The biggest world economies have still not been able to recover from something that happened in the year 2008. The economy of USA was completely shaken but behind it economies like India (basically BRICs) were also affected. Indian economy was doing well before the US sub prime mortgage crises. After 2008 it was only in 2015-16 that the economy could get back on its feet. Today I will be writing about the US crises 2008. It is a topic related to finance, so all the people here from a non finance background, you will get to read about a lot of new things today. Those of you from a commerce/finance background, you will also get to read about a lot of new things today too. It was a joke. But I guess you didn’t laugh.
This blog is highly technical and to understand the story in it we must understand many economic terms before hand. So please bear with me and carefully read the upcoming 12 paragraphs. By the end, I promise, you will know more than your economics teacher.
Today global business is a reality. But how is it possible? It is possible because of a marvelous financial system under it.
The system has three components. The first one is a system of payment across the borders. The second one is insurance because when things go wrong we need someone to help us out. The third one is information and market. When this structure is made we can move towards global business. The large scale flow of private capital across the world in the past thirty years aided by massive deregulation, is called financial globalization. Before private capital flow IMF and WB controlled the game. They still exist but are very small now (comparatively). How did they control the game before 1980? Let me answer this question with another question. Before 1980, If countries needed money where would they go?
The eclipsing of Bretton woods system, deregulation of the currency markets, domination of private capital flows, very poor regulatory frame works, domination of Wall Street’s extreme capitalist model and global connectivity were the six major developments which came together in 1980. Why are we about to study global connectivity or internet in finance’s context? The reason is that all the instant information today solely depends on the internet. The company listed in Bombay stock Exchange is also listed in Wall Street and NASDAQ. If a company is listed in both then instant information is coming on all the screens. Hence, the entire financial system which has made global business possible is only possible due to global connectivity.
Nassim Nicholas Taleb predicted the crises. He is the author of the famous book the black swan. As per him ‘Black Swans’ are highly unlikely events which turn out to be a reality. These are mostly negative by nature. From 2001-2007 the world GDP growth rate was very favourable. It went from 4 to 5 to 6 to 7 to 8% per annum. Everyone predicted it would go to 9 then 10 and on and on and on. But in 2008 it crashed in India. This is a classic example of black swan. What was its effect? Due to everything being connected, everything crashed, this caused the ambitious schemes in India to fail, the tax collection to fall down drastically and hence caused mass deficit. This is the challenge Narendra Modi’s government is facing. To bring GDP growth rate up, investment is necessary. Where will the money come from? It can come from India and it can come from abroad. Indians do not have high savings and foreigners don’t trust us. After excessive travelling he has been successful in bringing the GDP growth rate up and this is the reason I am his fan.
Next we talk about financial contagion. It is a scenario where small shocks which initially affect only a small part of the economy, spread to other financial sectors and countries, just like a medical disease. They destroy confidence. I will give a very simple example. Imagine you have 1 million dollars. You lend it to many people at a fixed rate of interest and keep some property as collateral. 50% people you gave the money to gave you fake property papers. These people give this money to other people for collateral and interest. Many of these new people gave fake papers. They lend the money further. This goes on and on and on. You think you are getting very rich, which you are, on paper, but when reserve bank of India comes for an audit it asks who was the first person you lent money to. After an audit of that person it tells you that 50% of your collateral papers are duds and hence 50% of your borrowers are NPAs or non performing assets. But you have your company listed on the stock market, both at Bombay Stock Exchange and the Wall Street because brokers were extreme capitalists. Your investors get the news that 50% of your borrowers are NPAs and they lose confidence. They take out their money, invest in land and gold and hence enter the real street. This is a classic spillover of a wall street problem into real street. Did you see the mix of black swan, wall street, real street, extreme capitalism and financial globalization? Imagine this on a huge scale, where almost every person of a country is involved. This is the reason people say life 50 years ago was very nice. Everything was independent.
A very important term we will be using again and again in the crises is ‘sub prime mortgages’. They are loans given to less worthy individuals to buy homes, during the US housing bubble of 2000. These mortgages eventually burst the bubble in 2000s.
A basic rule of capitalism is that government does not interfere in the business of a private company. But when a company is to big to crash the government uses a bail out. When a large corporate which was profitable and employed large numbers suddenly goes bust, the government does not let that happen due to many social considerations. The financial help given to avoid the bust is called a bail out. This is called too big to fail.
