Understanding the economic crisis

All major economies in the Western world will report negative growth in 2009 – the first time ever. There is now a 30% chance that every industrialized economy in the world will reports zero or negative growth in 2009, with the exception of China and India, who will report growth rates considerable lower than the past few years. There is talk of a great depression and a world wide recession from which we will take years to recover. We seem to be in a global economic meltdown. And we are having difficulty in trying to understand this looming catastrophe and what it will mean to us and our grandchildren. How did it all start? Who is to blame? What needs to be done now? How to make some sense of this financial and economic crisis?

Here is an attempt to try and understand it these tumultuous events.

Think of it as a three act drama. In the first act, we see the all too human desire – of wanting to own a home- playing out. In the old days, people would put down 20 % of the value of the house they wanted and take a mortgage to pay the balance over the next 20-30 years. The Banks scrutinized these loan applications for mortgages carefully to decide if the person could afford the house they were buying and would be able to make the monthly payments. But about a decade ago, human greed took over and went rampant. The banks found that they had more money than ever, thanks to profits from overseas and low interest rates for borrowing money domestically, and needed to make loans to increase their profits. So they decided to approve prospective home buyers for loans even when the buyer did not comply with the strict requirements of the past decades. These were the sub prime mortgages where no money down was required, documentation was waived ( no-doc loans) and ability to make the monthly mortgage payments turned a blind eye to. Of course the home buyers were happy and many of them bought 10-15 homes, none of them which they could afford, hoping to resell them in a growing property market to make a profit. The loan mortgage officers and the banks were happy since they got a cut from each such sale. And of course profits soared.

In the second act, the banks put together a large number of these mortgages into bonds called mortgage backed securities or collateralized debt obligations- CDO’s. The banks pay the rating agencies to grade these bonds so that they can then be sold on to investors on the Wall Street for a premium. The investors- which included banks worldwide, investment companies, hedge funds, pension funds, etc –bought these bonds as they provided a steady stream of money for the future. Some investors also insured them with insurance companies or banks ( the biggest insurer being AIG) against possible defaults in the future – of course again for a hefty premium. These insurances were the so called credit default swaps or CDS’s. No one really understands the risks of these bonds or how the securities are guaranteed. Nevertheless as their prices continuously climb, the securities become top selling items around the world.

As the third act begins, the story begins to come to a head in September of 2008. Some home buyers cannot make the payments on their houses. Home prices stop increasing and start falling as foreclosures spread in the neighborhood. Bankers have some of these failing loans on their book – but now they are called toxic assets. The prices of these bonds decline sharply. The investors who own these bonds demand compensation against their insurance policies from AIG. But AIG computer models did not predict that so many of these CDS will be called in and, in any case, they have not set aside any money for defaults. AIG believed in their computer models and no body was asking them to set aside money anyway. So now AIG has no money to reimburse the various investors, and they are millions of them and they are spread worldwide. If not paid, it means that all these banks and investors will lose all their money and perhaps go bankrupt along with AIG. For the moment, they stop lending any money to anyone. This in turn leads to more failures, more people out of work and more foreclosures all working in a vicious downward spiral with no end in sight.

Since so many of these banks and AIG are headquartered in the US, all of them appeal to the US government for help. In a panic, the US government decides to provide billions to AIG and then to the Banks hoping to stave off collapse of the financial system.

If you do not like dry as dust account above, listen to this musical instead.

But wait, the third act is not yet over. The hero of the drama ( aka “no drama Obama”) comes charging in and lays out a plan for the rescue of the world. The first step is to try and create jobs through major investments (aka the American Recovery act) which provide government funds to the states for infrastructure and to people directly. The second step is to lower interest rates and soften terms so that home buyers can remain in their homes and continue making mortgage payments. The third step is to provide funds to AIG so that they can honor their insurance commitments and the final step is to buy some of the toxic assets from the banks so that they do not need to set aside their own capital against these possible defaults but can use it instead for making more loans and provide credit to various investors for more investments that could lead to greater employment.

Will it work? Or will this drama end in tragedy? We do not know.