By Abhishek Sen
On 6th of May 2008 the CNBC website reported Mr. Martin Feldstein, a Harvard University professor and president of the National Bureau of Economic Research, United States, as saying that the US economy is steadily slipping into a recession. Looking at the economic indicators noteworthy are the facts that from March 2007 to March 2008, the unemployment rate jumped from 4.4% to 5.1%. In February, the manufacturing capacity use rate was 78.7, down 1.4% from its peak in July. (Source: www.marketoracle.co.uk)
The Federal Reserve has cut down its rate from 4.75% in September’07 to 2.0% in April’08. If we look at the quarterly percent change in the GDP (based on constant $ value) of US, the levels prevailing for 2007 and for the first quarter of 2008 resembles the levels that prevailed during the earlier recession of 2001. The real estate market plummeted after years of soaring values and foreclosures has gone up sky rocketing beginning from the later half of 2006.
The preceding paragraph hints to the well known fact that US is now in the midst of a financial meltdown called the Sub-prime Crisis, whose ripples are felt all over the global economy. Academicians and administrators around the world are trying to gauge how far reaching impact this crisis may have and how long it may last.
The roots of the present crisis may be traced back to the Dotcom Bubble burst and the subsequently ensuing recession in the United States in the year 2000. During mid 1990s, internet based companies became the buzz word in the US. The web-based technology projected itself as a new paradigm which caught the imagination of people and the companies operating in the domain were thought to have huge potential. Since the domain was comparatively new, it had the entire international market before it to tap. The companies could raise huge capital from the market easily and in no time their capital base soared as people showed much eagerness in investing with them. Many of the companies had huge capital bases even before the first dollar revenue entered their balance sheets. Each of the companies tried to out-compete the other and monopolize the market. In the bid to do so they raised huge capital and spent lavishly. But as always, in a competitive set up, only few emerge winners. So when the time came to open up the balance sheet to the share holders, many companies came up with dismal performances, far below what have been expected out of them. Their share prices crashed and many of the players in domain declared bankruptcy. There were 457 IPOs released in the domain in 1999. In 2001 there were only 76. Billions of dollars vanished in the wind and the economy started looking down the barrel. To compound the situation, the twin tower blast happened on September 11, 2001 forcing the economy to into a recession.
To tide over the situation, Allan Greenspan heading the Federal Reserve then, started cutting the fed rate drastically and on June 25th , 2003 the rate came down to 1% from a peak of 6% in January’ 2001. This was intended to inject more liquidity within the system, so that people have more money supply at disposal and thus can spend more. Spending was seen as a national duty so that the aggregate demand gets a boost and thus the economy comes back on trail once more. The policy worked well and the economy got the requisite boost.
As the interest rate was deliberately kept at drastically low levels, the cost of borrowing was much reduced. Around 2002-2003 the interest rate on a 30 year fixed mortgage was lowest in preceding 40 years. This worked very well for the real estate industry. As the cost of borrowing decreased people started borrowing and invest in real estate. The prices of houses started soaring and so did the demand for it. It was the cheapest source of equity around and since the price of the houses was perceived to go up and up, the belief was that loans of any amount can be paid back easily by liquidating the equity and even then a surplus can be made out of it. People started buying homes they can barely afford and the terms of the loans encouraged them even more to do so.
Till this far it was only a problem of excess demand and slow supply. So prices went up. If this were allowed to remain so, it could never have spiraled into a crisis. The other side of the story began as we bring the lenders into the picture. The real estate agents were earning profits out of this and so were the home owners. The financial institutions and banks as lenders also decided to join the bandwagon through creation of certain innovative financial tools. It is in this point that the root to the crisis lies. This is so because these very financial innovations in effect precipitated the crisis that we are currently in.
The business of financial institutions is to lend money at an interest. The more they lend, the more is their interest income and hence their revenue. The constraint in this case is the “creditworthiness” of the borrower. The JP Morgan rule of lending was lending to entities that are known to repay back. In this case the credit history of the entity was taken into considerations to judge the credit worthiness. This was in addition to the income or economic status of the entity. In the US the financial institutions and the banks, in order to expand their lending net, started lending to people with not so stellar credit history. This was not totally an uncalled for exuberance on the part of the banks. The economy was going up and up. The spending power of the people was increasing so long as they were able to liquidate their equity as and when needed. So there was no default as such. Though other economic factors could have indicated a rejection of loan application, the expectation that was created by timely repayment of earlier loans rendered lending to this group of entities a feasible option. So the banks started to include these groups in their lending net and but they did so typically in exchange of a higher interest rate since the risk of default was more here. This phenomenon of lending to entities with less than stellar credit history in exchange of a higher interest rate is known as Sub Prime lending. The amount of sub prime lending went soaring high in the US during this time. As on the second quarter of 2007 sub prime loans accounted for 14% of all outstanding mortgages in the US. This was just the beginning of the financial innovation.
