Faces Of Recession

"A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain..!! "

- Mark Twain

I am no Paul Krugman or Amartya Sen to talk about economics. The only economics paper that I have ever read was for my Management paper in my 7th semester, that too at the eleventh hour before the exams. Nevertheless, I decided to dig deep into causes of this recession (you start looking at things seriously, only when the impact zone is nearer to you). For starters US economy has officially started shrinking, 0.5% for this quarter. What amazes me is the failure of Big Corporations in US you name it Goldman Sachs, Lehmann brothers, Merrill lynch, AIG Insurance, Citi Group, Bear Sterns, Fannie Mae and Freddie Mac. These are A-list corporations that attract the best management talent in the world from Ivy League, Wharton and IIM’s in India. Just to give an idea, there only 10 countries in the world whose Gross Domestic Product is larger than their combined losses (Thank God, India is one of them). So the mistakes that have been done are not only big, but it’s also done by pretty smart people ( Now , they don't look so smart, after posting losses of billlions of dollars, do they??? ).


Let’s start the story of how US came to what it is today, it all started with the housing market in US. US government pro actively encouraged people in America to own their houses. Banks were encouraged to lend to people on an active basis. Greedy Banker’s who got money for pushing loans through, lent money to non credit worthy people. With more people willing to pay the extra amount to get their own house, the housing rates started climbing. Its simple story how demand had started going up beyond the supply and as a result the prices started to climb up. Many people took loans to buy the houses; this went on for a couple of years, creating what you call an artificial housing bubble. Our smart management guys, during this time came up with something called “Derivatives”. Its basically hi-fi term where you turn the credits the bank has given to you into some other piece of bond paper guaranteeing you the money against the house’s monetary value for which the money has been lent upon. Now comes the funda, this derivatives were sold by the banks and bought by other banks, financial institutions around the world. Especially investment banks like Goldman Sachs, Merrill Lynch bought these derivatives as a means of investing their money. Their logic was simple, the housing rates would go up further in the future, and so would the value of derivatives taken against the housing properties. As the housing rates went up, profits were being made by this banks, hence the exorbitant pay cheque’s for the CEO’s of this companies, who encouraged by their return on investments started putting more money into this derivatives. But as everything else, whatever that goes up must come down, when the demand for houses started slowing down, the housing prices started to fall. People suddenly realized that the house they bought for say 50,000$ by taking a loan was worth actually less than that in terms of market value, lets say it dropped to 40,000$. Now the question arises, would you continue to pay the loan to your bank for a higher price or abandon the house you bought to the bank and save what money you have on hand. Unfortunately most people chose the latter option. They simply defaulted on their loan payments and left them. Now the irony is, unlike in India where banks can sue the person for non loan repayment, banks in US cannot sue the person; they can only confiscate the property against which the loan was taken. So the house went to the bank, people walked of freely without paying the loans. But still, banks need to somehow rise the money, 50,000$ they had given as a credit to client to get back their money, but the house against which they had lent against is only worth 40,000$, a net loss of 10,000$.

Now imagine the above scenario played across multiple regions in US, with millions of people defaulting on their loans, they housing property value further plummeted, which translates to more loss of banks. With property value decreasing, less people were interested in making their hard earned money as an investment on houses, so less takers for houses. Add to this high oil prices that were observed at the start of the year (refer Oil on the Boil ), which was adding to the cost of common man and a weak US dollar, which drains out credit in the market. You have recipe for recession ready for you. At some point in this vicious cycle, there were not simply enough people to buy houses which banks needed to sell, to raise money, leading to shortage of credit on banks side. Of course, you can’t forget the Derivatives, which investment banks had bought. Well they were just meaningless pieces of bond papers, and nobody knew what their actual monetary value was. Panic set in, financial institutions were ready to sell these Derivatives, but there was no one to buy. They had just managed to exchange huge amounts of money against pieces of worthless paper (at least the paper value was worth something, though the money against which it had been bought upon had gone up in smoke). These derivatives percolated the toxicity across all financial institutions, leading to losses in billions of dollars.

One by one Merrill Lynch, AIG Insurance, Wachovia, Lehmann brothers, Bear Sterns ran out of money, which meant they either had to be taken over by other banks or file for bankruptcy or the government had put in tax payers money to save the private entity. Has Ben Bernanke, US Fed Reserve chairman had put it, these corporations are just too big, to allow them to fail. When big corporations collapse, people who work for them get fired leading to unemployment, less money on people’s hands to buy stuff. Again the same story, less demand means, less production, less work, more lay off’s. Its vicious circle, the only solution being pushing a stimulus package to the banks, so that it trickles down to common people, who can fuel for demand, hence bring about increase in production. Ben Bernanke did the right thing, by pitching for the 700 billion dollar bailout, but the question remains whether it is enough (because the toxicity of bad debts has ran into a whopping 1 trillion dollar). Now coming to the point, why did I talk about US economy so much, simple it’s not fair for people here in India (or in US) to get laid off by companies because of some Greedy Banker mismanaged the bank and a group of other CEO’s invested their money blindly in some pieces of paper without doing a proper risk assessment. But one thing I have learnt is Life’s not always fair. People go on harping about Globalization, how outsourcing has created millions of jobs in India. Well, this is the other side of Globalization; you just can’t keep on eating the cake, at some point of time you may have to bite the dust to!!

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