Monday, 13 January 2020

Great American Recession in 2007-08 Case Study

During the middle of the year 2007, world’s biggest economic power that is the United States got a severe jolt to its economy with the bursting of Housing Loan or Real Estate bubble popularly known as Sub Prime Mortgage Loans crisis when big investment Banks like Lehman Brothers had to be taken over by J.P.Morgan. Big housing loan players like Countrywide Financial Bank of America, Sub Prime Mortgage lender had to be taken over by Bank of America and Federal National Mortgage Association; another Sub Prime Mortgage Lender had to be taken over by new statutory Government US Undertaking Federal Housing Finance Agency.

Even if you ask a thousand people today about the great American Recession of Sub Prime Mortgage Lending Crisis in the United States, there will be thousand different answers, different explanations but no convincing reply as general public is used to find faults with their National Governments in Power, and point fingers at Barack Obama, George Bush or Dr. Manmohan Singh. Have you ever thought as to how a single person or the elected Governments can bring about a national crisis or even if they would have ever liked such a crisis to come to the fore? This is the finest example of the Laize-fair-economy or Free Capitalistic Economy without any control by the elected Governments.

To make the readers understand in more clear terms I am going to explain a concept of Evergreening of Assets instead of having Non-Performing Assets by small Banks all over the world. I used to hear about the concept of evergreening of assets by very small banks so that their balance sheets showed a rosy picture of their affairs. With the introduction of NPA norms the banks and financial institutions had/have to provide for likely losses due to the level of Non Performing Assets as Sub Standard, Doubtful or Loss. Now provisions have to be provided even for Standard Assets as no assets can be considered as zero risk assets.

I still wonder as to why these norms have been applied to the Corporate World so that their true financial position is known to the public and the Banks, who finance the corporate in terms of equity, debt, term loans or working capital limits. This economic lapse or bubble, when bursting globally, may astonish the small investors and bank’s depositor customers.

Anyhow coming to the point what is the concept of evergreening of assets. Say an asset or a loan with any Bank of financial Institution is showing signs of sickness and fit for being classified as Non-Performing Asset then the same Bank may enhance the working capital limits or provide mortgage loan to the owner of the business to enable the owner to come out of crisis without finding the actual reasons of crisis. In the meantime, the borrower will go to some other bank to seek a loan against the mortgage of the property based on the current market value of the property. The credit provided by the new bank will result in increase in money supply which will fuel the prices of property and the borrower, without generating any income out of the productive use of the extra funds, will get more loans from the same financial institution or a new lender. The Loan of the borrower will go on increasing without being classified as Non Performing Assets and the last lender in the chain will have to burn its fingers if the borrower is not able to find favor with other lenders/bankers/financial institutions. This is really what happened during the Sub Prime Mortgage Lending crisis when the smart people made money out of the real estate and when the air bubble burst, nobody knew the bottom line as all economic corrections depend upon real demand and real supply.

The very purpose of this article is to plug the loopholes in the economy which should work on the principle of real demand and real supply and all speculative activity be banned by the Governments immediately. I feel I am going off the track. Now coming to the great American Recession of 2007-08, we need to revisit the economic history of the 1990s.

Banks and Financial Institutions lend money to finance industrial projects, agriculture, retail loans, consumer loans and home loans depending upon the economic viability of the projects or repaying capacity of the borrowers in respect of retail loans. Sometimes when the national government do not want to increase the money supply by way of deficit financing then such governments encourage financing of real estate, stock, and shares through banks and lending institutions by framing lending schemes which do not require any constitutional amendment or legal sanctity and the smart people take benefit of such loopholes by taking recourse to speculative activities to create artificial demand and supply of real estate and/or stocks and shares and an artificial boost bubble gets formed sending global message that the economy of that country or nation is rapidly growing economy

By encouraging the banks and lending institutions, the governments had never thought that smart people will play the game in such a way so as to risk the very existence of sound investment banks like Lehman Brothers in the United States.

I would also wish that in India of my Dreams in 2047, there should be affordable shelter over every Indian citizen and to realize such dream in America the US government, which could not control the spiraling prices of homes offered by builders, in an effort to provide home to every American the Us government made it possible by way of a cheap and affordable mortgage lending as the government has no direct control over the selling prices of house and real estate. This cheap mortgage lending got the term subprime lending that lending below-prime lending rates or at cheap rates as we do see in India that Home Loans are provided at very cheap rates and effective rate of interest after considering the income tax exemptions is much below the rate of inflation – which indirectly means that your Home Loan account is at Zero Interest Rate.