Next the Financial Institutions innovated upon the concept of Asset Backed Securities (ABS). Asset Backed Securities is a type of security which is backed by a pool of assets which are otherwise illiquid in nature. They may also be based upon cash flow receivables from underlying assets. For example a credit card issuing bank may securitize its credit card receivables and sell that off to any investors. The bank is thus able to raise its capital and the investor in turn shall get the amount promised on the security. This concept was acted upon and a new instrument called Residential Mortgage Backed Securities (RBMS) was innovated. These securities typically consists of several mortgage loans bundled together wherein the residence of the borrower is kept as collateral. Within this pool of loans, the sub-prime loans are also included. These securities are then given various ratings by the credit rating agencies and based on this rating the investors purchase the securities. The advantage for the investor is that he or she can hold diversified portfolio by buying these securities. The RBMS were classified under various “trenches”. The higher trench of securities was promised the first dollar that would come in course of repayments. The lower trenches carried the risk of default and to compensate that they these securities carried higher rates of return for investment. The lowest trench carried the maximum risk of default but maximum return.
This enabled the banks to shift the burden of even sub prime loans out of their balance sheets. So they became more aggressive in widening their credit net. They loaned indiscriminately and also with clauses that enabled them to provide loans of greater amount. The clauses of down payment were overlooked, even they loaned more than value of the property. The argument was that the rate in which the home prices were rising, the borrower could finance it easily at future periods. By 2005 the home prices were rising by almost 14% every year. The credit rating agencies were also providing the securities with high investment grades and thus the banks or other financial institutions were having no difficulty in selling these loans off.
Further innovations came into the market in the form Collateralized Debt Obligation (CDO) which is nothing but a type of RBMS in which the existing mortgage loans were repackaged with other forms of securities (not necessarily the mortgage backed loans) like pension funds, hedge funds etc. In this way RBMS of lower trenches, consisting of sub prime loans as one of the components, could be bundled with other securities and could earn higher investment grade. The CDOs are also typically classified into several trenches and the same trickle down financing methods is applied here. Thus CDOs played the role of distributing the risk of the loan to broader number of investors in the economy as this typically can also include pension funds and other forms of security.
The CDO and RBMS together thus disconnected the lender of sub prime loans from the borrower of such loans in terms of risk of default which afforded the financial institutions the luxury of being reckless in lending loans. And amidst all these the housing prices continued to soar and people continued to speculate in them. The banks came up with more innovative schemes where the initial repayment was very low but after the expiry of a specific period the payment would sky rocket. These schemes were called Adjustable Rate Mortgage (ARM). People took these loans eagerly in the hope of making huge profits out of increasing home prices and thus the late repayment was perceived to be fairly easy.
This phenomenon continued through 2005 and 2006. In late 2006, due to the rising fear of inflation, interest rate was increased. As the rate of interest increased, the cost of loans and hence the amount to be repaid to the lender, increased suddenly. Also the repayment of the ARMs began to start. Default increased suddenly. As the default rates went up sharply, the so called innovative financial instruments, CDO and RBMS suddenly became just a paper’s worth. They were highly illiquid as the cash flow backing them stopped. The lenders of mortgage loans could no longer sell their sub –prime loans to other agents. Many of the large financial giants such as Bear Sterns which was later on brought by JP Morgan Chase, JP Morgan Chase themselves, Citi bank were hit by high defaults. They were also holders of many CDOs which also hit their revenue sheet. Many of the players declared bankruptcy and had to close down which declared the onset of Sub prime crisis. Banks and financial institutions became much alarmed and disbursing loans and thus liquidity crunch ensued. The contagion effect has worked in this case and institutions across the globe have been hit by the sub prime crisis.
To overcome this impending crisis, the central banks across the globe are cutting down the interest rate to inject money into the system and thus to boost up aggregate demand. The government of the United States has started lending generously to the financial institutions to maintain their viability. The fed rate cut also has the impact of providing the banks to borrow from the fed at a low rate of interest to maintain their capital base. In addition to that the US government has also started a project called “New Hope” wherein they are talking with the lenders and the borrowers of ARMs so that the lenders freeze the initial low repayment rate for another five to six years, in which time the borrower can approach the loan repayment in a more methodical manner. Also the government is providing tax relief to the affected population. But the crucial factor is the downward spiral of the home prices. The sooner that stabilizes the better it is for the US and the global economy. More and more the home prices drop, more is likely to be the equity loss of the people which will aggravate the situation even more.