You will see that different investors got different rate of interest in the crises. To understand that we should first understand credit risk and liquidity risk. Credit risk is the risk of loss due to non payment of debt owned by an entity. Liquidity risk refers to the situation that an entity will have insufficient cash to meet its obligations. This can happen when the company’s products are no longer in demand.
The most important definition is CDO or Collateralized debt obligation. It is a security backed by a diversified pool of debt obligations like bonds, loans or home mortgages.
CDS which is credit default swap is a financial contact between a protection buyer and a protection seller thus it is an insurance against default. Finally Leverage is Borrowing huge chunks of money to earn huge profits by scaling up deal sizes.
Now that we know what CDO, CDS, leverage, credit risk, liquidity risk, bail out, sub prime mortgage, financial contagion, black swan, financial systems are, we can finally get to the US sub prime mortgage crises. So are we ready to understand this flow chart?
It was believed the price of homes will never go down in the US because every family wanted to live in a better house. A typical prime family has a father, a mother, a son or a daughter and a pet, that is it. The prime family wants a better house house. But unless you are a rock star or an industrialist you can not buy a house without a loan. The family goes to a mortgage broker whose sole job is to join you and the bank. As soon as you get a loan from the bank, the bank keeps the mortgage papers, which basically means that your house is not your house until you repay the entire loan with interest. This is the ideal system and always runs smoothly, but the Gramm-Leach-Bliley Financial Modernization Act of 1999 wanted the system to move faster. The investment banks enter the picture. These are the banks which are run by the best outputs of the best colleges and universities. The job of these banks is to help people earn huge amounts of money and take interest in between. This is absolutely legal. Its sources of money before Gramm-Leach-Bliley were leverage, China and Japan and US Federal Bank. The fat cats (very rich people) who are the people with excess pension funds, mutual funds and sovereign funds invested money in US Federal bank before 1999. Other than people with such funds, huge investment banks and people with hedge funds invested in US federal bank.
After 1999 Gramm-Leach-Bliley Financial Modernization Act allowed investment banks to deal with commercial banks. The commercial banks sold many mortgage papers to investment banks. The investment bank made a new weapon with all these papers called CDO. The investment banks made three slices of the CDO. The first slice is called AAA or safe. The people in this slice are those with a high fixed income. The second slice is BBB or okay, the people in this slice are not as well to do as the ones in first slice and the third slice is risky where people belong to sub prime families. The banks asked the insurance company AIG to insure all three slices and make CDS. Now the main investment bank is the big player. While the American Federal bank is giving the fat cats, the offshore investment banks and people with hedge funds only 1% interest rate, the investment bank is willing to give the AAA slice to the fat cats for 4% interest, the slice BBB to offshore investment banks for 7% interest and the risky slice to people with hedge funds for 10% interest. It thus spread the time bomb world wide. But the problem has not started yet. We are in 2003-2004. Everyone is very happy.
But now, all the three investors call investment bank and ask for more slices because they are getting amazing interest rates. The investment bank puts the pressure on commercial banks to get more mortgage papers. The bank puts the pressure on mortgage broker. This broker goes in the market and gets many new costumers. After 6 – 12 months, ultimately one day comes when the prime families run out. All the prime families have bought the houses they wanted. The pressure messed up the situation. As a broker all you care about is your commission and to get it all you have to do is get costumers. You don’t care if they are prime or sub- prime and you develop teaser loans. A sub prime family has one father, one mother, three sons, two daughters, 6 dogs, 2 cats and an average paying job (just an example). Due to teaser loans, which are the loans with low rates of interest at first but higher rates later, sub prime families couldn’t pay back their loans after 1 or 2 years. When you do not repay loans bank seizes your property. Now the problem starts. The investors see that the money is not coming. The repossessed homes are sold. So over night property prices started dropping. The prime families see that the value of their homes is much lower than the loan they are giving. They leave their homes and shift to a cheaper but much more luxurious house. This causes the market to fall down even faster than before. In this disaster no one knows who has which mortgage paper across the globe. So the banks stopped exchanging money overnight. The banks stopped giving loans to the people who were in need of money and the economy of USA crashed. Everyone drowned across the globe because no one knew who has which sub prime loan because the banks which monitored it closed down. The investors in this crises were investors in India and all of them pulled the money from the stock markets of India. Whenever USA will stop QE or Quantitative easing which is pushing money in the economy, global investors will stop investing in India because they have been a victim of financial contagion and trust nobody. This is how India is related. This was the US Housing crises, financial crises, credit crises and sub prime crises.
One thing we can learn from this is that pressure is never good. So dear CBSE lift the pressure off us. Hope you enjoyed the blog!