last category of loan was most lucrative for the customer as buying house for investment was a good proposition.

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World Recession and Emerging Challenge_ SN The banks structured all these products in such a way that they had deceptively low monthly payments in the beginning followed by higher payments in later part. This induced higher rate of delinquencies and foreclosures. The question that becomes important is what made the lenders feel that they could take on the extra risk introduced by these products? The answer to this question leads to the interesting boom in the credit derivative market that had been the creation of the banks. Banks often sell their loan portfolio to investors in order to reduce the risk exposure. While this is an effective measure, this is difficult to implement as the loan portfolio of one bank may not suit the needs of another investor. As a result the portfolio ends in sale with large discounts for the banks. However, this issue was largely been eliminated during the period 2003 – 2006 with the growth of another product in the name of Collateralized Debt Obligation ( CDO ). In fact CDO market started booming. The CDO are securities that are backed by a portfolio of bonds or loans. This product could be better tailored to match the needs of the investors through ‘tranches’ or classes of securities with different levels of risk offering the investors wide range of choices. Although these tranches made the sale process easy, the problem it created was that it tended to obscure the inherent credit risk of the underlying risky loans. With the growth of in the securitization market or the market typified by a pool of loans or mortgage backed securities, this model had a metamorphosis with the introduction of a third party – the pooling underwriter. The latter is normally a separate financial institution that builds special purpose vehicle ( SPV) like CDOs that are securitized by loans. The pooling underwriter further breaks the instruments into various tranches __ each tranche representing a pool of loans with similar risk exposure. These tranches are then sold to third party for immediate cash. This also benefits the lender in the sense that the latter can transfer its credit risks. The life cycle is also known as originate- and – distribute approach. In this the credit risk is now applied at two levels___ at origination during the underwriting process of loan and the pooling process when the risk measurement has to be applied to calculate the risk of each tranche. But in this whole process of sub-prime loans, both loan and pool underwriters based their decision mostly on scores provided by Fair Isaac Corp. – scores which are popularly known as FICO score. This was done as historical data for the customers in this segment were lacking. But as researchers discovered later , the FICO score was not enough to get the true picture of the creditworthiness of the customers or the investors. 1.1. How big is the sub-prime crisis? In September 2007 issue of Financial Market Trends (FMT), it was reported that the likely size of sub-prime and Alt-A mortgage losses was USD 300 bn1. The official views at that time were in the USD 100 – 150 bn range. That previous estimate was based on a 14% over-all defaultloss probability applied to the stock of mortgages ( sub-prime, Alt-A etc ) of about USD 2.3 trillion. The 14% was based on weighing up the ABX indexes ( prices of credit default swaps used to insure risk of default in the underlying sub-prime mortgage) across vintages and tranches at the time of September 2007. Strictly speaking the ABX applies to sub-prime, the worst part of the market, whereas private label Residential Mortgage-Backed Securities ( RMBS) include mortgages other than subprime – for example Alt-A , jumbo loans etc. CDO and Structured Investment Vehicles (SIV) use RMBS and other asset backed securities ( ABS). The CDO issuance was USD 1.47 trillion in 2007 and the figure becomes much larger if unfunded synthetic CDOs are included.

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A. Blundell-Wignall, “ Structured Products: Implications for Financial Markets”, Financial Market Trends, volume 2007/2, No. 93.

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World Recession and Emerging Challenge_ SN What ultimately happened in the financial market in USA is now history. Whether it is a huge market failure, or irresponsible oversight of the regulator or the government, or lack of responsibility and prudence of the banking system _ researchers are busy now to look for the real cause of this financial disaster. 2. Spill Over to Other Countries The world is now truly globalized as economies are interlinked through trade and capital movements. In this process the sub-prime crisis originated and deepened in the United States had spill over to Europe and other countries. One third of RMBS related CDOs is thought to have moved offshore and to Europe in particular. Insurance companies are likely to have a large part of the RMBS held in Europe. From a financial intermediation perspective they do not mark to market. Nevertheless, levered financial institutions are also exposed to RMBS – backed products, so all of the issues concerning losses and deleveraging above apply in Europe too. Also the European banking system concern is its exposure to banks in Eastern European countries. They fix their exchange rates and borrow in foreign currency. Inflation is accelerating in some of these countries as capital inflows and managed exchange rates prove incompatible ( the famous trilemma in international finance). This situation may emerge as a close parallel of Asian Currency Crisis of 1997. 3. Spill Over In Asia Asia is less directly exposed to sub-prime crisis in USA. But as the US dollar declines, these countries face a different type of risk __ asset inflation through excess liquidity. This is a possibility as many countries in this part of the world peg their currency to US dollar and may try to resist exchange rate appreciation. But if these countries want to avoid the rolling bubbles associated with excess liquidity, they are to follow more flexibility in their exchange rates. Unfortunately some countries still maintain rigid peg to US dollar to maintain competitive edge in export markets even though it is widely recognized that the concerned currencies are undervalued. Among the countries in Asia China and Hong Kong had some direct loss exposure to US sub-prime crisis . One estimate put the exposure of the Chinese financial system to the US structured credit products at about USD 10 billion. The direct exposure to sub prime related assets accounted for 3.7 per cent of total banking asset in China2. Other important countries that are expected to have spillover effects are Japan, South Korea, Taiwan and India and that has happened through their trade links. The United States counts for about 22 per cent of India’s exports and meltdown of US economy would affect the economy of India to the extent proportional to the export linkage. But it will be less compared to China. 3. Conclusion The fear of recession in the US is now translated in some sectors of the economy and one effect of that is the deterioration in the climate of credit. Commercial credits, car loans, credit card loans – all look very much precarious. All these cast their shadow on the complex cascade derivative structure in the Wall Street only to reinforce the question that how creditworthy all these credit ratings are!

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Tao Sun and Xiaojing Zhang, Spillover of the US Subprime Turmoil to Mainland China and Hong Kong SAR: Evidence from Stock Markets, IMF, WP/ 09 / 166, August, 2009

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World Recession and Emerging Challenge_ SN The sub-prime crisis taught us several lessons. First, somewhere in the evolution of the financial crisis when the cobweb of financial engineering had been creating the securitization maze , the relation between the short term real interest rate and the long term rate got snapped. Second, the resources of the central banks were flooded with arbitrage-able assets like equities, bonds, real estate and other financial assets created through financial engineering. This aspect constrained the power of the central bank to articulate monetary policies to halt the bubble. Third, once the human mania starts on any issue, and in this case it is with buying houses with bank mortgaged loans, monetary and fiscal policy become powerless and the situation continues till the bubble burst. This has exactly happened in US and the effects then spread across political boundaries. *******

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