On 6th of May 2008 the CNBC website reported Mr. Martin Feldstein, a Harvard University professor and president of the National Bureau of Economic Research, United States, as saying that the US economy is steadily slipping into a recession. Looking at the economic indicators noteworthy are the facts that from March 2007 to March 2008, the unemployment rate jumped from 4.4% to 5.1%. In February, the manufacturing capacity use rate was 78.7, down 1.4% from its peak in July. (Source: www.marketoracle.co.uk)
The Federal Reserve has cut down its rate from 4.75% in September’07 to 2.0% in April’08. If we look at the quarterly percent change in the GDP (based on constant $ value) of US, the levels prevailing for 2007 and for the first quarter of 2008 resembles the levels that prevailed during the earlier recession of 2001. The real estate market plummeted after years of soaring values and foreclosures has gone up sky rocketing beginning from the later half of 2006.
The preceding paragraph hints to the well known fact that US is now in the midst of a financial meltdown called the Sub-prime Crisis, whose ripples are felt all over the global economy. Academicians and administrators around the world are trying to gauge how far reaching impact this crisis may have and how long it may last.
The roots of the present crisis may be traced back to the Dotcom Bubble burst and the subsequently ensuing recession in the United States in the year 2000. During mid 1990s, internet based companies became the buzz word in the US. The web-based technology projected itself as a new paradigm which caught the imagination of people and the companies operating in the domain were thought to have huge potential. Since the domain was comparatively new, it had the entire international market before it to tap. The companies could raise huge capital from the market easily and in no time their capital base soared as people showed much eagerness in investing with them. Many of the companies had huge capital bases even before the first dollar revenue entered their balance sheets. Each of the companies tried to out-compete the other and monopolize the market. In the bid to do so they raised huge capital and spent lavishly. But as always, in a competitive set up, only few emerge winners. So when the time came to open up the balance sheet to the share holders, many companies came up with dismal performances, far below what have been expected out of them. Their share prices crashed and many of the players in domain declared bankruptcy. There were 457 IPOs released in the domain in 1999. In 2001 there were only 76. Billions of dollars vanished in the wind and the economy started looking down the barrel. To compound the situation, the twin tower blast happened on September 11, 2001 forcing the economy to into a recession.
To tide over the situation, Allan Greenspan heading the Federal Reserve then, started cutting the fed rate drastically and on June 25th , 2003 the rate came down to 1% from a peak of 6% in January’ 2001. This was intended to inject more liquidity within the system, so that people have more money supply at disposal and thus can spend more. Spending was seen as a national duty so that the aggregate demand gets a boost and thus the economy comes back on trail once more. The policy worked well and the economy got the requisite boost.
As the interest rate was deliberately kept at drastically low levels, the cost of borrowing was much reduced. Around 2002-2003 the interest rate on a 30 year fixed mortgage was lowest in preceding 40 years. This worked very well for the real estate industry. As the cost of borrowing decreased people started borrowing and invest in real estate. The prices of houses started soaring and so did the demand for it. It was the cheapest source of equity around and since the price of the houses was perceived to go up and up, the belief was that loans of any amount can be paid back easily by liquidating the equity and even then a surplus can be made out of it. People started buying homes they can barely afford and the terms of the loans encouraged them even more to do so.
Till this far it was only a problem of excess demand and slow supply. So prices went up. If this were allowed to remain so, it could never have spiraled into a crisis. The other side of the story began as we bring the lenders into the picture. The real estate agents were earning profits out of this and so were the home owners. The financial institutions and banks as lenders also decided to join the bandwagon through creation of certain innovative financial tools. It is in this point that the root to the crisis lies. This is so because these very financial innovations in effect precipitated the crisis that we are currently in.
The business of financial institutions is to lend money at an interest. The more they lend, the more is their interest income and hence their revenue. The constraint in this case is the “creditworthiness” of the borrower. The JP Morgan rule of lending was lending to entities that are known to repay back. In this case the credit history of the entity was taken into considerations to judge the credit worthiness. This was in addition to the income or economic status of the entity. In the US the financial institutions and the banks, in order to expand their lending net, started lending to people with not so stellar credit history. This was not totally an uncalled for exuberance on the part of the banks. The economy was going up and up. The spending power of the people was increasing so long as they were able to liquidate their equity as and when needed. So there was no default as such. Though other economic factors could have indicated a rejection of loan application, the expectation that was created by timely repayment of earlier loans rendered lending to this group of entities a feasible option. So the banks started to include these groups in their lending net and but they did so typically in exchange of a higher interest rate since the risk of default was more here. This phenomenon of lending to entities with less than stellar credit history in exchange of a higher interest rate is known as Sub Prime lending. The amount of sub prime lending went soaring high in the US during this time. As on the second quarter of 2007 sub prime loans accounted for 14% of all outstanding mortgages in the US. This was just the beginning of the financial innovation.