A layman may not understand the intricacies of principles of economics and it is my earnest desire that every one of you needs to understand the Sub Prime Lending Crisis faced by the United States so that we can avoid similar situations in our own country. Through a hypothetical example below I am clearing all the doubts of my readers:     

Let us meet Krishna, who wants to sell his house after retirement as he wants to live with his son and grandchildren in California. He puts the signboard “For Sale – contact Krishna at xxxxxxxxxx”.

Now, we come across Lovely, who is 24 years young and is working professionally for the last 2-3 years and has just built up meager bank balance not sufficient to buy a house but she wants to buy Krishna’s House. Lovely and Krishna reach an agreement to buy and sell the house for a consideration of say $2,50,000 but Lovely has no savings as she has just finished up paying her educational and car loan. Now Lovely is a genuine buyer and her demand is basic economic demand with no speculation in mind.  She approached her Bank to make arrangements for paying the price of the house to be purchased.

Under normal circumstances, Lovely will have to contribute the down payment or margin money, which used to be around 25% to 35% of the settled price of the house to be purchased. In the above deal, Lovely will have to contribute $62500 to $65000 but Lovely had savings of just say $15000. In the United States, what happened? The government to facilitate available shelters to the needy the US government instructed the bankers to soften the conditions of down payment, rate of interest and other conditions in such a way that the individuals, who could never think of buying a home also started buying homes and the Banks provided loans to such individuals knowing very well that their borrowers had no repaying capacity, no stake of their own and even then they could dream of stepping into the home of their dreams. When the banks provide loans to such individuals who have no or little money to offer down payment then it is known as Subprime Loan.

Now Lovely is the proud owner of her dream house purchased from Krishna through Mortgage Loan and the people who could not afford to buy a house were suddenly given access to cheap credit, which leads to an increase in home sales.

When the banks started offering affordable and cheap credit, more and more people started buying houses resulting in prices of houses started skyrocketing. It is a simple Supply and Demand theory of Economics which says that when demand increases for an article, the price of that article goes up as well.

With the value of homes skyrocketing, firstly the people started building more and more homes to meet with increased demand, and smart people started buying homes as investment opportunities.

Banks had no mechanism to differentiate between the real people like Lovely, to whom the US Govt. wanted to help to acquire loans through cheap credit, and the smart people, who took the benefit of the same cheap credit as available to Lovely to make a profit by selling houses to real people like Lovely. This triggered the real people to also fall into the footsteps of smart people, which had a money multiplier effect.

During this real drama, the real people like Lovely got struck up with huge loan outstanding with no means to repay and Banks had to start initiating recovery proceedings forcing the real people to sell their housed purchased with cheap credits and once again smarter people again swung into action to buy such houses at cheap rates as due to increased selling pressure there was imbalance in supply and demand.

With the collapse of the housing market, there was a huge impact on the construction companies and builders or real estate players. Building of new homes came to stand still and there was a demonstration effect on almost all the sectors of the economy viz. reduced demand for skilled and unskilled labor causing unemployment, raw materials used in the construction activities resulting in decreased demand for wood, cement and all type of building materials forcing small units of suppliers of raw materials to put up their shutters.

To strengthen the vote banks the governments may think of providing Homes to those who can not actually afford them, or other facilities to the citizen as free dolls as governments have, at their command, the Public Sector Banks to make the cheap credits available to even the lethargic public who do not want to contribute anything to the national economy and ill afford to service the debts. Moreover, the national Governments need to put an end to any speculative activity of any nature through stock and share markets, commodities markets, metal markets so that there is real demand and real supply based on real prices as the readers will appreciate that if the big market players hoard food grain stocks or stocks of essential commodities there will be hue and cry due to supply chain getting suppressed by the hoarders of black marketers. When the national governments can control the hoarding of stocks of essential commodities, then why the national governments can not put an end to any speculative activity in such a way that when you wake up in the morning the US $ may drop down by 25% to Indian Rupee without any effort by the US or Indian Government but with the speculations going high in both the countries as speculators rule the market to mislead real investors who are big in number but are not organized to carry away the market sentiments.