The recent recession has taken a huge toll on people across the world. Everyone in the planet is affected by it in some way or the other. During a recession all sort of bad things happen. Millions loose jobs. Real estate values plunge. Companies go bankrupt. Stock markets crash. Air travel is significantly reduced. Bank lending will come to a standstill. People spend less. Everyone associate all bad things happening to them to the recession.
The best part about recession is that, when it happens, economists scream from their roof tops about the impending danger. It is the subject of discussion and debate in every nook and corner. Unless you are staying in a cave and is totally cut off from the rest of the world, you are unlikely to miss this. However once we recover from the recession, no one tells you about that. You can't blame them because the recovery is a gradual process.
So how does one determine we are out of the woods? Well, some of the signs are recovery in the stock market, companies resume hiring in masses, banks start lending money, real estate values start picking up and so on. Until the arrival of the next recession everything looks rosy.
Where do we stand now? Experts state that we are on a road to recovery. Only time can tell.
It is a vicious cycle. The recovery does not mean it is the beginning of eternal glory for world economy. The cycle will continue. World economies will rise and fall. Today's renewed hope will be the beginning of another bubble in the making which will get burst eventually.
How did the recent crisis begin? You may have heard terms like Credit crisis, Sub-prime mortgages, Collateralized Debt Obligation or CDO and so on. Here is an attempt to put all the pieces together. Courtesy Jonathan Jarvis.
The credit crisis brings two group of people together. The home owners and investors. Home owners represent their mortgages and investor represents their money. These mortgages represent houses and investors represent large institutions like pension fund, insurance companies, sovereign fund, mutual funds etc. These groups are brought together through the financial system by a bunch of banks and brokers commonly known as Wall Street. These banks on Wall Street are closely connected to these houses on main street. To understand how let us look a little further.
Years ago the investors were sitting on a pile of money looking for their good investment to turn into more money. Traditionally they go to federal reserve (the US central bank) or they turn to treasury bill believed to be the safest investment. Due to lower interest rates offered by fed, investors said no thanks to fed and treasury bill. On the flip side, Banks on wall street could borrow money easily from fed at lower interest rates. Add to that general surpluses from Japan, China and the Middle East and there is an abundance of cheap credit. This makes borrowing money easier for banks and causes them to go crazy with leverage. Leverage is borrowing money to amplify the outcome of a deal. Leverage makes good deals into great deals. This is a major way Banks make their money. So Wall street takes out tons of credit, makes great deals and grows tremendously rich and then pays it back. So far so good.
The investors (the large institutions mentioned above) sitting with a pile of cash see this and wants a piece of the action and this gives wall street an idea. They can connect the investors to the home owners through mortgages. Here is how it works. A family wants a house. So they save for a down payment and contact a mortgage broker. The mortgage broker connects the family to a lender who gives them a mortgage. The broker makes a nice commission. The family buys the house and becomes home owners. This is great for them because housing price have been rising practically forever. Everything works out nicely. One day the lender gets a call from the investment banker who wants to buy the mortgage. The lender sells it to him for a very nice fee. The investment banker then borrows millions of dollars and buys thousands more mortgages and puts them into a nice little box. This means every month he gets the payment from the home owners for all the mortgages in the box. He then cuts the box into three slices and name them 'safe', 'okay' and 'risky'. Then packs the slices back up in the box and call it a collateralized debt obligation or CDO.
A CDO works like 3 cascading trays. As money comes in, the top tray (namely 'safe') fills in first and spills over into the middle (okay) and whatever is left into the bottom(risky). The money comes from home owners paying off their mortgages. If some owners don't pay and default on their mortgage, less money comes in and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risks the bottom tray receives high rate of return and the top tray receives lower but still a nice return. The credit rating agencies stamp the top trays a AAA rating making it the safest. The okay tray gets a rating BBB still pretty good and they don't bother to rate the risky slice. Because of the AAA rating the investment banker can sell the safe slice to the investors who only want safe investments. He sells the okay slice to other bankers and the risky slices to the hedge funds and other risk takers. The investment banker makes millions. He then repays his loans. Finally the investors have found a good investment for their money much better than the 1% treasury bills. They are so pleased they want more CDO slices. So the investment banker calls up the lender wanting more mortgages. The lender calls up the broker for more home owners but the broker can't find anyone. Everyone that qualifies for a mortgage already has one.
But they have an idea. When home owners default on their mortgage the lender gets their house and houses are already increasing in value. Since they are covered if the home owners default, lenders can start adding risk to new mortgages, not requiring down payments, no proof of income, no documents at all. That is exactly what they did. So instead of lending to responsible home owners, called prime mortgages, they started to get some that were less responsible. These are sub-prime mortgages. This is the turning point. So just like always, the mortgage broker connects the family with the lender and a mortgage making his commission, the family buys a big house, the lender sells the mortgage to the investment banker. He turns it into a CDO and sells slices to the investors and others. This actually works out nicely to everyone and makes them all rich. No one was worried because as soon as they sold the mortgage to the next guy it was his problem. If the home owners were to default, they didn't care. They were selling off the risk to the next guy and making millions like playing hot potato with a time bomb.
Not surprisingly the home owners default on their mortgage which at this moment is owned by the banker. This means he forecloses and one of his monthly payments turns into a house. No big deal. He puts it up for sale. But more and more of his monthly payments turn into houses. Now there are so many houses for sale on the market, creating more supply than there is demand and housing prices aren't rising anymore. In fact they plummet.
This creates and interesting problem for home owners still paying their mortgages. As all the houses in their neighborhood go up for sale the value of their house goes down and they start to wonder why they are paying back their $300,000 mortgage when their house is now worth only $90,000. They decide that it doesn't make sense to continue paying even though they can afford to and they walk away from their houses. Default rates sweep the country and prices plummet. Now the investment banker is basically holding a box full of worthless houses. Because of his buddy the investor to sell his CDO. But the investor is not stupid and says no thanks. He knows the stream of money isn't even a dribble anymore. The banker tries to sell to everyone but no body wants to buy his bomb. He is freaking out as he borrowed millions of dollars to buy these bombs and he can't pay it back and can't get rid of it.
But he is not the only one. The investors have already bought thousands of these bombs. The lender calls up trying to sell his mortgage but the banker won't buy it and the broker is out of work. The whole financial system is frozen and things get dark. Every body starts going bankrupt. But that's not all. The investor calls up the home owner and tells him that his investments are worthless and you can begin to see how the crisis flows in a vicious cycle. Welcome to the crisis of credit.
Rajesh Kumar
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