Next the Financial Institutions innovated upon the concept of Asset Backed Securities (ABS). Asset Backed Securities is a type of security which is backed by a pool of assets which are otherwise illiquid in nature. They may also be based upon cash flow receivables from underlying assets. For example a credit card issuing bank may securitize its credit card receivables and sell that off to any investors. The bank is thus able to raise its capital and the investor in turn shall get the amount promised on the security. This concept was acted upon and a new instrument called Residential Mortgage Backed Securities (RBMS) was innovated. These securities typically consists of several mortgage loans bundled together wherein the residence of the borrower is kept as collateral. Within this pool of loans, the sub-prime loans are also included. These securities are then given various ratings by the credit rating agencies and based on this rating the investors purchase the securities. The advantage for the investor is that he or she can hold diversified portfolio by buying these securities. The RBMS were classified under various “trenches”. The higher trench of securities was promised the first dollar that would come in course of repayments. The lower trenches carried the risk of default and to compensate that they these securities carried higher rates of return for investment. The lowest trench carried the maximum risk of default but maximum return.
This enabled the banks to shift the burden of even sub prime loans out of their balance sheets. So they became more aggressive in widening their credit net. They loaned indiscriminately and also with clauses that enabled them to provide loans of greater amount. The clauses of down payment were overlooked, even they loaned more than value of the property. The argument was that the rate in which the home prices were rising, the borrower could finance it easily at future periods. By 2005 the home prices were rising by almost 14% every year. The credit rating agencies were also providing the securities with high investment grades and thus the banks or other financial institutions were having no difficulty in selling these loans off.
Further innovations came into the market in the form Collateralized Debt Obligation (CDO) which is nothing but a type of RBMS in which the existing mortgage loans were repackaged with other forms of securities (not necessarily the mortgage backed loans) like pension funds, hedge funds etc. In this way RBMS of lower trenches, consisting of sub prime loans as one of the components, could be bundled with other securities and could earn higher investment grade. The CDOs are also typically classified into several trenches and the same trickle down financing methods is applied here. Thus CDOs played the role of distributing the risk of the loan to broader number of investors in the economy as this typically can also include pension funds and other forms of security.
The CDO and RBMS together thus disconnected the lender of sub prime loans from the borrower of such loans in terms of risk of default which afforded the financial institutions the luxury of being reckless in lending loans. And amidst all these the housing prices continued to soar and people continued to speculate in them. The banks came up with more innovative schemes where the initial repayment was very low but after the expiry of a specific period the payment would sky rocket. These schemes were called Adjustable Rate Mortgage (ARM). People took these loans eagerly in the hope of making huge profits out of increasing home prices and thus the late repayment was perceived to be fairly easy.
This phenomenon continued through 2005 and 2006. In late 2006, due to the rising fear of inflation, interest rate was increased. As the rate of interest increased, the cost of loans and hence the amount to be repaid to the lender, increased suddenly. Also the repayment of the ARMs began to start. Default increased suddenly. As the default rates went up sharply, the so called innovative financial instruments, CDO and RBMS suddenly became just a paper’s worth. They were highly illiquid as the cash flow backing them stopped. The lenders of mortgage loans could no longer sell their sub –prime loans to other agents. Many of the large financial giants such as Bear Sterns which was later on brought by JP Morgan Chase, JP Morgan Chase themselves, Citi bank were hit by high defaults. They were also holders of many CDOs which also hit their revenue sheet. Many of the players declared bankruptcy and had to close down which declared the onset of Sub prime crisis. Banks and financial institutions became much alarmed and disbursing loans and thus liquidity crunch ensued. The contagion effect has worked in this case and institutions across the globe have been hit by the sub prime crisis.
To overcome this impending crisis, the central banks across the globe are cutting down the interest rate to inject money into the system and thus to boost up aggregate demand. The government of the United States has started lending generously to the financial institutions to maintain their viability. The fed rate cut also has the impact of providing the banks to borrow from the fed at a low rate of interest to maintain their capital base. In addition to that the US government has also started a project called “New Hope” wherein they are talking with the lenders and the borrowers of ARMs so that the lenders freeze the initial low repayment rate for another five to six years, in which time the borrower can approach the loan repayment in a more methodical manner. Also the government is providing tax relief to the affected population. But the crucial factor is the downward spiral of the home prices. The sooner that stabilizes the better it is for the US and the global economy. More and more the home prices drop, more is likely to be the equity loss of the people which will aggravate the situation even more.
Source:i) Various Articles from http://www.investopedia.com/
ii) Definitions and concepts have been defined following http://www.econlib.org/
1 comment:
A complicated crisis has been explained in a very lucid way.
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