Deep-Insight

This article is one of many articles on American financial crisis on the web, although it’s not much different except for the fact that I like most of the people am a layman. Well if I am then how have I written this article ? I researched internet and discussed the matter with people who are good at this … and this article is a sum of how they made me understand the matter.

0. What is the crisis ?

The first question one asks is what is an economic crisis ? Well an economy is the system through which whatever is produced by various companies is distributed to people who buy these goods and services (Insurance and banking do not produce goods they provide services instead) from their salaries or profits. Now when all these parameters namely production, distribution and consumption grow together in tandem then economy is said to be in good health. As a consequence people’s salary increases which leads them into buying more goods which in turn boosts profit of big and small companies and tiny businesses. However if any of these move in the wrong direction or move too fast or too slow as compared to other parameters a crisis happens.

Now over to what is happening right now in US economy, most repeated line on the news now days is that subprime mortgages have crashed which is causing all this slowdown. Lets take a detour to understand subprime mortgages

• All financial companies take money from one source (investors, saving accounts etc) and invest it out into other sources like giving money out on loans, buy shares or bonds with it. In the process they earn more money than they have to return to their own source and this is their profit.
• Anybody who wants to take a loan, borrow money say to buy a house they need credit ratings, these ratings tell the banks as to asses how much risk do they take while giving loan to that person. A person with a better credit rating is more likely to succesfully return the loan amount than a peron with a bad credit rating. According to these ratings the rate of interest (the additional amount of money along with loan to be returned) is set. Higher rating is equivalent to a low rate of interest and higher chances of getting the loan sanctioned.
• Now these big financial companies came up with an idea so as to lend money to those people who did not have proper credit ratings (e.g. People with bad loan repayment records). This category of loans was called subprime loan, this according to wikipedia is the practice of giving loan to people who did not qualify for best market intrest rates because of their bad credit ratings. SO what these companies did was they said that we’ll give you money and we’ll overlook the fact that you haven’t paid your loans in the past and in exchange of this you people will pay us higher rate of interest to us. This resulted in huge amount of profits for the finance companies, as now they were not only doing more business (of giving loans) but they were doing it at higher profits too (higher interest rates).
• This arrangement worked for several years because the assets (things people bought with the loaned money e.g. houses) were increasing in prices so even if someone was unable to pay high intrest loans the company always had the asset (in our example the house) as security (in case of non payment they can easily sell the house). In the meantime other companies also got involved in this practice.
• The finance companies issued bonds for subprime loans in the market, these bonds offered higher returns (Income) to people. So many people and other companies (even european banks) bought these bonds and invested huge amount of money in these bonds. Insurance companies too got involved in insuring these loans as this resulted in increased business for them.

Now what has happened is that the rates in housing markets have crashed and this has caused a major problem for the finance companies. As they had given loans to people who were unreliable and risky to give the loan to and hence they are unable to repay loans but unlike earlier the companies can’t depend on the assets which in many of the cases are houses (a house is found to be the biggest contributor to an average American’s net worth). Now the price of these houses is decreasing instead of increasing so even if these companies sell these houses they won’t be able to get back their money or the interest due to them. This in turn is causing a rise in claims from insurance companies which share part of the risk and hence part of the losses if they occur. So both finance and insurance companies are suffering huge losses and as a direct consequence they are not able to return money to the bond holders (Subprime loan related bonds) and these happen to be companies from other sectors and even other banks which did not directly indulge so much in subprime markets. So the bond prices are going down resulting in a loss for all the parties involved.
All this would be covered in detail in the later sections.

1. Brief Time-Line of the crisis

Click Here for a larger image. This is just a brief time line and many events might have been skipped but the purpose of this was just to give an idea of how things have been taking place and as this article is not meant for experts so I think that readers will excuse me if some of the finer details have been missed.

2. Causes

After the dot com bubble burst in late 2000 and 2001 beginning many companies went into huge loss, as the share prices fell and companies faced huge amount of asset reduction American economy faced a slowdown. Feds (Govt. Authority which sets the interest rates in banking sector) aggressively lowered federal fund interest rates from 6.5% to 1% in 2004, lowest since 1958. Now it is widely considered that this was excessive cut and it should not have continued beyond 2002 - 03.

Excessively low rate of interest resulted in a housing boom thus causing a surge in demand of houses. This in turn caused the price of houses to rise and everybody started investing their savings in housing market.

With ever rising house prices lending institutions relaxed their lending rules as the housing collateral behind the loans was gaining in value, so these banks had increased security in case of non repayment of loans. Mortgage banks and other lenders began to accommodate subprime borrowers with dubious credit by extending mortgage loans to homebuyers who would not have qualified in other times.

With the demand for mortgage loans increasing, large banks resorted to some inventive financing of their own in order to economize their capital. They began repackaging loans and slicing them into some exotic new types of securities, and in so doing, shifted their lending risk to the buyers of such securities. Thus came into being a new class of securities-often rated AAA by credit rating agencies - that money market funds, insurance companies, pension funds and other investors could purchase.

3. Current Situation

Now Feds are again decreasing the interest rates so as to stop the collapse in lending markets. Biggies of financial world are booking huge losses and some of them like New Century Financial, American Home Mortgage, Countrywide Financial Corporations face bankruptcy or have narrowly avoided it. You might not have heard about these companies but the probability is that they probably own or have dealings with your own bank.

Oil prices are almost at an all time high and this is going to hurt common Americans hard. During all the earlier financial crisis when US economy faced performance issues oil prices fell too. But this time they are holding constant, as a result while Americans will have less to spend gasoline prices (and in turn transport prices of goods) will hold high hence they’ll have to pay more for the same goods. The main reason behind this is that now rising economies from developing world like China and India are driving oil consumption and hence OPEC (Oil Producing and Exporting Countries) is not afraid of any immediate significant recession in demand.

US companies face losses and falling demands result is that they would have to cut down on costs which may result in lesser employment and more outsourcing.

4. Future Scenario

Now lets see what can happen in future?

The immediate consequence of this mortgage crisis seems to be an inevitable credit crunch. This will result in formation of new credit guidelines which will deny hundreds of thousands of Americans the opportunity to own their homes. This overreaction to the ongoing crises will deepen the pit into which US economy seems to be falling. Availability of credit is like a lubricant to the engine of economy, and as it becomes difficult to acquire economy will face a further slowdown.

Besides this high oil prices are going to hit average American hard in the wallet, this will cause gasoline prices to increase and hence every industry associated with it (like transport) will have increased cost which again would be passed to the consumer, the average American.

Now over to rest of the world, earlier whenever America sneezed world economy used to catch a cold. Meaning that in the past whenever US economy even began to show symptoms of slowdown world economy would begin sliding on a downward slope. Now the situation has changed developing countries like China and India are still gaining momentum with one clocking double digit growth and the other nearing the same. European zone being closely integrated with US economy has felt shocks but they seem to be much milder there in Europe than in United States. Besides that world economy is not that much dependant on US anymore, US share of world imports has fallen from 25% ion 2000-01 to under 19% now, so world economy will face slowdown but now it has the ability to compensate for some part of the problem.

5. Conclusion

Best hope lies with the very fact that world economy will not fall into the slowdown process (atleast not to the extent it did earlier) and here lies the best way out of this crises. US can now depend on rest of the world specially the developing countries leading the growth race to eventually bring it out of slowdown. As these markets wont be facing a slowdown so demand for products in these markets will rise. If US industries take advantage of falling dollar value backed by carefully framed policies and target these markets they might trigger another cycle of robust growth for US economy.