Year 2008 has been dramatic for United States and the whole world. To summarize everything - Real estate crash, financial sector turmoil, credit crisis, liquidity crisis, a wave of bankruptcies and worldwide economic slowdown!!! The subprime crisis was just a trigger to a much bigger and pervasive crisis. It is not a mere downturn, but the problem has deep roots.
How it all started? Asset prices in US were massively overpriced thanks to mainly irresponsible and illogical Government and FED (USA central bank) policies and reckless Wall Street. Extremely loose credit standards led to people borrowing money to buy houses which they could not afford- be it a pizza delivery boy or someone working at McDonalds. These subprime borrowers (borrower who have a credit score below a particular level – high credit risk) were able to pay low initial mortgage payments. (For first 1 or 2 years they had to pay only interest component and interest rates were very low). They were hoping to make some money with rising home prices.
Wall Street securitized all these mortgages and repackaged it as Mortgage backed securities (MBS) and CDOs. MBS are securities whose cash flows are backed by the principal and interest payments of a set or a pool of mortgage loans. In CDOS, these pools are divided into different levels or tranches ((by issuers); the top level represents the higher credit rating, pays lower coupon and are less risky, whereas the lowest level has the low credit rating, pays high coupon but enclose more risk. Most of these securities are highly illiquid and should have been given very low credit rating, but were given AAA rating by credit agencies. These mortgages were insured by the companies like AIG. Wall Street giants used their reputation to sell this gold plated crap worldwide; they also had considerable exposure to MBS themselves. Most of the banks engaged in arbitrage where they would obtain funding on short term loans with low interest rates and invested in MBS (which yield high interest rate but are fundamentally risky); these banks were significantly over leveraged.
Adjustable-rate mortgages began climbing in mid-2007; most of the subprime borrowers found it difficult to pay mortgage payments after reset period (Where payment also includes Principal component). Homeowners began to default on their mortgages. House prices were also on decline from 2005. In many cases the value of the homes fell below mortgage; here creditors are at big risk as the homeowner can just walk away. MBS turned out to be toxic waste; everyone now wanted to avoid it but there is no market for it. Subprime crisis further led to credit crisis. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Their arbitrage using MBS started falling apart and they stared incurring huge losses in subprime. In June 2007, 2 Bear Stearns managed hedge funds declared huge losses in subprime. Real blow hit USA in 2008, with Bear Stearns going under in March, then followed Fannie Mae and Freddie Mac in summer and Lehman, AIG in September; Morgan Stanley, Citi also took huge blows and now we have auto giants like GM, Ford in immense troubles. After financial sector meltdown, Stock markets took real hit with more and more companies declaring depressed or negative earnings. It has now hit the main street with the wave of bankruptcies and the surge in inflation. There are deep economic consequences too - People with negative home equity cannot take out money to start new businesses or send their kids to college etc.
US led financial Tsunami soon hit the world. USA is the world's biggest economy (30 per cent of global GDP) and now world's biggest debtor country. Its economy is based on consumption and borrowing with negative saving rate. Most of the countries have heavily invested in USA. To add to their woes, their exports took deep blow with demand from world’s largest consumer plummeting.
In nutshell, outrageous monetary policies and easy credit standards led to credit expansion, increase in leverage, increase in risk appetite, increase in asset prices and oversupply. Now as the bubble is deflating, we are seeing the opposite - credit contraction, tightening lending standards, deleveraging, risk appetite goes down, asset prices go down, and markets go down, decrease in supply through bankruptcies.
What to expect now? The recession may last for one more year if the situation is handled properly, can last for even 10 years if it is messed around. House prices fall will continue for some time. We are no way near bottom in terms of bankruptcies. There will be more unemployment. Asset deflation will be massive – bailouts needed are massive. Low interest rates and excessive money printing will start showing its evil side and there could well be hyper inflation after democrats take over. Dollar may collapse. The list of troubles is just too big.
What needs to be done? Need to get supplies down through bankruptcies. We need to create belief, trust and conservative loan. It’s not bad thing if prices of home fell, we can have more credit checks. Also as more defaults occur, the face value of the debt decreases - there is growth again. As there are more bankruptcies there are great entrepreneurial opportunities. The time is also apt to revamp the regulatory architecture.
There has been too much of wealth destruction. The golden question - Where has the major portion of the money gone? I bet - it’s the pockets of big Wall Street executives!
- Finance freak
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